In recent weeks, political will has begun to amass in support of federal efforts to stem subprime foreclosures. In particular, the Federal Reserve’s actions to prevent the collapse of Bear Stearns emboldened proponents of foreclosure assistance, who saw the Fed’s intervention as a bailout of Wall Street. At the same time, the spillover effects of subprime foreclosures on the broader economy have quieted critics of federal intervention.
The result has been increased congressional attention to the issue, with the House recently passing legislation that would allow FHA refinancing of troubled loans. Given President Bush’s promise of a veto, the prospects of the current bill appear dim. However, the willingness of a number of congressional Republicans to support foreclosure assistance raises the possibility of a legislative package under the new administration in early Spring 2009.
In Shelterforce’s Spring 2008 issue, John Taylor (“Help Now, Not Later”) outlines a pragmatic approach to mitigating the tide of subprime foreclosures. This response is deeply needed, and action must be taken to aid struggling homeowners. However, such actions should be viewed as a short-term response to the foreclosure crisis and not as a comprehensive solution to the issues raised by subprime lending.
These interventions, designed to prevent foreclosure, do not address the underlying market failures that led to widespread origination of risky mortgage products. In the short term, the market may appear to be self-correcting, as new subprime originations remain at a fraction of their 2005 and 2006 levels. However, investors’ newfound caution should not be expected to persist, especially as housing markets begin to recover.
Instead, regulators must expect lenders to continue to develop new and increasingly complex credit products. This reality must be central to a forward-looking revision of federal lending regulations, one that focuses on protecting consumers’ interests while permitting (and even encouraging) such innovation. After all, the initial growth of the subprime industry — through higher-cost, fixed-rate mortgages — was once hailed for creating unprecedented access to homeownership for many underserved groups.
The confusing truth of the subprime mess is that the culprit is not the availability of non-traditional products, per se, but rather the increasing gulf between the financial sophistication necessary to navigate the mortgage market and the ability of consumers to do so on their own. To be sure, some borrowers accepted undue risk, speculating on sustained growth in home prices. Many accepted mortgages that in hindsight were unsustainable in the long-term. However, we now know that the primary mistake of many of these households was to trust their mortgage lender, assuming that lenders would not approve loans that carried substantial risk of failure.
Regulators have thus far approached this issue by promoting financial education and consumer choice, a position that expects consumers to accumulate expertise to rival that of mortgage professionals. In contrast, a well-functioning mortgage market requires that consumers’ interests be equally represented at all stages of the mortgage transaction. Succeeding in this regard requires a legislative package that both broadly addresses the fallout from subprime foreclosures and enacts basic changes in the federal approach to mortgage regulation. Unfortunately, a long-term solution to these issues is complicated by two factors:
- 1. The fallout of the foreclosure crisis is concentrated in underserved communities and extends beyond the homeowners who are directly facing foreclosure.
The tragedy of the current crisis is that the impacts are concentrated in communities that have the least ability to withstand a wave of foreclosures. In study after study, researchers have documented higher rates of subprime activity in neighborhoods with high proportions of low-income and minority residents. (See “Losing Ground,” by Sarah Ludwig, Shelterforce, Summer 2007.)
Researchers at the Federal Reserve Board and the University of Pennsylvania recently examined the distribution of subprime lending activity across neighborhoods in seven major U.S. cities. Even after adjusting for differences in credit quality, subprime activity is strongly associated with a neighborhood’s income, educational, and racial/ethnic composition.
The direct result is that the residents of these neighborhoods will disproportionately bear the costs of foreclosures. Furthermore, the impact of an individual foreclosure is shared by the borrower who signed the risky mortgage contract and the borrower’s neighbors, including those who prudently searched for and originated low-risk mortgages. While the impact of a foreclosure on nearby property values is greatest in direct proximity to the foreclosed property, the effect has been shown to extend for several blocks. When multiple foreclosures are present, the effect can be devastating to the whole neighborhood.
In many communities, high foreclosure rates have left many homeowners owing more than their home is currently worth, a recipe for further foreclosures. Unless federal regulations convincingly eliminate the presence of problematic lending practices in these communities, this process all but ensures that mainstream lenders will remain wary of extending mortgage credit in these communities, even to well-qualified borrowers. In this way, the footprint of subprime foreclosures is left on entire communities, requiring policy responses that couple efforts to mitigate the extent of foreclosures with support for community-based lending activities.
