My mailbox today is stuffed with letters from borrowers who are being barred from the conventional (non-FHA) market by mortgage underwriting rules that have become increasingly detailed and rigid. In many cases the rules leave no room for discretion by the loan originator, and where there is discretion, originators are often too frightened to use it because of the heightened risk of having to buy back the mortgage or incur other penalties.

 Fannie Mae and Freddie Mac are the major source of the problems, but the large wholesale lenders who acquire loans from thousands of small mortgage lenders and mortgage brokers have their own rules which in many cases are even more restrictive than those of the agencies. Before the financial crisis, compliance with underwriting rules was subject to casual spot checks. Today, every loan is carefully scrutinized, and those that don’t past muster must be repurchased by the seller. The loss on a buyback wipes out the profit on about 8 loans of the same size.

 The Affordability Requirement Is a Curse

 The most important of the underwriting problems involve income documentation. The abuses that arose during the go-go years before 2007 had such a major impact on the mindsets of lawmakers, regulators and Fannie/Freddie that an affordability requirement has become the law of the land; all loans must be demonstrably affordable to the borrower. I have already written about the absurdity of this requirement, which makes ineligible many perfectly good loans to good people – such as the lady with a lot of equity and perfect credit who wants to borrow the money she needs to stay in her home for a few years before she sells it.

 The affordability requirement imposes an especially heavy burden on self-employed borrowers, who face the greatest difficulty in proving that they have enough income to qualify. Prior to the crisis, a variety of alternatives to full documentation of income were available, including “stated income,” where the lender accepted the borrower’s statement subject to a reasonableness test and verification of employment.

The Self-Employed Are Back to Square One 

 Stated income documentation was designed originally for self-employed borrowers, and it worked very well for years. Then, during the go-go period preceding the crisis, the option was abused. Instead of curbing the abuses we eliminated the option, which is akin to outlawing knives after an outbreak of hari kari. Rejection of loan applications by self-employed borrowers with high credit scores and ample equity are now commonplace. This letter is typical.

 “We were pre-approved, found a home for less than the amount approved, paid for appraisal, inspection, earnest money, title company, then a few days before closing the lender told us they cannot honor the approval because our business income was 40% lower in 2009 than 2008…can they do this?”

 In this case, I have not been able to determine whether there was a rule change — from using the average of the two years to using the lower of the two years — or whether it was the interpretation that changed, but the result is the same: rejection. Before the crisis, this home purchase would have been saved by using stated income documentation.

 Note that in this particular case, the cost of rejection to the buyer was raised by the incompetence of the lender. Allowing the buyer to proceed almost all the way to a closing before checking their tax statements is inexcusable. Any home buyer whose income is business-related should be sure to get their income approved before putting down earnest money and incurring other mortgage expenses.

 The Robotization of Underwriting

Loan underwriting, the process of deciding whether a loan application should be approved or rejected, used to be a profession that demanded a high level of discretion and judgment. That is no longer the case, as illustrated by this letter.

 “My wife recently applied in her name only for a mortgage to purchase a single family home which will be our residence. She earns a $70,000 salary that is more than enough to cover the mortgage and has a credit score of 800. We have no debt.

 I work from home trading stocks. In the market crash 08/09 I sustained losses in my trading account of $90,000. We file our taxes jointly. Today my wife’s application was refused citing Fannie/Freddie guidelines that state that tax losses must be deducted from her income…We are stunned…”

 This case is typical of many that used to involve a judgment call by the underwriter. The issue is whether the husband’s capital loss actually indicated a potential threat to the ability of his wife to service the mortgage. If the husband had $400,000 in his trading account, for example, the plausible judgment would be that such a threat was remote and the loan should be approved. But in this case, the underwriter did not explore the circumstances — the rejection was automatic based on the rule. With no alternative types of documentation available, the loan was not made.

 Why didn’t the underwriter use the judgment for which he is presumably being paid? He acted like a robot instead of an underwriter because his employer had instructed him to stay within the letter of the rules. The risk from making a judgment call that turns out to be mistaken has become so high that lenders find it more prudent to avoid such calls altogether.

The Lowest Rates Are Available to Few 

 In addition to curtailing unduly the number of potential borrowers who qualify for loans, the current policies of Fannie and Freddie have shrunk the number of acceptable borrowers who qualify for the best prices to a very small group. To get the lowest rate possible on a mortgage sold to Fannie Mae, the borrower must have a credit score of 740 and a ratio of loan to property value of no more than 60%. The property must be single family but not manufactured, and in an area not subject to an “adverse market delivery charge.” The mortgage cannot have an interest-only provision, and any second mortgage has to be included in the 60% limit noted above.

 Fannie and Freddie are working at cross purposes to the Federal Reserve. The Fed is trying to counter economic weakness by forcing down long-term interest rates, including those on prime mortgages, to all-time lows. Fannie and Freddie have made it increasingly difficult for potential borrowers to qualify, and cut the number who qualify for the very best rates to a trickle.

 Thanks to Jack Pritchard for helpful comments.

