Consumer groups believe that lenders should be held liable if they allow borrowers to take home mortgages that aren’t suitable for them. Previous articles in this series concluded that a suitability standard was not an effective way to deal with bad mortgage selection, unaffordable loans, refinances that don’t benefit borrowers, or overcharging.
This article looks at suitability as a potential remedy for another remedy that has never worked properly: mandatory disclosure rules.
The conventional wisdom, which I shared for a long time, is that government should formulate and enforce disclosure rules because that assures uniformity of disclosures across the market. But if the disclosures mandated by government are useless or worse, which is the case, uniformity does not help borrowers. Indeed, poor disclosures can be worse than no disclosures because they often lull borrowers into a false sense of security.
Here are some of the problems with the existing system of federal disclosures:
Excessive Number of Disclosed Items: Disclosures are so voluminous that borrowers are overwhelmed, unable to extract what might be useful from what is garbage.
Poor Selection of Disclosed Items: For example, lenders must show the sum of all scheduled mortgage payments over the life of the loan, which not one borrower in a hundred actually pays, but not total lender fees, which every borrower pays. On option ARMs and HELOCs, lenders must disclose the initial rate, which may hold for one month, but not the margin, which affects the rate for the remainder of the term. Interested readers will find many more examples on my Web site under “Mandatory Disclosures.”
Obsolescence: The disclosures are not kept up to date. For example, in 2007, the disclosures had not yet recognized the special problems associated with interest-only mortgages and option ARMs, which had been around as early as 2002. The interagency group of federal regulators in late 2006 recommended that lenders voluntarily develop their own disclosures about these instruments, as opposed to revising the existing regulations, so it could get done more quickly.
The deficiencies of existing mandatory disclosures can be traced back to the ways in which they are developed.
Divided Responsibility: Responsibility for mandatory disclosure has been largely divided between the Federal Reserve System (FRS) and the Department of Housing and Urban Development (HUD). Each agency developed its own disclosure form without any consultation with the other. While there is overlap between them, there is no way for a borrower to reconcile the information on the two forms. Neither agency assumes responsibility for the confusion.
Uncoordinated Legislation: Mandatory disclosures arise out of the Truth in Lending Act, Real Estate Settlement Procedures Act, Equal Credit Opportunity Act and the Gramm-Leach-Bliley Act dealing with privacy. These laws were passed at different times to deal with different problems, and assigned administrative responsibility to different agencies. None of these laws require coordination among administering agencies.
Influence of Pressure Groups: While borrowers have little influence on the disclosures, interest groups have a great deal. In many cases, their footprints in the regulations are quite clear. While not always harmful in the instance, they are in the total because they invariably swell the size of the disclosures.
Disclosure is the one area in which the concept of suitability makes a lot of sense. Lenders could be held responsible for the adequacy of disclosures to borrowers because lenders are the experts on the mortgages they offer, and the suitability of disclosures does not depend on information about individual borrowers.
With lenders responsible for the suitability of disclosures, we can be sure the disclosures will be kept up to date. When a new mortgage is developed, the lender will be obliged to develop the disclosures that go with it. There would be no division of responsibility to confound the process.
However, to generate a superior product, a public entity would be needed with authority to rule whether disclosures are suitable. Otherwise, lenders would adopt the pattern that pervades securities disclosures, which is to disclose everything, including the most trivial and remote risks to the borrower. This would overwhelm borrowers (just as it overwhelms most investors), but would protect the lender against legal liability. On top of that, the disclosures would vary from lender to lender.
The public board would be charged with the responsibility of assuring that the disclosures proposed by lenders actually work for borrowers. If disclosures had to be approved by a public board, the major proposals would come from mortgage technology companies and the technology departments of major lenders. As particular disclosures were approved, they would quickly spread through the industry, with the result that uniformity would be widespread, if not complete.
The detailed charge to such a board — its legal basis, size, composition, method of selection and financing — are questions for another day.
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.