Deregulation That Will Make the Home Mortgage Market Work Better: Eliminating Rigid Income Documentation Rules

December 20, 2016

The incoming Trump administration has made very clear that eliminating regulations of all types was a major agenda item. The question is whether or not they can do that effectively, and the home mortgage market will be a good test case. New home construction today is running well below what would ordinarily be expected at the current phase of the business expansion, and a major cause may be some of the regulations imposed in the aftermath of the financial crisis.

I underscore “some” because regulation is not a quantity – something that conservatives want less of and liberals want more of. Some regulations are good and some are bad, and the objective ought to be to get rid of the bad ones and retain or even strengthen the good ones as needed. A good regulation is one that makes the market work better, and a bad regulation is one that doesn’t, which makes it worse than no regulation.

It often takes a great deal of knowledge and wisdom to fashion a good regulation, and here also you have a political split. Conservatives usually have less confidence than liberals that regulators have the competence necessary to fashion good regulations.  But what we are going to see in the next year or so is how well a new batch of conservative regulators do in identifying the bad regulations that need to be axed. This article aims to give the new mortgage regulators a head-start by identifying a particularly bad regulation directed to mortgage documentation requirements.

In the decade prior to the financial crisis, documentation requirements evolved from full doc for every borrower to a range of requirements, from full doc to no doc, with 5 categories in-between.

The less complete the documentation, the higher the price of the mortgage and the larger the required down payment and credit score. These three poles of the underwriting system were flexible in the sense that a good score on one could offset a poor score on another.

That sensible market-based system worked well until the housing bubble emerged in the early years of this century, when lenders and borrowers alike came to believe that house prices would rise forever. When house prices continually rise, it is very difficult to make a bad loan because borrowers unable to pay can sell their houses at a profit.

In that atmosphere, large numbers of borrowers elected less than full documentation so that they could exaggerate their incomes and purchase more costly houses, while many lenders accommodated them by relaxing their standards and reducing their surveillance. When the bubble burst in 2006, mortgage defaults and foreclosures rose to levels not seen since the 1930s.

The Federal Government in response imposed a range of new regulations, one of which was to eliminate all documentation options other than full documentation, and to make it an absolute requirement. No longer could inadequate documentation be offset by good credit or large down payment. That is when I began to receive letters from self-employed loan applicants whose applications were rejected because they could not document adequate income, notwithstanding that their credit was pristine and they were making a substantial down payment. Many of these rejected borrowers are small business owners who collectively are important contributors to economic growth.

In an important recent article in The Journal of Finance Brent W. Ambrose, James Conklin and Jiro Yoshida show that the income exaggerations that played a major role in the boom and bust were concentrated among borrowers who could have documented their incomes with W-2s but chose not to so they could lie. Self-employed borrowers did not lie about their incomes.

The implications for regulatory reform are very clear. Full income documentation should be required only for those with incomes shown on W-2s. Self-employed applicants should have access to multiple documentation options, and underwriters should have discretionary power to balance the option selected against the applicant’s credit score and down payment.

This is one small yet important example of a bad regulation that is easily fixable when there is a will to fix it. In the weeks to come, I plan to identify a number of others.

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