Related posts:

1. The Problem In 2010 Is Underwriting
2. Change Jobs Before Or After Applying For a Mortgage?
3. Will the “Financial Stability Act of 2010″ Improve Mortgage Disclosures?

As an illustration, a large proportion of the consumers who took option ARMs during the go-go years leading to the crisis believed that the initial interest rate, in many cases as low as 1%, held for 5 years. In fact, that rate was good for only the first month.

Borrowers taking option ARMs received a booklet about ARMs in general, a description of all ARM programs in which they expressed an interest, and historical or worst cases examples of how ARMs work. But the one piece of information they needed to avoid a horrendous mistake was not there. The default rate on option ARMs today is horrendous, and it is expected to be higher next year.

Divided Responsibility For Mortgage Disclosures

A major reason why government-mandated mortgage disclosures are so bad is that there are too many agencies involved in the process. One consequence of multiple agencies is excessive disclosures, as each agency focuses on its own with little or no regard for the requirements imposed by the others. Voluminous disclosures tax the absorptive capacity of borrowers, and make it hard for them to find what is really important, because it may be concealed in a sea of garbage.

Multiple agencies also lead to inconsistencies between the disclosures required by the different agencies, to the befuddlement of borrowers. For several decades now, borrowers have had to live with the Good Faith Estimate required by HUD and the Truth in Lending statement required by the Federal Reserve, with no way to reconcile or connect the two.

But perhaps the worst result of having too many cooks is a lack of clear accountability for the total package of disclosures. Since no one agency is responsible for keeping disclosures up to date, they are always behind the curve in responding to market developments.

Wrong Agencies Have Responsibility For Mortgage Disclosures

Two of the cooks should not be in the disclosure business. By far the worst is the Congress, which is the least competent and the least responsive to the need to stay current. The original Truth in Lending legislation in 1968 included specific mandated disclosures that are as inane today as they were then. Once specific disclosures are mandated by law, it seems impossible to get rid of them, no matter how useless they are or become.

I don’t believe the Federal Reserve should be in the consumer disclosure business either. While the Fed has always been the most competent of the Federal agencies, it has done a wretched job with disclosures. The problem has been that consumer protection has had the lowest priority among its diverse responsibilities, and properly so. Monetary policy and bank regulation are its major concerns, and going forward its responsibilities in these areas will only get larger as it becomes the key player in dealing with issues connected to systemic vulnerability.

The third agency involved in mortgage disclosures is HUD, which is highly bureaucratic and politicized but at least its responsibilities for mortgage disclosure are consistent with its overall mission and other responsibilities. The new Good Faith Estimate that became effective this year against fierce opposition is a substantial improvement over the old one, but it took forever.

Disclosures Under the “Restoring American Financial Stability Act of 2010”

Given this backdrop, the creation of a new consumer protection agency under the “Restoring American Financial Stability Act of 2010” appears to herald a new beginning. The agency will assume authority for disclosures in all consumer markets, absorbing the disclosure responsibilities of the Fed and HUD. Indeed, the new agency is instructed to “combine the disclosures required under the Truth in Lending Act and the Real Estate Settlement Procedures Act of 1974 into a single, integrated disclosure…” [Sec. 1032 (f)]

However, while the agency would take over disclosure responsibilities from the Fed and HUD, Congress does not deal itself out of the disclosure picture. On the contrary, the Act may have more new mandated disclosures than the original Truth in Lending Act. Some of these are sensible, such as providing an early warning of a pending rate increase on ARMs, and the Act could have instructed the new agency to implement a disclosure for that purpose. Instead, the Act specifies exactly what the disclosure must be, making the agency responsible for a disclosure it did not design.

And it gets worse, because some of the specific mandated disclosures in the Act are nonsensical and will prejudice the ability of the new agency to do its job. For example, lenders will be obliged to disclose the “wholesale rate of funds”, whatever that is. They must also disclose the total amount of interest paid over the life of the loan as a percent of the loan amount, which is a useless number for any borrower making a financial decision. I could go on at great length. The Act, instead of using the creation of a new agency as the occasion for eliminating the role of Congress as a source of mandated disclosures, reinforces that role.

Related posts:

1. Will the “Financial Stability Act of 2010″ Improve Mortgage Disclosures?
2. ARM Disclosures: Government Drops the Ball
3. How to Protect Mortgage Borrowers

Much the best way to protect consumers in the home loan market is to simplify the structure of the market so that borrowers have direct access to the information they need without Government intervention. This could be done by creating direct links between the primary market where loans are originated, and the secondary market where they are priced.

I noted in a previous article in this series that borrowers in Denmark can borrow at a rate equal to the current yield on the secondary market price of their loan, which they can easily find on-line, plus a standard .50% markup. This leaves only up-front lender fees to be negotiated on a case-by-case basis, and these are set competitively because borrowers are fully capable of distinguishing higher fees from lower fees. There is no required Truth in Lending or Good Faith Estimate documents because none are needed.

