Editor’s note: This is the second in a two-part series. Read Part 1, "Why no subprime ‘criminals’ have gone to jail."
As noted in last week’s article, the subprime debacle arose out of a housing bubble within which decision-makers assumed that house prices would rise indefinitely. Rising home prices convert virtually all home mortgage loans into good loans.
Within the bubble culture, violating underwriting standards in order to make homeowners out of those who could not meet these relics of a bygone era was a good deed — as well as good business. Bank regulators, as well as mortgage lenders and investment banks, were caught up in it.
When the housing bubble in the U.S. collapsed, the resulting financial crisis generated enormous costs — costs that could have been many times higher if not for timely and massive interventions by the federal government.
The consensus of the post-mortems was that the bubble and subsequent crisis never should have happened, and that new laws were needed to prevent it from ever happening again. The result was Dodd-Frank, a massive piece of legislation directed almost entirely to that end.
Dodd-Frank is typical of legislation passed in the immediate aftermath of disasters. With the disaster fresh in mind, political barriers were easy to overcome, which is the case for acting promptly. The downside is that the results in many cases are knee-jerk and not well thought out.
Since the major abuse within the bubble was the violation of underwriting standards, a major thrust of Dodd-Frank was to create barriers to that ever happening again. The barrier was to expose lenders to legal liability if they made loans that were not "qualified mortgages" as that term was to be defined by the new Consumer Financial Protection Bureau (CFPB) established by Dodd-Frank.
The CFPB recently declared that qualified loans cannot have any of a long list of provisions that are viewed as risky, including negative amortization, an interest-only period, a balloon payment, waiver of all documentation requirements, or a term exceeding 30 years. Under these rules, which become effective Jan. 1, 2014, a lender making an unqualified loan that goes into default is vulnerable to legal action by the borrower. For all practical purposes, therefore, the market will consist of qualified mortgages.
This approach will probably prevent another housing bubble, but it is the most anti-consumer measure that could have been adopted — and under the guise of "consumer protection." Consumers lose a raft of potentially useful options that render mortgages unqualified, no matter how useful they may be in a particular case — not to mention the innovations of the future that will not materialize. Innovation would require application to CFPB to accept a new option as "qualified." The home mortgage market will be thoroughly bureaucratized.
It didn’t have to be done this way. The many options that existed during the bubble period could have been preserved by eliminating the profit illusion associated with the riskier ones. The profit illusion was an essential part of the bubble — without it, the bubble could not have been maintained or even begun.
You eliminate the profit illusion by eliminating the profit associated with violating underwriting guidelines. Existing accounting systems allow lenders to record as income all the upfront fees collected in originating loans, and all the interest received from borrowers beginning in month one.
During the bubble, the same accounting system was used for the best prime loans and the riskiest of subprime loans. When large numbers of the riskier loans went into default, it became clear that a major part of the "income" collected in prior years was not income at all but should have been set aside as a reserve for future losses.
The profit illusion can be eliminated by requiring that reserves be set aside on each loan based on its risk. This is "transaction-based reserving," or TBR. It is common practice in the insurance industry, including mortgage insurance, where it works very well.
As applied to home mortgages, a portion of the risk increment paid by the borrower, say 50 percent, would constitute a required allocation to a contingency reserve. For example, if a prime mortgage were priced at 4 percent and zero points, the reserve allocation for a 6 percent, 2-point mortgage might be 1 percent plus 1 point. Allocations to contingency reserves don’t become income for an extended period, and are not taxable until released.
The designers of Dodd-Frank operated in an environment hostile to lenders, who were blamed for the crisis, and solicitous of consumers who were viewed as victims of it. Yet their "remedy" has been welcomed by lenders, who appreciate knowing exactly what the rules are, while it deprives consumers of options that they would otherwise have, and ought to have. This is what comes of legislating in the immediate aftermath of a crisis.
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.
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