Policy

Shiller’s “Continuous-Workout Mortgages” Won’t Address the Crux of the Problem

Robert Shiller in an article in The New York Times proposed a more flexible home mortgage that he argues would help prevent crises like the current subprime mortgage crisis. Shiller, […]

Robert Shiller in an article in The New York Times
proposed a more flexible home mortgage that he argues would help prevent crises like the current subprime mortgage crisis.

Shiller, an economics professor at Yale and author of The Subprime Solution: How Today’s Global Financial Crisis Happened and What to Do About It, proposes a mortgage with “automatic adjustments based on shifts in national housing-cost indexes and futures markets …..as well as economic indexes like the unemployment rate.”

Shiller’s proposal (and his entire article) misses the crucial point that the current subprime mortgage crisis has been caused not by rigid mortgage products, but by fraudulent practices, abusive mortgage lending terms (such as exorbitant mortgage rates, high unjustified fees, prepayment penalties, and loans with negative amortization), and fly-by-night operators who could unload the primary mortgages to investors in the secondary market and wash their hands off these mortgages altogether.

Mortgage brokers played a key role in the abusive practices of the subprime market. Home mortgage loans were made to some people who were clearly not in a position to make the monthly payments over the long term. Some loans had negative amortization from the day the loans were initially made.

How will a continuous workout mortgage prevent such abuses? If anything, the scope for abuses only increases when there are non-standard mortgage products.

Shiller’s article did not propose regulations to curb abusive lending practices. He seems to suggest that having private lenders provide the continuous workout mortgages will solve the problems in the mortgage industry.

Shiller’s proposal to have a mortgage with “automatic adjustments based on shifts in national housing-cost indexes and futures markets …., as well as economic indexes like the unemployment rate” has other problems as well. Housing markets, as we know, are local — if national housing price indexes are going down (let’s say), a particular homeowner might be facing exactly the opposite situation — rising prices. Imagine if he/she is stuck with an “automatic adjustment” in the wrong direction.

Similarly, it doesn’t make sense linking mortgage adjustments to the national unemployment rate. It would be far more useful to have custom-built mortgage adjustments for each individual’s circumstances — such as his/her unemployment or changes in prices for the home owned by the individual. So these automatic adjustments would work like an insurance policy — insuring against sudden job loss or housing price declines.

Naturally, this insurance will come at a cost, as Shiller acknowledges: “cost of workouts would be priced into the original mortgage rate.”

Now, watch out for some statistical discrimination as well as other discrimination: Groups with the highest likelihood of becoming unemployed and whose neighborhoods have the highest risk of housing price declines will face a higher mortgage rate, as the cost of the workouts get priced in.

Isn’t this the so-called risk-based pricing that was used by subprime and predatory lenders to lend at exorbitant rates to minorities and other vulnerable borrowers? Isn’t this practice — and other abuses of “risk-based pricing” such as arbitrary fees — what contributed to the present crisis?

If there is one thing we should have learned from the subprime mortgage crisis, it is that when private lenders are allowed leeway to deviate from standard mortgage products, they will use this flexibility to squeeze out the last dollar in profits from borrowers. And with vulnerable borrowers (such as those who are not very financially savvy), they will use every marketing ploy to get them to accept terms that are very onerous to the borrower but highly profitable to the lender and investors.

The mortgage industry ought to change in the direction of standardization. In particular, exactly the same mortgage products should be offered in minority neighborhoods, inner-city neighborhoods, and older neighborhoods as are offered to white borrowers in neighborhoods with healthy housing markets. If private lenders are not willing to provide these “prime products,” then the government should step in and provide them.

The mortgage rate offered for a primary residence to any home buyer in America should be the prime rate. And, at least post-Panic of 2008, no one can complain that such a move will lead to big government. A government agency committed to providing prime mortgage credit to home buyers for their primary residence will cost much less than $700 billion.

If homeownership is a national goal, then why not have this available to everyone at fair and reasonable terms? Sure, lower-income people will most likely own homes of low value, and rich people will own larger and better-quality homes. That is acceptable. But mortgage terms — mortgage rate, fees, length of maturity etc. should not be disparate for lower-income and higher-income people.

And after all, a home mortgage loan is secured credit. It is backed by a valuable asset — the value of the home. If homes are realistically valued in the first place (not over-appraised, as was a common abusive lending practice that contributed to the present problems), and if neighborhoods and communities are not neglected, there is no reason to expect that a home will not at least maintain value over time.

So there is really no risk for a government agency to make a secured loan on prime terms for the ownership of one primary home to all citizens who want to own a home. If homeownership has all the social benefits that are commonly accepted by policy makers (frankly, I am a little skeptical), then this is definitely worth doing.

If we really want more Americans to be homeowners and sustain homeownership, we can do it.

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