Another important simplification would be to require that all third party services required by lenders, such as title insurance and appraisals, be purchased by lenders, with the cost included in lender fees. This would eliminate multiple costs and transactions that needlessly confuse borrowers, while reducing the cost of these services. In contrast to borrowers, lenders are knowledgeable purchasers and can purchase in quantity.

In Denmark, third party costs associated with mortgages are inconsequential. The Danish Government guarantees the accuracy of title registration records, making private title insurance unnecessary. Costs of appraisals and registration fees are borne by lenders and passed on to borrowers in lender fees, which is how it ought to be done here.

But I don’t fool myself into believing that these badly-needed changes will be enacted. Legislation covering mortgages is lobbied mainly by the mortgage banking industry and the consumer groups, and while they differ on many issues, neither would support the reforms described above. The mortgage bankers wouldn’t support them because they would reduce the profitability of mortgage banking, and the consumer groups wouldn’t support them because they would reduce or eliminate the need for consumer groups.

Making Mortgage Disclosure Rules Effective

This raises the question of how best to protect borrowers within our existing market structure? Borrowers today are exposed to an army of loan originators who know vastly more about the products, prices and procedures than they do, and who generally use that information to their own advantage. We have looked to Government to redress this information in-balance by enacting mandatory disclosure rules, but for the most part this effort has failed. In counseling thousands of borrowers on disclosure issues, I find that the number of borrowers benefitting from the disclosures is no larger than the number confused by them, and a much larger group ignores them altogether.

The major shortcoming of existing mortgage disclosure rules is that critical information that borrowers could use often is not disclosed, or is not disclosed early enough to be useful, and when it is disclosed, it tends to gets lost in a torrent of garbage disclosures. Borrowers are swamped with information they cannot use.

Why? A major reason is divided responsibility. At the Federal level, responsibility is divided between HUD and the Federal Reserve, which do not coordinate, while state disclosures add to the pile. Divided responsibility encourages disclosure overload, because no one agency has responsibility for the totality of disclosures. In addition, inconsistencies arise between disclosures mandated by the different agencies.

A second reason for the failure of mandatory disclosures is that the agencies with disclosure responsibilities are burdened with other more pressing responsibilities. This is particularly the case with the Federal Reserve, whose major priority has been monetary policy and its second priority has been the safety and soundness of the banking system. Consumer protection has been a poor third, with the lowest claim to the Board’s attention. Those priorities are not going to change. Indeed, with the Fed assuming more responsibility for the stability of the non-bank financial sector, de facto if not yet de jure, consumer protection is likely to have an even lower priority in the future.

These are the reasons I have supported the Administration’s proposal for a new Consumer Financial Protection Agency (CFPA). The agency would replace the existing system of fragmented responsibility, and it would not be burdened with responsibilities other than consumer protection. The Administration’s proposal for CFPA is discussed in detail on my web site.

Related posts:

1. How to Protect Mortgage Borrowers
2. Fed TILA Proposals Indicate It Should Exit Consumer Protection
3. Do Balloon Loans Protect Mortgage Borrowers?

In my view, over the long-run one of the agencies should be entrusted with developing a private secondary market to replace the one that collapsed during the crisis. In the short run, both agencies need to get on-board the Government’s policy of stimulating economic recovery.

Developing a New Private Secondary Market

As discussed in Redesigning the Housing Finance System, the new market should have the following major features:

*Firms issuing mortgage securities retain full liability for every security they issue. This makes the market safe for investors.

*New loans are financed by selling them directly into open security issues of the same type. This makes the market efficient.

*Borrowers have direct access to the secondary market, borrowing at the price of the security sold to finance their loan, plus a rate markup and fees charged by the lender. This makes the market transparent, protecting borrowers against being over-charged.

*Borrowers have the right to pay off their mortgage by buying back an equivalent amount of bonds, at the lower of par and the market price. This makes the market stable, protecting borrowers against rising market interest rates.

Fannie Mae and Freddie Mac should compete to determine which will be selected to develop this new market. If there ever was a need for two agencies in the past, there clearly will be no such need in the future. The agency selected to oversee the development of the private market would recast its own secondary market operations so that the markets work in the same way. The other agency should be placed in liquidation. The surviving agency should be the one that wins the competition between them for the best secondary market implementation plan.

Participating in Economic Recovery

Although they are now part of the Federal Government, the agencies are operating at cross-purposes to the Federal Reserve, as if they are trying to earn their way out of conservatorship. While the Federal Reserve has purchased huge amounts of their mortgage backed securities to lower interest rates for home buyers and refinancers, the agencies have been adding a series of price add-ons that have raised financing costs to countless millions of potential borrowers.

The price increments imposed by the agencies are called “Loan Level Pricing Adjustments” (LLPAs) in Fannie jargon, and “Post-Settlement Delivery Fees” (PSDFs) in Freddie jargon. They are upfront payments expressed as a percent of the loan balance and are based on loan-to-value ratio (LTV), FICO credit score, and various loan characteristics related to risk. Before the crisis, they were largely limited to special programs, but in March, 2008, they were applied to standard programs. In March of this year, they were increased by both agencies.