- 2. Regulation of the mortgage industry must be adaptable to changing products and market conditions.
The current set of fair-lending policies and regulations was designed within the context of the traditional model of mortgage lending, in which a bank or thrift makes an approval/denial decision on a prime-rate mortgage. In recent years, the development of risk-based pricing and subprime lending has fundamentally altered lenders’ approach to mortgage origination, effectively rolling back the potency of these provisions. For instance, the Home Mortgage Disclosure Act enables community organizations to both observe the location of lenders’ originations and examine lenders’ approval/denial decisions. However, it offers little help to analysts seeking to monitor loan pricing or the use of potentially predatory mortgage terms.
The relaxation of existing regulatory provisions also occurred through changes in the institutional landscape of the mortgage market. Where prime lending activity continues to occur predominately through banks and thrifts, a disproportionate number of subprime lenders organized themselves as independent mortgage companies. By 2005, only 20 percent of subprime loan originations occurred through lenders subject to fair-lending examinations.
This previous experience with regulatory oversight suggests that any reforms must be based on a broad definition of lending activities, one that encompasses the full extent of existing and anticipated lending activities. For example, despite the dramatic reduction in funding for non-traditional mortgages, concerns have already surfaced in Ohio about the unscrupulous use of land contracts in a way that imitates the flipping of subprime refinance mortgages. The aggressive use of land contracts in this case was technically legal, and the scheme ironically came under investigation only when the lender attempted to bundle and sell pools of these products to investors.
A Comprehensive Legislative Package is Necessary
Given the emerging evidence of lenders’ aggressive and sometimes predatory practices, the temptation may be to identify and eliminate practices of specific concern. This response, while necessary for particularly egregious practices, offers at best a short-term solution.
Legislators must couple short-term responses with a more basic revision in the way consumers’ interests are represented during the mortgage-origination process. Our current situation exemplifies the insufficiency of regulation that holds “Let the buyer beware” as its core philosophy. Regardless of a consumer’s level of financial sophistication, mortgage professionals can be expected to have an informational advantage and to use this advantage to further their own interests. Unless lenders’ self-interest can be made consistent with consumers’ interests, this informational inequality is bad news for borrowers (and even worse news for borrowers with less education and/or financial knowledge).
One promising response is to create a fiduciary duty for mortgage originators to act in consumers’ best interests. Originators should be legally obligated to notify borrowers when a lower-cost option is available. However, their financial incentives and compensation must also mirror this affiliation with the consumer.
Jack Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania, and an expert on the operation of the mortgage industry, has proposed the Upfront Mortgage Broker Model, whereby brokers would be required to disclose an upfront price for their services prior to submitting the borrower’s application. This disclosure must include any compensation from lenders and be presented in simple terms (e.g., as a fixed fee or hourly rate). By decoupling broker compensation from the pricing of the mortgage, this mechanism eliminates the financial incentive to steer borrowers toward higher-cost products. It also effectively allows borrowers to directly observe and compare brokers’ financial incentives, improving their ability to select a trusted adviser.
A related approach should be taken to regulatory oversight of the mortgage market. Consumer interest groups and researchers must be provided the opportunity to evaluate the operation of lending markets, particularly within distressed communities. Previous attempts at this type of disclosure have offered some success in the past, but failed to keep pace with changes in the surrounding market. This experience suggests that future efforts must be based on a broad definition of lending activities that is responsive to future changes in the market. (See “Stemming the Red Tide,” by John Atlas and Peter Dreier, Shelterforce, Spring 2008.)
The need for these basic reforms creates an increased challenge to legislators. The deep needs of struggling homeowners in the short term require immediate action. However, legislators should seek to couple such assistance with more basic reforms to the regulatory structure. Not only are these reforms necessary to protect underserved consumers and communities, but they also offer the greatest chance of preventing future crises.
Unfortunately, there may be a limited political window for real reform. As the housing market slowly recovers and the subprime crisis falls out of the public agenda, the political will to stand up to industry lobbyists is likely to dry up as well. At present, given President Bush’s resistance to a comprehensive foreclosure rescue policy, the best chance for substantive reforms appears to be with Democratic success in the coming elections. But the new president and Congress will have to act quickly, while the issue remains in the forefront of the public consciousness. Until then, consumer advocates and struggling homeowners are left to hope that such action will not be too late.