Bad mortgage selection has become a major problem with the explosion in the volume of complicated interest-only mortgages (IOs) and option ARMs (OAs). These instruments are often marketed deceptively to borrowers who don’t understand them and are not prepared for the risks.
The first article in this series considered one proposed solution: making lenders liable for the suitability of all mortgages including IOs and OAs. I concluded that this idea would not work mainly because the responsibility would have to be delegated to loan officers and mortgage brokers (“loan providers”). Loan providers mainly sell loans, which is inconsistent with responsibility for enforcing a suitability rule.
A second approach to bad mortgage selection, advanced by federal regulators from five agencies, is to impose a new set of disclosure requirements on lenders. Instead of trying to amend existing requirements, which is badly needed, they would simply add the new requirements to the pile. The rationale for that is the need to get something out fast.
While the agencies have developed a set of suggested disclosures, lenders are free to develop their own. Realistically, however, all or virtually all lenders will adopt the suggestions because it is their best protection against liability.
The suggestions include descriptions of IOs and OAs, and several illustrative tables. They are actually quite good, but their only impact would be to raise lender costs. I doubt that they would save a single borrower from folly.
Existing disclosures are largely ignored by most borrowers, and the new disclosures will simply be added to the pile. Borrowers ignore disclosures because too many hit them at one time, much of it is useless garbage, and few borrowers can extract the useful nuggets from the garbage. So all get short shrift, which would also be the fate of the new disclosures.
Unless, that is, there is someone directly involved in the process who tells the borrower, “Read this one before you sign on, it is truly important.”
But there isn’t! The loan providers with whom borrowers deal have a financial incentive to do just the opposite. They sell IOs and OAs. Expecting them to promote disclosures that will raise questions and perhaps thwart a deal is like expecting an automobile salesman to call attention to low gas mileage or poor collision performance. The interagency group blinds itself to this reality by constantly referring to disclosures being provided by “institutions.”
In refinance deals particularly, loan providers are not going to do anything more than the law requires. In dealing with a home purchaser, they can often afford to be neutral because the borrower who doesn’t take one instrument will take another. But in the refinance market, IOs and OAs are usually sold as a way of reducing payments, and if disclosures pointing up risks and future costs make the payment reduction less attractive, the result may be no deal at all.
Given the way in which mortgages are sold, a new disclosure added to the morass of existing disclosures can be effective only if it hits mortgage shoppers between the eyes, and cannot be swept aside by loan officers and mortgage brokers. My proposal is the following very simple rule:
Whenever a shopper is quoted a monthly payment, he or she must also be shown the highest monthly payment possible on that loan and the month it would be reached, assuming the borrower always makes the minimum payment allowed.
This rule focuses on the primary motivation for taking IOs and OAs: the lower initial payment. By showing what can happen to the payment, it forces borrowers to acknowledge that the loans have a downside that should be considered. The rule would put borrowers on their guard, which is what a disclosure rule is designed to do.
Based on past experience, the lender and broker trade groups will find this proposal unacceptable — because it emphasizes the negative. They believe that mandatory disclosures should be “balanced,” showing the good news as well as the bad.
But potential borrowers are besieged with good news; they hear about the possibility of “borrowing $150,000 for just $500 a month” from TV, radio, newspapers, the Internet and their loan providers. To be effective, mandatory disclosure has to be negative because it is designed as a corrective to an onslaught of hype.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.