The federal government has stepped into a battle between banks and borrowers and for once, the government is on the right track: New stricter loan guidelines should be applied not just to interest-only and payment-option adjustable-rate mortgages, but also to an entire category of esoteric and extremely complicated loan products.
Six members of the U.S. Senate Banking, Housing and Urban Affairs Committee have asked banking regulators to subject hybrid ARMs to the same underwriting and disclosure guidelines that recently were mandated for other so-called “exotic” mortgages. Hybrid ARMs include such creatures as the “2-28” loan, which has a fixed introductory rate for two years and then fluctuates with market interest rates.
The new federal guidelines require federally chartered banks to disclose the risk of significantly higher payments and assess the borrower’s ability to make payments at the fully indexed rate on all payment-option ARMs and interest-only home loans. The guidelines were issued in September 2006 and have been adopted in modified forms for state-chartered institutions in more than 20 states as well.
The Mortgage Bankers Association disagrees with the senators’ position. The trade organization argues that hybrid ARMs, on average, experience rate increases of no more than 2-3 percent, that most such loans are refinanced early on, and that many borrowers couldn’t qualify for the loans without the more flexible guidelines.
The chief flaw in those arguments is that they don’t address what happens to borrowers who qualify for these loans but aren’t able to refinance before the payments become burdensome. The negative outcomes are suggested in the significantly higher delinquency rates for subprime borrowers who have adjustable-rate rather than fixed-rate loans. The delinquency rate in the third quarter of 2006 for subprime borrowers who had fixed-rate loans was 9.5 percent. The rate in the same period for subprime borrowers who had ARMs was 13.2 percent.
The problem is that too many loan products seem to have been designed to maximize lenders’ short-term profits with little or no regard for borrowers’ long-term financial health. Perhaps that’s reasonable or even commendable because banks are in business to make a profit. But limits are nonetheless appropriate and necessary as a matter of public policy. Cheaper cars may be more affordable, but safety standards are still the best way to prevent fatalities on the road.
The argument that tougher guidelines will prevent some people from buying a home is also flawed because borrowers as a whole also need to take more responsibility for their own financial decisions. The conservative road to home ownership through a sizeable down payment and a strong credit history may seem old-fashioned, but is nonetheless well paved, well traveled and more secure than the road of easy money.
The debate over loan guidelines really devolves into a tradeoff between higher rates of home ownership and lower rates of loan delinquencies and foreclosures. Should public policy create as many new homeowners as possible in the short term on a sink-or-swim basis? Or should public policy help ensure that new homeowners will be able to keep afloat financially in the long term? Guidelines that ignore the long-term impact of exposure to interest-rate fluctuations benefit lenders. Guidelines that consider the future worst-case scenario protect borrowers.
Government regulations shouldn’t exist to protect people from their own poor decisions. But when an industry makes its products so complicated that only experts can understand them when those products have such a huge impact on so many people’s lives, much more is at stake and regulation becomes not only an option but also a lesser evil than an unfettered marketplace.
Indeed, loan products have become complicated and some segments of the loan industry have become so predatory that protectionism is not only necessary, but long overdue. When simple 30-year fixed-rate mortgages were the norm, borrowers were in a good position to make well-informed choices. Today’s esoteric loans, which transfer the risk of interest-rate fluctuations from the lender to the borrower, are much riskier and much harder to understand. What’s more, lenders and investors can offset interest-rate risks through large pools of mortgages while individual borrowers are exposed to such risks on an undiversified basis of only one or two mortgages at a time.
Finally, lenders may come to appreciate the need for more sensible loan guidelines now that a federal district court judge in Wisconsin has ordered one bank to rescind some payment-option adjustable-rate mortgages because the disclosures, which included the phrase “5-year fixed,” were confusing. The bank intends to appeal the judge’s decision, according to a news report on the case.
Marcie Geffner is a real estate reporter in Los Angeles.
Copyright 2007. Marcie Geffner. All rights reserved. No part of this article may be used or reproduced in any manner whatsoever without written permission of the author.