For example, the LLPA today on a loan to a borrower with a credit score below 620 is 1.5% if the LTV is 60.01-70%, and 3% if the LTV is above 70%. If the loan is on a property with 2-4 dwelling units, there is an additional LLPA of 1%. If the property is a rental, another LLPA kicks in for 1.75% if the LTV is 75% or lower, 3% if the LTV is 75.01-80%, and 3.75% on LTVs above 80%.

LLPAs and PSDFs are cumulative. Fannie Mae will charge a borrower with a FICO below 620, an LTV of 80.1-85%, buying or refinancing a 2-unit investment property 3.00% + 3.75% + 1% = 7.75%. More likely, such a borrower would give it up, as millions have.

I am a strong believer in risk-based pricing, but the agencies are over-shooting the mark in order to generate revenue, as if this will offset their excessive liberalizations during the years of boom and euphoria. If a borrower applying to refinance has been current on his loan for at least the last 12 months, there is no good reason to charge any price premium at all, regardless of LTV, credit score, type of property or loan purpose.

Underwriting requirements have also been tightened, with many if not most self-employed borrowers now shut out of the market. With full documentation now mandatory, I see a steady stream of self-employed refinance applicants with perfect payment records, high credit scores and substantial equity who can’t qualify. Before 2008, such applicants would qualify under stated income documentation, which was originally designed for them. The stated income option was abused during the housing bubble, and the agencies response was to eliminate it rather than fix it. Shameful.

Appraisal rules have also become a major bottleneck. On May 1, 2009, the agencies issued a Home Valuation Code of Conduct (HVCC), which is discussed in detail on my site. The upshot is that HVCC has reinforced the downward bias in appraisals that developed after the crisis, increased the time it takes to get an appraisal, eliminated the ability of a borrower to use the same appraisal with multiple loan providers, and made it impossible to get any appraisal at all when the appraiser can’t find three comparables in the same area.

Before HVCC, I never ran into cases where prospective borrowers were unable to get any appraisal, but now I see it often. The agencies should be required to find ways to undo the damage that HVCC has inflicted on this market.

Related posts:

1. What Should Be Done With Fannie Mae and Freddie Mac? (Sixth of a Series)
2. What Do Fannie Mae and Freddie Mac Do?
3. Fannie Mae Under the Gun

Before the crisis, the non-Federalized part of the market was much larger because it was supported by a private secondary market. Lenders originating loans that did not meet the requirements of any of the Federal agencies could sell them in the private secondary market. But that market collapsed in 2007 and has yet to reopen.

One result has been a sharp widening of the yield spread between conventional loans that can be sold to Fannie Mae and Freddie Mac, and those that can’t. Today, the spread between a $417,000 loan purchasable by the agencies and a $418,000 loan that isn’t purchasable by them, but which is otherwise identical, is almost 1%. Before the crisis, it was 1/4-3/8%.

The key to an effective redesign of the housing finance system is the development of an effective private secondary market, but not the kind of market we had before. That market was markedly inferior to the Danish model, which could easily be transplanted here.

US Secondary Market: A House of Cards

The US market had a structural defect that made it extremely vulnerable to a contagious loss of confidence. Every individual mortgage security was a stand-alone entity secured by whatever reserves or insurance protections were embedded in that security. If these reserves turned out to be superfluous, as they always were before the crisis, they were paid out to investors who owned a residual claim to them. These were often the firms that had issued the security. While these firms had the right to remove unneeded reserves, they were under no obligation to provide additional reserves if this proved necessary.

Since the surpluses on one security were not available to meet deficiencies on others, and since no one was obliged to provide additional reserves if this became necessary, the entire market was a house of cards. When some securities did run into trouble and were downgraded by the credit rating agencies, fears about the status of others ran rampant and the entire house collapsed.

In the Danish model, in contrast, every mortgage security is a bond that is a liability of the firm issuing it. The Danish mortgage banks issue multiple bonds, and if one of them experiences a high loss rate, all the resources of the bank are available to deal with it. There has never been a default on a Danish mortgage bond in over 200 years. During the very worst months of the financial crisis, it was business as usual in the Danish mortgage bond market.

Borrowers Have No Direct Linkages to Secondary Markets

In the US model, the secondary market and the primary market where loans are made to borrowers, are distinct, connected only through transfers of ownership over a period of time. For example, a loan closed by a small (“correspondent”) lender is sold to a larger wholesale lender who sells it to an investment bank who places it in a new mortgage security. Months may pass between the date when the loan is closed and the date when the loan becomes collateral for a security.

In the Danish model, in contrast, there are no transfers of ownership, because each individual borrower is funded directly by the secondary market. The mortgage bank sells the mortgage to investors simply by adding it to an open bond issue of the bank covering the same type of mortgage. If the new loan is a 5% 30-year FRM, for example, it is added to the bank’s outstanding bond secured by 5% 30-year FRMs.

Reflecting these differences in the relationship between primary and secondary markets, borrowers in the US face far more challenges in shopping for mortgages than borrowers in Denmark. Borrowers in the US don’t have access to secondary market prices, and if they did, it would do them no good because there would be no way to use it. They are on their own in dealing with loan originators, many of which use a variety of tricks of the trade to extract as much from them as possible.

