Reflections on Mandatory Counseling

June 12, 2015

Economists who extoll the virtues of free markets concede that markets don’t work well under conditions of “information asymmetry” -- when one party to transactions, who knows a lot more than the other party, specifies the contractual terms of the transaction. Unfortunately, information asymmetry characterizes some very important markets, including the markets for medical services and home mortgages.

Regulatory Approaches to Information Asymmetry

In the home mortgage market, three approaches have been used to offset or neutralize the effects of information asymmetry. If legislators/regulators deem a provision in a loan contract as potentially injurious to mortgage borrowers, they can:

·        Bar lenders from offering it; this is regulatory prohibition.

·        Require lenders to disclose the feature including its dangers in documents provided in a timely manner to borrowers; this is mandatory disclosure.

·        Bar lenders from executing a transaction that includes the provision without first having received a certificate from an authorized counselor that the borrower has been counseled and understands the provision; this is mandatory counseling.

I have written many articles on regulatory prohibitions and mandatory disclosures in the mortgage market, most of it critical, but this is my first look at mandatory counseling. Except for reverse mortgages, it has not been much used until recently.

Mandatory Counseling in the Standard Mortgage Market

The Dodd/Frank law enacted after the financial crisis, which aimed broadly to change the financial system in ways that would prevent another crisis, called for imposition of mandatory counseling on mortgages with especially risky features. Last year, the newly created Consumer Financial Protection Bureau (CFPB) began to issue regulations implementing mandatory counseling rules. It attracted little notice, however, because very few mortgages requiring mandatory counseling are being written today. The problem to which it was directed no longer existed. Legislators and regulators, like generals, often prepare for the last war.

A good illustration is adjustable rate mortgages (ARMs) with provisions for negative amortization, where the loan balance can rise in the early years because the required payment does not have to cover the interest. During the bubble years preceding the crisis, millions of what were called “option ARMs” were written with such provisions, and when the bubble burst in 2007 the default rate on such loans rose to horrendous levels. If mandatory counseling had been enacted in 2004, much grief would have been avoided.

In 2014 when the Dodd/Frank rule became effective there were no negative amortization loans being written, and the problem of excessive liberality in lending rules that had prevailed in 2004 had flipped 180 degrees; lending rules were excessively restrictive -- and still are.

Mandatory Counseling in the HECM Reverse Mortgage Market

In the HECM reverse mortgage market, mandatory counseling has been a requirement from the beginning. The goal was to protect seniors and their most valuable possession, their home. My informal survey of borrowers indicates that most of them find the counseling useful to some degree.

The weakness of the requirement is that it only protects seniors against a class 1 mistake: taking a reverse mortgage when they would do better without one. Virtually all the seniors who are counseled have been to a lender first, which means that they have already made at least a tentative decision to proceed. Very few seniors opt out of the process as a result of counseling, suggesting that there are very few class 1 mistakes.

Mandatory counseling does not protect seniors against a class 2 mistake: not considering a reverse mortgage when taking one would substantially enhance the quality of their life. There may be millions of class 2 mistakes consisting of seniors who never heard of reverse mortgages, or never heard anything good about them, but would nonetheless benefit from one. They need counseling on how the various reverse mortgage options might benefit them, but no such facility exists.

Counseling directed to class 2 mistakes would focus on the best possible use of the reverse mortgage, which means helping the senior make the best choices among the different ways of drawing funds, the type of mortgage (ARM versus FRM), and the combination of interest rate and origination fee. These issues are now off-limits to counselors whose goal is preventing class 1 mistakes.

In a future article, I will describe a plan for creating a counseling facility directed at class 2 mistakes.  

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