Over the past five years I’ve been in and out of Chicago looking for investment property. I’m a radio freak and I can distinctly remember lender radio commercials touting low interest Adjustable Rate Mortgages (ARM’s). Five years ago the lenders were saying, “Come to us and we’ll get you a mortgage. You won’t believe how much house you can buy at these low ARM rates.” Today the same lenders’ radio commercials are saying, “Come to us and we’ll get you out of that high interest rate ARM and convert you to an affordable fixed rate mortgage.”
As I’m sure you’re aware, thousands of people purchased homes a few years ago with an adjustable rate mortgage. Instead of opting for a fixed rate mortgage around 6%, they got a three-year ARM, which was locked in at around 4.5 % for the first three years. The kicker is that after three years the rate may adjust upward if interest rates rise. Some buyers getting 4.5% for the first three years found themselves paying 8% or higher by the end of the fifth year. This almost doubles the monthly house payment, putting many mortgages into foreclosure. Many buyers who signed up for sub-prime mortgages did so because they couldn’t afford the house payment at 6%; the sub-prime loan was their ticket to purchasing a home. They knew the risks of higher interest rates at a later date, but somehow thought they could get through it. Families whose financial prospects and incomes increased during the five years after purchase could later re-finance at a lower rate. Those with flat incomes and poor credit ratings couldn’t refinance and many of them lost their homes.
Now Congress is attempting to “solve” the subprime loan crisis by increasing regulations for mortgage lenders, including mandatory licensing of all mortgage brokers. This is the same Congress that 20 years ago scolded mortgage companies in capital hill hearings for not finding ways to make housing affordable to the poor. The mortgage industry responded by coming up with new financial products (like the Adjustable Rate Mortgage) to make homes more affordable for lower income families. The problem with these loans is that the poor don’t have much disposable income; hence sub-prime mortgages are very risky. Now the same Congress that urged mortgage companies to provide more credit to lower income people is accusing mortgage companies of exploiting the poor! What’s a poor lender to do?
The free market has an answer to this subprime mess. It is a just and fair answer. First of all, the lenders (mortgage companies and large financial institutions to whom he loans were sold) will lose millions of dollars. That’s their penalty for being stupid and making “bad” loans to non-credit worthy borrowers. Second, the homebuyers who go into foreclosure will have to sacrifice any equity they have in the mortgage (which is usually negligible) and will have to move their families to less desirable housing. It may take two or three more years, but if Congress keeps its hands out of this, everything will work itself out. When all is said and done, both borrowers and lenders will have learned a valuable lesson; consumers will be far less likely to take the bait of an ARM and lenders will be less likely to offer them; especially to financially “marginal” buyers.
Unfortunately, Congress will probably not let the market solve this problem. Politicians will kick into “crisis mode” and try to “help” the unfortunate people who have lost their homes. This sentiment was recently expressed by US Representative Carolyn Maloney, a New York Democrat when she said, “What is important now is for those who are in a position of power to help protect homeowners and stabilize the system. Congress should lessen collateral damage.” If Congress takes Maloney’s advice it will create a lot of perverse incentives in the economy. Some examples will suffice.
The Bailout . Congress may make taxpayers “bail out” the homebuyers, but this is simply a disguised way to bail out the financial institutions that made bad loans. If Congress passes a bailout package, homebuyers will believe that no matter how stupid they are in the future, the government will help them. Moreover, big banks like Citigroup and UBS will be spared the financial beating that they deserve and will be more likely to engage in “marginal” loans in the future.
Increased Lender Regulation. Anyone who has completed mortgage documents has signed page after page of forms required by the Federal and State regulators to warn homebuyers of their rights. Interest rates are disclosed, terms of the loan are disclosed, and all kinds of buyer rights are explained. The last thing we need is more regulations in the mortgage industry. More regulations will increase costs of loan processing which will be passed on to consumers. Does anyone really think that adding twelve more forms to loan closing documents is going to make a difference?
Broker Licensing. Some states require mortgage brokers to be licensed. This is supposed to insure consumer protection. It doesn’t work. Occupational licensing only increases barriers to entry in the mortgage business, which limits the supply of brokers and increases the price of loans. Occupational licensing increases the wages of practitioners without offering any meaningful increase in consumer protection. We’re not talking about heart surgery here; this is the mortgage business!
As long as consumers want houses and lenders want to make money, loans will be made. Sometimes companies make risky loans and get burned. Likewise, homebuyers that sign up for mortgage obligations that they cannot possibly meet will have to find cheaper housing. This is the way of the world and the last thing we need is more governmental intervention. Republican representative John Campbell of California was correct when he said, “Before we rush into any action here in Washington, we need to see how well the industry and the markets are able to adapt to the contraction that’s going on. There’s a risk that if you overreact that you’ll actually dry up available resources to make sub prime loans.”