In Denmark, borrowers can price their loan by accessing secondary market prices on-line. They enter the type of mortgage they want and the interest rate, and find the corresponding bond selling for the highest price. The prices of all Danish mortgage bonds are shown on the NASDAQ web site, http://www.nasdaqomxnordic.com/bonds/denmark. (Alternatively, they can go to a broker or loan officer who is paid by the lender selected, who has access to the same bond data with consumer-friendly add-ons.) The borrower pays the bond price plus a .5% rate add-on by the lending bank, plus some out-of-pocket fees that are set competitively.

Refinancing Options Are Limited

When market interest rates drop, borrowers in both the US and Denmark, can refinance at par to lower their interest rate. When market interest rates rise, however, only borrowers in Denmark can refinance at the lower market price. Borrowers in the US must pay off their old loan at par.

For example, Doe has a $200,000 balance on his 5% mortgage, and he expects to sell his house for $250,000 in a market in which home buyers pay 5%. But before he can sell, market rates jump from 5% to 7.5% and potential buyers can now only afford to pay $200,000, wiping out Doe’s home equity. However, because of the rate increase, the market price of Doe’s 5% mortgage has dropped from 100 to 90. If Doe is a Dane, he can refinance into a 7.5% loan by paying $180,000 to retire his old loan; by so-doing, he retains a piece of his equity. If Doe is from the US, he must pay $200,000 to retire his existing loan.

Given the already substantial depletion of home equity in the US, the need to reduce the further losses that will occur when interest rates begin their inevitable ascent, is compelling.

Thanks to Alan Boyce for sharing his expertise in the Danish system.

Related posts:

1. Redesigning the Housing Finance System
2. Is it Done Better in Denmark?
3. The Mortgage Crisis: US Versus Denmark

But most of the recent proposals designed to strengthen the regulatory system are reminiscent of the old adage concerning generals preparing to fight the last war. A core problem is that we don’t know where the next shock to financial stability will come from, and what financial instruments will be used to make the big bets that ultimately turn sour. The next time, the malefactors may very well be firms that are not on anybody’s radar screen today, using financial instruments that do not now exist.

We should have learned this from the unexpected features of the most recent crisis. Who would have guessed that the largest of the recklessly risky bets, requiring the largest Government rescue, were laid by AIG, a holding company that mainly owned insurance companies and was essentially unregulated. (Because it also owned a thrift, AIG was legally subject to regulation by the Office of Thrift Supervision, but that agency did not have the knowledge or resources to deal with an insurance company with affiliates in 130 countries, and evidently did not even try.) Further, the credit default swaps that AIG used to make its bets was a relatively new instrument.

One of the few useful proposals that has emerged from the post-crisis post mortems has been to create a systemic risk regulator whose jurisdiction is not limited to conventional industry boundaries. It is essential that the regulatory net be made wide enough to cover all the firms that might become important players in the next emerging bubble leading to a crisis.

It is also essential that the systemic risk regulator have the proper tools. Capital requirements, which regulators now depend on to ensure safety and soundness, don’t do the job, for reasons noted last week. The regulator must be able to remove some of the profit from taking excessive risk during a bubble period, while requiring that firms taking on these risks increase their capacity to bear loss.

The needed tool is transaction-based reserving, or TBR. Under TBR, financial firms are obliged to contribute a part of risk-based income to a contingency reserve account that is not accessible for 10 years except in an emergency. Income allocated to reserves would not be taxable until it was withdrawn 10 years later.

Here is an over-simplified example. The lender makes a prime home mortgage loan at 5%, the risk component of the rate is 1%, and the TBR is half of that or 0.5%. The lender shifts to a sub-prime loan at 7%, the risk component is now 3% and the TBR is 1.5%. The capital requirement doesn’t change, but the TBR reduces the profitability of the shift, and if the lender does it anyway, the required allocation to the contingency reserve becomes three times as large.

We have extensive experience with TBR in connection with private mortgage insurance companies (PMIs), which have been subjected to it since the industry began in 1956. PMIs have allocated 50% of their premium income to a contingency reserve for 10 years. These reserves have allowed the PMIs to meet all their obligations in connection with the extraordinary losses suffered by lenders during the current crisis. They may or may not make it, depending on how long the crush of foreclosures lasts, but if not for TBR, they would have received Government support or disappeared a long time ago.

A systemic risk regulator armed with TBR could cope with the next threat to financial stability, whatever that turned out to be. Because TBR is transaction-based rather than institution-based, the regulator’s jurisdiction would extend to any institutions involved in transactions that it viewed as a threat to systemic stability.

Of course, the rules could vary by type of institution, and lots of details need to be worked out, such as the rules for determining the risk component of various kinds of transactions, and for investing and safeguarding reserves. Rules must also be developed for firms that originate risky transactions and then sell all or part of their interest. In such cases, the required reserve allocation might be divided among all those in the chain of ownership, which would be a way to assure that they all had some “skin in the game.” Alternatively, the entire allocation might be imposed on the last actor in the chain, who would transmit the burden back through the chain in the price paid.

