Reforming the Market: Would HR 1728 Help?

May 4, 2009


Reading proposed legislation designed to “reform” the mortgage market is usually a depressing experience for me. Most of the proposals would take us further away from, rather than closer to a competitive system that works for borrowers. This is certainly true of HR 1728, called the Mortgage Reform and Anti-Predatory Lending Act, which was winding its way through Congress when this was written.  

Virtually every section of HR 1728 bears the fingerprints of consumer groups and/or mortgage lenders. Legislators and their staffs operate under the illusion that by adjudicating between these groups, they can achieve a balance between the interests of borrowers and those of lenders. This is an illusion because most of the policies espoused by consumer groups further the interests of consumer groups, not those of consumers.

The tragedy is that neither lenders nor consumer groups want to make the market work more effectively. Lenders don’t want it because a well-functioning competitive market would force down prices. Consumer groups don’t want a well-functioning competitive market because it would reduce the need for consumer groups. They prefer to entangle lenders in a maze of complex rules and potential liabilities, which provide opportunities to counsel and litigate for borrowers, and make special deals with selected lenders.

The mortgage market works poorly because borrowers know so little relative to the loan originators they deal with. Economists call this the problem of information asymmetry. There are two major tools for over-coming information asymmetry: mandatory disclosures and transaction-simplification rules, which are discussed in turn. 

Mandatory Disclosures

Under mandatory disclosures, Government mandates by law that lenders must disclose what borrowers need to know to negotiate on an equal basis. We have had mandatory disclosures for three decades, however, and it has not helped borrowers in the slightest. Mandatory disclosure has raised lender costs, lengthened transaction periods, but for the most part has left borrowers as confused and overwhelmed as before. Indeed, judging from the many hundreds of letters I have answered on the subject, the required disclosures in many cases have created more rather than less confusion..

The reasons are well known to everybody familiar with the process, including many of the consumer groups. The total volume of disclosures is excessive, overwhelming borrowers; a large proportion of disclosed items is garbage of no value to borrowers; some disclosed items are irreconcilable with others because they originate with different agencies; and none are abreast of the current market.

The major source of these problems is the early decision by Congress to make itself the source of many of the items subject to disclosure. The garbage disclosures all come from Congress. As just one example of many, the requirement that every transaction must show the sum of all scheduled monthly payments over the term of the loan, which is a completely useless number, is in the law.

Congress is also responsible for entrusting the two most important disclosures, Truth in Lending and Good Faith Estimate of Settlement, to two different agencies (HUD and the Federal Reserve Board), which have never succeeded in reconciling them. And of course, there is no possible way to keep disclosures up to date when substantive changes require new legislation.

The remedy is obvious. Congress should remove itself from disclosure operations and eliminate all existing Congressionally-mandated disclosures. Sole responsibility for all mortgage disclosures should be entrusted to one agency, which would have the legal authority to set and revise the rules as needed. This is the approach taken a few years ago, to good effect, in the UK.

The approach taken by HR 1728, in contrast, leaves the current disclosure system in place, adding a new set of mandatory disclosures to the pile. Under one of them, lenders will be obliged to disclose “the comparative costs and benefits of each residential mortgage loan product offered, discussed or referred to by the originator.” Compliance with this rule alone, ignoring extensive other new disclosures stipulated in 1728, would probably double the size of the garbage pile dropped in the lap of hapless borrowers. Needless to say, none of the existing garbage disclosures are eliminated.  

The cardinal sin of any disclosure system is over-load, because borrowers have limited time and limited attention span. Disclosing too much is the same as disclosing nothing because nothing is absorbed. Adding even a badly-needed and well-designed new disclosure to an existing pile of garbage disclosures does nothing but increase costs. An agency whose sole business is disclosure would quickly learn this, but Congress never will. 

Transaction Simplification Rules

Transaction-simplification rules are needed to separate third party service transactions from the mortgage transaction; to sharply reduce the number of lender charges that can vary from loan to loan; and to assure the validity of price quotes. These rules would empower borrowers to protect themselves from abuse by loan providers.

Rule 1, as simple as it is obvious, is that any third party service required by lenders must be paid for by lenders. The cost of these services would be embedded in the mortgage price, in the same way that the cost of automobile tires is embedded in the price of an automobile. But the price would be much lower because lenders can buy the services for less than borrowers, and it would no longer needlessly complicate the mortgage transaction.

Rule 2 would limit lender charges to points, expressed as a percent of the loan amount, which are traded off against the interest rate; and one fixed dollar fee, that must be posted and the same for all transactions. This rule would eliminate fee escalation, which is common practice.

Rule 3 would require that the prices that lenders lock be the same as the prices they quote to a borrower shopping the identical loan on the same day. This rule would eliminate low-ball price quotes, which pervade the market.

Not surprisingly, none of these rules are found in HR 1728, which is aimed not at empowering borrowers to protect themselves, but at replacing private decision-making by lenders with Government-imposed rules.

Some of the rules in HR 1728 are sensible, such as the requirement that mortgage originators be licensed. It would also prohibit the sale of single-premium credit insurance, which would be barred by my more comprehensive rule 1. But other rules in HR 1728, knee-jerk reactions to abuses that arose during the go-go years prior to the crisis, are toxic.

One involves mandating detailed underwriting rules and procedures, the Congress in effect telling lenders how they must assess risk. This is the same kind of legislative over-reach that Congress embedded in Truth in Lending, where it itemized the specific items that had to be disclosed, with the disastrous results discussed above.

A second toxic rule requires that lenders be responsible for assuring that borrowers who refinance obtain a “tangible net benefit.” As shown in The Tangible Net Benefit Rule, the net benefit in every refinance transaction depends at least in part on something known only to the borrower. Making the lender liable for what is in the borrower’s head is bad policy.

A third rule would require that all mortgage lenders retain 5% of the credit risk on any loan they sell. I am not sure if this rule will prove toxic or not, but it will raise costs, especially those of the smaller lenders who sell all the loans they write. A major consequence of this rule is discussed below.

HR 1728 provides an escape hatch from these three rules. The rules are in effect waived on “qualified mortgages.” A qualified mortgage is one that has an annual percentage rate (APR) no more than 1.5% above that of a “prime” transaction, on which the borrower’s total payment obligation does not exceed some maximum to be prescribed by regulation, has a 30-year term, and fully documents the borrower’s financial status.  

The qualified mortgage escape hatch from these rules will divide the market between qualified and non-qualified mortgages. The non-qualified group will be larger, since it will include all loans with terms other than 30 years, loans with debt-to-income ratios above the level deemed prime by the regulators, loans to borrowers having FICO scores below about 660, which pay a rate premium of about 1.5% in the current market, most loans to self-employed borrowers, most loans for investment purposes or on other than single-family houses, and all loans with risk variables that in combination require a risk premium of more than 1.5%. In the current market where risk premiums are extremely high, that covers a lot of ground.

HR 1728 says nothing about the down payment, the most important risk variable of all. If prime loans are viewed as having down payments of 20% or more, which is consistent with the concept of “prime”, mortgage insurance on loans with smaller down payments will increase their APRs, pushing many of them into the non-qualified sector as well.

Borrowers taking non-qualified loans will pay a price increment charged by lenders to cover the additional liabilities they assume under HR 1728. This will be an addition to the large risk premiums they already pay in a highly risk-averse market. Prime borrowers get a pass.

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