Mortgage Suitability

March 9, 2007, Revised August 28, 2009

Consumer groups believe that lenders should be held legally responsible for placing borrowers into mortgages that aren’t suitable for them. The argument is based on analogy to the securities industry: a Federal suitability rule has worked there, so why not with home mortgages?

Proponents of a suitability standard believe it is the answer to a raft of problems besetting the home mortgage market, including:

          *Borrowers selecting mortgages that are excessively risky.

          *Borrowers selecting mortgages that are not affordable.

          *Borrowers receiving no tangible benefit from refinancing.         

 Suitability Applied to Excessively Risky Mortgages

I discuss the first with particular reference to option ARMs (OAs), because it matches the securities market problem most closely.

The Problem of Bad Mortgage Selection: The following is a composite of many letters from borrowers who took out option ARMs (OAs) in 2005 and 2006, which were sent to me during the crisis years that followed.

"I took this loan because the monthly payment was much lower than any of the alternatives…The interest rate was only 1% because I qualified for a special program…I was led to believe that it would last for 5 years…I realize now that it didn’t and that my loan balance has been going up every month…I am afraid that next year my payment is going to increase so much I won’t be able to afford it…How do I get out of this mess? Do I have recourse against the loan officer (broker) who talked me into it."

OAs along with interest-only mortgages (IOs), which have some similar features, were marketed to borrowers who are attracted by the lower initial payments. In all too many cases, however, they didn’t understand why the payments are lower, and were not prepared for the risks of higher payments in the future.

Bad mortgage selection was a minor problem until the later stages of the housing bubble, when the volume of OAs and IOs exploded. The marketing of these mortgages was often based on deception. The most blatant piece of deceit, which I saw time and time again, was to lead or allow the borrower to believe that the very low quoted rate on an OA held for 5 years, when it actually held for one month. Because of their horrendous default rates, OAs stopped being offered in 2007, but IOs continued to be available.

Suitability As a Remedy: If lenders were held liable for making unsuitable mortgages, they would have to delegate operating responsibility to those who deal directly with borrowers: loan officers and mortgage brokers, who I will call "loan originators" or LOs. Their role is analogous to that of security brokers.

          Short-Run Versus Long-Run Financial Interest: Both LOs and security brokers have a financial stake in their clients taking a mortgage or purchasing a security. Judging that a mortgage or security is not suitable for a client costs them money in the short-run. However, the short-term interest of brokers in selling unsuitable securities is usually over-ruled by their long-term interest in maintaining a roster of satisfied clients. While transactions-oriented operators looking for the fast-buck exist, some of them operating out of the proverbial boiler rooms, they are on the periphery of the industry.

In the home mortgage market, in contrast, client-oriented LOs are the minority group. The great majority sell loans. To force LOs to follow a suitability standard,  lenders would have to hire an army of inspectors, and there is no one to ride herd on most mortgage brokers, who are independent contractors.

          Information Required to Determine Suitability: Determining the suitability of an investment or a mortgage requires balancing the objectives of the client against the risk of the instrument. In the case of investments, this is relatively easy because the client’s objective can almost always be framed in terms of risk versus return.

The objectives of mortgage borrowers, in contrast, are diverse, complex, and often not known by the LO. Here are 5 objectives that have been reported to me by borrowers who have selected OAs.

          *Reduce cash outflow to invest the excess in securities.
          *Reduce cash outflow to pay down a second mortgage.
          *Reflecting unstable income, pay principal when convenient.
          *Qualify to purchase more house.
          *Reduce current payment to avoid default.

I sometimes get involved in an exchange with borrowers on whether their particular objectives are worth the risk, and sometimes I express my opinion to them quite forcefully. I would not want the legal right to over-rule them, however, because I am not that smart.

Let’s look at the first because it is the case most analogous to the securities market model, and it illustrates clearly why the model can’t be extrapolated to home mortgages.

Many borrowers tell me that they took an IO or OA so they could invest the saving in monthly cash flow relative to other mortgages. Given this objective, whether or not the mortgage is suitable for the borrower depends on whether a) they have the discipline required to invest the savings every month rather than spend it; and b) they have access to investments that will yield a return higher than the mortgage rate without taking excessive risk.