A great advantage of TBR, relative to capital requirements is that TBR does not depend on discretionary actions by the regulator to offset the excessive optimism that feeds bubbles. Once the TBR rules are established, a shift to riskier loans during periods of euphoria automatically generates larger reserve allocations because riskier loans carry higher risk premiums.

Related posts:

1. A Way to Prevent TBTF Firms From Taking Excessive Risks
2. Revamping the Regulatory System — to Prevent It From Happening Again
3. Is There a Way Firms Now “Too Big to Fail” Can Be Allowed to Fail? (Second of a Series)

Why Firms Become Too Big to Fail

TBTF firms in some cases provide services that are critical to the functioning of markets, such as acting as a dealer or providing settlement or escrow services. In some cases, they own many hundreds of affiliates in foreign countries, failure of which become problems for each country’s regulators, who may or may not talk to each other. TBTF firms also are likely to have credit and other obligations in such large volume and to so many other firms that a failure to pay could panic investors and cause markets to freeze.

The need to rescue TBTF firms was underscored by the Lehman Brothers case, where officials could not find a legal way to effect a rescue in time; the ensuing disruption was devastating. Herring notes that “Lehman’s bankruptcy has led to civil proceedings on three continents where transactions were aborted in the middle of the clearing and settlement process.” He notes that about forty-three thousand transactions are still open and have yet to be negotiated or litigated.<

The unstated policy adopted after the Lehman failure was that no more Lehmans would be permitted because the costs were excessive. But the cost of rescues is also staggeringly high.

The Cost of Rescuing TBTF Firms

The immediate cost of rescue operations is the expenditure of public funds to protect the creditors of TBTF firms. The long-run cost is that the rescues of TBTF firms that have already occurred increase the likelihood that even more costly rescues will be needed in the future.

The high probability of rescue gives firms an incentive to become TBTF if they are not one already. TBTF firms enjoy a competitive advantage based not on their efficiency or customer service, but simply on their being TBTF. Since their creditors are confident that they will be protected, there is no need for creditors to monitor the soundness of the TBTF firms to whom they entrust their money, which encourages TBTF firms to earn more by taking more risks. In short, if the problem is not fixed, it will get worse.

Is There a Way to Eliminate TBTF Firms?

Nothing that has been proposed by the Administration or the Congress to date will eliminate TBTF firms. Size restrictions will probably be adopted, but will have little impact unless they require widespread downsizing, which nobody is proposing. The proposal for a Governmental resolution authority that, in Paul Volcker’s words “should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure,” might make the rescue process more orderly and less frenzied, but it won’t stop rescues. On the contrary, it will probably make rescue more certain by eliminating the possibility that Government won’t be prepared to take action. Had such an authority been involved in the Lehman case, it is almost certain that Lehman would have been rescued.

A Government resolution authority would have more muscle if it could require that all systemically important firms develop an approved “wind-down plan”, which would specify exactly what the firm would do in the event that it became insolvent. Herring has a detailed description of exactly what a wind-down plan should include. To be approved by regulators, the plan would have to show how the firm would wind up its affairs, and those of all of its affiliates, in a reasonable time frame and without any adverse spillovers to other firms.

This approach would be fiercely resisted by TBTF firms and would be extremely challenging for regulators to implement effectively. If successful, wind-down plans would eliminate or reduce disruption costs, such as those that result from the aborting of transactions in process, but it is not at all clear that it would eliminate the perceived need to protect creditors. A wind-down plan won’t necessarily prevent a contagious loss of confidence if the firm doesn’t pay its debts,

It follows that equal if not greater emphasis ought to be given to preventing TBTF firms from getting into trouble in the first place. That is the topic of next week’s article.

Related posts:

1. Is There a Way Firms Now “Too Big to Fail” Can Be Allowed to Fail? (Second of a Series)
2. Reforming the Financial System: Do We Need a Financial Commission? (First of a Series)
3. A Way to Prevent TBTF Firms From Taking Excessive Risks

Of course, the political process is most receptive to reform while memories of the crisis remain strong and its after-effects are still being felt. But there is a serious downside to legislating reform while we are so close to what happened. Reform proposals tend to focus on preventing the same sequence of events that we very recently lived through. This is reminiscent of the old adage about generals preparing to fight the last war. The next potential financial crisis is going to be different from the last one, just as that one was very different from the savings and loan crisis of the early 80s.

There is another very serious drawback to legislating reforms while memories of what happened are still fresh. Many of the proposals are suffused with hostility toward groups that are viewed as malefactors – especially “bankers” and “Wall Street”, which have almost become curse words. It’s easy to be mad, especially if you have been burned by the crisis in some way, but it is not a good backdrop for the thoughtful legislative reforms that we need.

Nothing disrupts the process of rational thought quite so much as the prior conviction that the problems were caused by the greed of wicked people. But the fact is that commercial bankers, investment bankers and mortgage bankers were not suddenly caught up in an epidemic of greed, they have always been greedy. Usually, their greed has acceptable, even good results for society but occasionally a business and regulatory environment arises in which it leads to disaster. If we intend to prevent another crisis, that environment should be the focus.

To examine the issue properly requires a coherent approach that is most appropriate to a commission with a broad mandate. In the best of all worlds, the findings of such a commission would precede legislative proposals. The articles in this series are agenda suggestions for such a commission. They are organized in terms of six major issues, which are summarized briefly below. Future articles will deal with the separate issues in more detail.

Is There a Way to Allow the Failure of Firms That Are Now Viewed as “Too Big to Fail” (TBTF)? One of the most traumatic and disruptive features of the recent financial crisis was that the Government was forced to rescue firms that had behaved recklessly. These firms were TBTF, meaning that the repercussions from their failure would have destabilized the entire system. Draconian measures that would require TBTF firms to shrink drastically in size and complexity are probably not feasible. Aside from that, is there any way to reduce the repercussions of failure to the point where allowing failure becomes a viable option for regulators?

Why Have Regulators Failed to Prevent Excessive Risk-Taking by TBTF Firms? If there is no acceptable way to convert FBTF firms into firms that are not TBTF, a way must be found to prevent such firms from getting into trouble in the first place by effectively regulating their risk exposures. But if we expect regulators to do better next time, we better understand why they struck out the last time, and fix the deficiencies. In particular, why haven’t capital requirements worked the way they are supposed to?

If Capital Requirements Can’t Do the Job, What Can? It is essential that the regulatory net be made wide enough to cover all the firms that might become important players in the next emerging bubble leading to a crisis. This calls for a systemic risk regulator whose jurisdiction is not limited to conventional industry boundaries. But the regulator must have tools that will work, which regulators now do not have. Is there a tool that would either remove some of the profit from taking excessive risk during a bubble period, or require that firms taking on these risks increase their capacity to bear loss?

How Should We Redesign the Housing Finance System? The system today is in shambles, largely because of the shutdown of the private secondary market. The Federal Government underwrites 9 of every 10 loans, and the remaining private market sliver is in danger of becoming dominated by a small number of very large originators. First priority should be to reestablish a private secondary market, but do we want to resurrect the model that collapsed? Or should we adopt the Danish model, which has never crashed in over 200 years?

What Should Be Done With Fannie Mae and Freddie Mac? Are the agencies today working at cross-purposes to the Administration’s plan to stimulate recovery? In the long-run, should they be entrusted to administer a program to develop a private secondary market?

How Do We Make Consumer Protection Effective? How can mandatory disclosure systems and other consumer protections be improved, and where should responsibility for it be placed?

Related posts:

1. Reforming the Financial System: Do We Need a Financial Commission? (First of a Series)
2. Is There a Way Firms Now “Too Big to Fail” Can Be Allowed to Fail? (Second of a Series)
3. What Should Be Done With Fannie Mae and Freddie Mac? (Sixth of a Series)

To Shop For a Mortgage or Note to Shop

Those who would likely do better retaining an expert may be uncomfortable with the bargaining and confrontations that may be associated with effective shopping; or they may know very little about mortgages and disinclined to invest the time required to learn more. My practice has been to recommend that such borrowers seek out an Upfront Mortgage Broker (UMB),

UMBs practice full transparency in pricing their services. The borrower and UMB agree in advance (in writing) on the UMB’s fee, which includes any payments received by the broker from the lender. The UMB passes through the wholesale price to the borrower. This approach converts the broker from an independent contractor to the de facto agent of the borrower, although the relationship may not meet all the legal requirements of agency.

UMBs belong to the Upfront Mortgage Brokers Association (UMBA), a non-profit organization that lists UMBs by state and discloses background information about each member. I am the (unpaid) chairman of the board of UMBA.

The New GFE Mirrors the UMB Code

The new disclosure requirements from HUD that became effective January 1 include a major provision that mirrors a key part of the UMB creed. All loan providers must now disclose their total origination fee on the new Good Faith Estimate (GFE). For brokers, the fee must include any payments received from the lender on loans carrying interest rates above the par or zero point rate, called the yield spread premium, or YSP.

The New GFE Does Not Convert All Brokers Into UMBs

Many readers have asked me whether these new requirements have converted all brokers into UMBs, and whether, as a result, UMBA was going to shut itself down, its job done? The answer to both questions is “no.” For one thing, it is extremely difficult for borrowers to know whether any loan provider is required to disclose YSP. The requirement applies only to brokers, defined as loan providers who do not fund loans. Loan officers who are employed by lenders have no comparable requirement. Further, in order to avoid having to disclose YSP, many brokers are joining pseudo lender organizations that change their legal status from independent contractors to loan officer employees of lender firms. They may keep their names and look exactly like the brokers they were before, except that now, in the eyes of the law, they are not brokers and don’t have to disclose YSP.

There is only one sure way for a borrower to know that the loan provider they are dealing with is subject to the full disclosure rules. If they belong to UMBA, they are brokers who are required to disclose YSP.