An LO typically has no knowledge of the securities a mortgage borrower plans to acquire. Contrast that to a securities broker, who knows the risk of the investments being offered to his client because the broker himself is offering them. Furthermore, the mortgage loan provider has no special expertise for analyzing the wisdom of the borrower’s decision, and no special insight into whether the borrower is a disciplined investor.

The upshot is that making lenders responsible for mortgage suitability is not a manageable way of dealing with the problem that some borrowers select mortgages unsuitable for them.

Proposal by Federal Regulators For Additional Disclosures: An alternative approach to the problem of bad mortgage selection was proposed by an inter-agency group of Federal regulators in 2006 when the problem had reached alarming proportions.*  Instead of trying to amend existing disclosure requirements, which was badly needed even without the challenges posed by the new instruments, they would simply add the new requirements to the pile. The rationale for that was the need to get something out fast.

[*Proposed Illustrations of Consumer Information For Nontraditional Mortgage Products, Comptroller of the Currency, Office of Thrift Supervision, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and National Credit Union Administration, September 25, 2006.]

These proposals were actually pretty good but were never implemented, and it is just as well because they would not have accomplish their purpose no matter how good they were. The problem is that they would not have replaced any of the old disclosures, which are already excessive, but would have merely added to the pile that borrowers ignore.
Much of it is useless garbage, and few borrowers can extract the useful nuggets from the garbage. So all get short shrift, which would also be the fate of the new disclosures.

Unless, that is, there is someone directly involved in the process who tells the borrower “Read this one before you sign on, it is truly important.” But there isn't! The loan officers and mortgage brokers with whom borrowers deal have a financial incentive to do just the opposite. They sell IOs and OAs. Expecting them to promote disclosures that will raise questions and perhaps thwart a deal is like expecting an automobile salesman to call attention to low gas mileage or poor collision performance. The inter-agency group blinds itself to this reality by constantly referring to disclosures being provided by "institutions".

In refinance deals particularly, loan providers are not going to do anything more than the law requires. In dealing with a home purchaser, they can often afford to be neutral because the borrower who doesn’t take one instrument will take another. But in the refinance market, IOs and OAs are usually sold as a way of reducing payments, and if disclosures pointing up risks and future costs make the payment reduction less attractive, the result may be no deal at all.

A Disclosure That Would Work: Given the way in which mortgages are sold, a new disclosure added to the morass of existing disclosures can be effective only if it hits mortgage shoppers between the eyes, and cannot be swept aside by loan officers and mortgage brokers. My proposal is the following very simple rule:

Whenever a shopper is quoted a monthly payment, he must also be shown the highest monthly payment possible on that loan, and the month it would be reached, assuming the borrower always makes the minimum payment allowed.

The analogue to this proposed disclosure rule is the APR rule, which says that whenever an interest rate is quoted, an APR must also be shown. When the rate quote (payment) changes, the APR (highest payment/month) will also change. The difference is that because most borrowers don’t know what the APR means, that rule does very little good, whereas borrowers do understand what "highest payment" means.

This rule focuses on the primary motivation for taking IOs and OAs: the lower initial payment. By showing what can happen to the payment, it forces borrowers to acknowledge that the loans have a down side that should be considered. The rule would put borrowers on their guard, which is what a disclosure rule is designed to do.

Based on past experience, the lender and broker trade groups will find this proposal unacceptable – because it emphasizes the negative. They believe that mandatory disclosures should be "balanced", showing the good news as well as the bad.

But potential borrowers are besieged with good news, they hear about the possibility of "borrowing $150,000 for just $500 a month" from TV, radio, newspapers, and the internet. Many also hear it from their loan providers. To be effective, mandatory disclosure has to be negative because it is designed as a corrective to an onslaught of hype.

Mortgage Suitability Applied to Unaffordable Loans

The Problem - Is There One? While there is a wide agreement that bad mortgage selection has become a serious problem, the proposition that unaffordable loans have become a problem is questionable.

Those who see unaffordable loans as a serious problem identify it with high foreclosure rates. Foreclosures impose a high cost on the individuals who are foreclosed upon, and their communities may suffer as well. Further, the more liberal underwriting standards that emerged during the housing bubble, which made it possible for households with weaker financial credentials to become homeowners, also increased the potential for higher foreclosure rates.