In addition, the new disclosure rules are designed to help borrowers shop for mortgages, not for mortgage experts. Origination fees must be disclosed by the loan provider only after a borrower has submitted a loan application. HUD envisages borrowers shopping for mortgages by comparing the completed GFEs received from multiple loan providers. But borrowers shopping for mortgage experts are not helped at all by a requirement that they submit an application in order to learn how much the experts charge for their services. Borrowers shopping for an expert need this information before making application, indeed, in their first meeting with the expert.

In short, a borrower who wants to retain a mortgage expert at a fixed fee to shop the market should shop UMA members. This assures that the experts they shop will immediately provide the information borrowers need to make an informed selection because UMBA members are explicitly committed to working with borrowers in this way.

Related posts:

1. Shop For a Mortgage or Retain an Upfront Mortgage Broker: Has the New GFE Changed the Ground-Rules?
2. Shop Retail, or Retain Agent to Shop Wholesale?
3. What Is an Upfront Mortgage Broker?

The System Encourages Payment Myopia.

Like all sales people, loan officers and mortgage brokers sell an alluring present, not a challenging future. Lenders have created instruments that support their efforts by offering reduced payments in the early years at the cost of higher payments and larger balances in later years. The most radical of these was the so-called option ARM, which allowed borrowers to make payments that did not cover the interest for 5, and in some cases 10 years before the hammer fell. Since the crisis erupted in 2007, the default rate on option ARMs has been so horrendous that they are no longer being written. But payment myopia continues.

Today, the instrument that most appeals to the payment myopic is the interest-only (IO) mortgage. On IOs, the borrower pays only interest in the early years, usually for 10 years. All adjustable rate mortgages have an IO version, as does the 30-year fixed-rate mortgage. There are some defensible reasons for selecting an IO, which I discuss in Mortgage Selection in the Post-Crisis Market, but most borrowers who take them do it for the lower payment in the early years, to the neglect of the future. That’s why I don’t like IOs.

Ways to Overcome Neglect of the Future

Recently I have begun to think about possible ways to overcome payment myopia, other than preaching, which I know from personal experience doesn’t work. I was provoked by a recent discovery of a method of inducing more employees to sign up for retirement plans offered by their employers. That a large proportion did not take advantage of plans that were highly advantageous to them was another manifestation of the general tendency to undervalue the future. Underfunding retirement plans and payment myopia have the same roots in the human psyche.

It was discovered that if new employees, instead of being offered an opportunity to join the retirement plan, were automatically entered and given an opportunity to opt out, the participation rate increased dramatically. Is there a comparable technique, I wondered, that might induce mortgage borrowers to give greater weight to the future in their mortgage decisions?

Confronting Future Costs

Part of the reason why borrowers discount the future so heavily in making mortgage decisions is that the future is not as clearly seen as it could be. As a general rule, the right type of mortgage for John Doe is the one with the lowest total cost for Doe. The total cost is a borrower specific number, because it depends on how long the borrower expects to have the mortgage, his investment rate and his tax rate. Total cost is the sum of all monthly payments of principal and interest, points and other settlement costs paid upfront, lost interest on monthly and upfront payments, less tax savings and balance reduction.

But Doe does not know the total cost of the various mortgages he is offered because nobody calculates it for him. He knows the starting mortgage payment very well because it is shown on multiple documents. Hence, what should be a limiting condition – the starting payment must be affordable – for all too many borrowers becomes the only thing they look at in making a selection.

Here is an illustration using an IO, which as I noted above has a strong appeal to payment myopic borrowers. On February 10, a prime borrower could have had a $300,000 30-year FRM at 4.875%, or an IO version of the same loan at 5.5%. The payment on the first was $1587, and on the IO it was $1375, a difference of $212 a month. Over 10 years, that amounts to a saving of $25,516. In addition, assuming the borrower can earn 2% on his money and is in the 27% tax bracket, the interest loss on payments is $1939 smaller on the IO, and the tax savings at 27% is $9020 higher. This adds to a total of $36,475 in “saving” on the IO. But, at the end of 10 years, the borrower will still owe $300,000 on the IO, and only $243,101 on its fully amortizing counterpart, which is a balance reduction of $56,899. Bottom line, the total cost is $20,424 larger on the IO.

Oh, yes, let’s not forget that in month 121, the payment on the IO jumps from $1375 to $2064, where it remains for the next 20 years. The fruits of payment myopia are indeed bitter.

So how does a borrower who is determined not to be payment myopic find the total cost of different mortgages? Don’t expect to get it from your loan provider. If you have all the necessary details about the alternative mortgages, you can calculate the total cost to you of each mortgage using my calculator 9ai. The only on-line source that will calculate the total cost for you automatically is www.home-account.com, in which I have a financial interest. Their commitment to provide the borrower-specific total cost of every loan was part of my deal with them.

Related posts:

1. Overcoming Payment Myopia
2. The Worst Mistake of Mortgage Borrowers
3. Preparing For Retirement by Reducing the Payment