There is little doubt that this process went too far, but when the bubble morphed into a financial crisis, the opposite problem emerged: well-qualified borrowers, especially the self-employed, found it very  difficult to qualify. (See Who Gets to Refinance In a Stressed Market?) The problem is that the excessive liberality that arose during the bubble precipitated new regulations requiring that all loans be affordable to the borrower -- loans based strictly on collateral were no longer acceptable. This was overkill.

The Rule That No Loans Can Be Based Solely on Collateral: This rule has been pushed by community groups, and was endorsed by regulators from the 5 Federal agencies. In my view it is dumb rule. preventing transactions that are in the clear interest of the borrower. One such case arises with elderly owners who are house-rich but income-poor. In Can I Live Off My House, I describe a case where I worked with a mortgage broker to keep a low-income widow in her home for the 5 more years she wanted to stay there. She had a lot of equity but couldn’t afford the taxes. The mortgage that allowed her to stay in the house would not meet any affordability test.

A case with even wider applicability is where a self-employed  borrower can't trade off the large equity in his home against not being able to meet the complete documentation requirement that emerged during the financial crisis. A potential borrower I counseled had a credit score of 800+ and 30% equity in his property, but could not get a loan. One can argue, in this case, that the rigid documentation requirement is equally to blame.

Other cases involve financial stringencies viewed as temporary by the borrowers, which collateral-based loans allow them to weather. Because of the collateral, the lender need not second-guess the borrower’s judgment that the stringency is temporary, a critical point when the loan amount is too small to justify high origination costs.

A large proportion of HELOCs is collateral based, because they are usually second-mortgages, often for small amounts, and high origination costs would make them unprofitable.

People who move to a new community without a job there sometimes take HELOCs on their existing house. This gives them the funds they need to make a substantial down payment on a collateral-based loan in the new community. The loan is unaffordable because when they buy it they have no income, yet the borrower is 99% sure that they will have income shortly.

If collateral-based lending was ruled illegal for institutions, the borrowers who need them will have nowhere to go except to the "hard-money lenders" – individual investors who specialize in collateral lending at high prices.

Mortgage Suitability Applied to No-Benefit Mortgage Refinancing

The Problem: Refinances that are not in the borrower’s interest were a major problem during the housing bubble, much less so in the ensuing crisis. I often receive mail from borrowers who realize they made a mistake when they refinanced, asking how to undo the mistake or whether they have any recourse against the loan provider.

The problem of refinances that involve no benefit to the borrower is associated with aggressive merchandising by mortgage brokers and loan officers during the bubble. They drummed up refinance business among borrowers who otherwise might never have given it a thought. Interest-only mortgages and option ARMs were their tools of choice. The first line of their pitch was often some variant of "Mrs. Jones, how would you like to reduce your payment from $1200 to $600?"

Applying the "Net Benefit" Rule of Suitability: Proponents of a suitability standard would make loan providers responsible for assuring that a refinance provides a net tangible benefit to the borrower. The "net" is critically important. All or virtually all refinanced mortgages provide tangible benefits, otherwise borrowers wouldn’t do them. The worst example of a predatory loan I ever saw – a borrower refinanced a zero rate loan into a 13% loan – put some cash in the borrower’s pocket.

Under a suitability rule, the loan provider must determine whether or not the benefit outweighs the cost. This would make loan providers responsible for something over which they have little or no control. The article Are Lenders Responsible For a Net Tangible Benefit? looks at the different reasons borrowers refinance and in each case, concludes that "whether or not the benefit outweighs the cost in any particular case depends heavily on what is in the borrower’s head." Loan providers do not have the information needed to second-guess them.

Concluding Comment

The suitability concept doesn’t help in dealing with bad mortgage selection, unaffordable loans, or refinances that involve no net benefit to borrowers.  Trying to apply the concept to these problems is potentially counter-productive to the degree that it results in vaguely-worded laws that make lenders responsible for things they cannot control.

The one area where the concept does make sense is disclosures, which are entirely under the lender’s control. Shifting responsibility for disclosures from the Federal Government, which has proven it is not equipped for it, to the private sector and a public board, is an idea whose time has come.

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