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The Mortgage Professor on Suitability:

I was delighted to open my Washington Post this morning and see that the Real Estate Section of the paper is now carrying the column by the Mortgage Professor, Jack Guttentag. I've been a regular to his web site over the past couple of years, and I'm glad that he is going to be made widely available here. I've always liked Guttentag because he is not solely a practical personal finance advisor nor an abstract economic theorist, but rather is a great combination of the two. Today's column is a gem . It takes on the faddish and confused proposals to impose the "suitability" requirement developed in securities law onto mortgage lending. Consider:

The case for a mortgage suitability standard looks both simple and plausible, and it appears to have been making headway in Washington. A federal suitability rule has worked in the securities industry, the argument goes, so why wouldn't it work with home mortgages?

One major difference between the two markets is that the securities market has only one problem to which suitability is directed: preventing unsophisticated investors of limited means from being sold securities that are too risky for them. The home mortgage market, in contrast, has multiple problems for which suitability has been offered as a remedy.

First he notes that unlike the securities market, suitability in the mortgage market is directed at the wrong parties to resolve the underlying problem. But then he observes the more fundamental point about trying to impose a suitability requirement in this area:

The objectives of mortgage borrowers, in contrast, are diverse, complex and often not known by the loan provider. Here are five objectives that have been reported to me by borrowers who have selected option ARMs and interest-only loans:

· Reduce cash outflow to invest the excess in securities.

· Reduce cash outflow to pay down a second mortgage.

· Pay principal when convenient.

· Buy more house.

· Reduce payment to avoid default.

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

As I said, I've been reading the Mortgage Professor for years and I recommended him strongly for those interested in both the practicalities and policies of mortgage issues. I often agree with him and even when I don't he is always informative.

nevins (mail):
It all sounds good on paper, paternalistically protect people from their own folly. But just wait until it turns out that those 'protected' happen to be more likely to be of some ethnicity that howls of redlining will rise.
Instead, protection should extend no further than requiring plain text contracts, no small typefaces, no faint or grey text on the backs of pages, and a section on risks clearly stating all the ways the contract could end badly for the consumer. Then let the chips fall. No group gets singled out for 'protection' yet all get a clear contract.
3.17.2007 11:40am
Zywicki (mail):
Nevins:
Great point--I think that's the key question to untangle here: To what extent are we dealing with plain old fraud and deception by crooks versus something that calls for a regulatory solution.
3.17.2007 11:57am
Ken Arromdee:
But just wait until it turns out that those 'protected' happen to be more likely to be of some ethnicity that howls of redlining will rise.

If they *don't* "protect" the borrower, they are then seen as exploiting minorities (or helping businesses exploit minorities) by putting them into needless debt in order to make a buck. The accusations of racism can happen either way, and failure to "protect" the borrower is no help against them.
3.17.2007 1:13pm
alkali (mail) (www):
I would point out that the suitability rule is not exactly a "federal" rule. It is an NASD conduct rule. It is actually framed as a rule that a broker can't recommend an investment without reasonable grounds for believing it to be suitable.

That rule is directed at retail brokers who deal face-to-face with customers, make recommendations and generally demand higher commissions. However, because it is a limitation on a broker's ability to make recommendations, the rule doesn't reach brokers who never make recommendations to customers, e.g., the $x-per-trade online brokers who will execute any trade you want if your account can cover it.

That limitation on the scope of the rule makes economic sense: if you want someone to sit down with you, review your financial situation, and make an investment recommendation that you can expect to be suitable for your needs, that person is going to have to be compensated for their time and risk. If you don't want that, you can pay $x-per-trade and rely on your own judgment. (I'm not slagging the $x-per-trade brokers, here, incidentally: I use one.)

As the linked article suggests, most people who get mortgages are not dealing with an intermediary who is an analogue of the high-service, higher-commission retail broker in the securities industry. That seems to me a significant obstacle to imposing such a rule on the mortgage industry.

However, I think the linked article is wrong to the extent that it implies that the securities industry suitability rule doesn't let brokers consider the details of their clients' situations (indeed, the point of the rule is that brokers should do that) or somehow doesn't allow customers to make decisions contrary to their brokers' recommendations (the rule is a limitation on what brokers can recommend, not a limit on what customers can do).
3.17.2007 6:14pm
Zywicki (mail):
I should clarify that when I commented that Nevins made a "great point" I was specifically referencing his second point, about getting a clear contract, rather than the first point about racial disparities, on which I express no opinion.
3.17.2007 10:09pm
microtherion (mail):
There's a wonderful explanation how option ARMs work at Calculated Risk today. It should give readers a pretty good idea what level of risk is incurred in those mortgages, and what sophistication is required from the buyer.
3.18.2007 2:34am
Porkchop (mail):
There already is a "suitability rule." It's not aimed at borrowers, though, and it has not been well-enforced. Some would argue that safety and soundness requirements are not a consumer protection rule, but if it keeps borrowers from getting loans that they would default on anyway, it serves the same end.

The types of loans discussed have had, from their inceptions, extremely high risks of default, especially if interest rates continue to rise and/or unemployment goes up. Those loans violated fundamental principles of safety and soundness at the time they were made. No federally insured financial institution should have participated in making or funding them, and no such institution should have acquired them from a broker. (Of course, with securitization of mortgage loan pools, it is not necessary for insured institutions to participate at all.) It's a losing proposition, and the only ones who really profit are those who receive fees at closing or those who are able to skim equity through pointless refinancings.

There is a huge amount of fraud in the application process, too, so the borrowers are not always blameless. False documentation of income and assets is rampant, often with the assistance of mortgage banking personnel. Of course, with low-doc and no-doc loans (and the higher fees and interest rates that accompany them), you may not need false documents. One troubling aspect is that there is no uniform regulation or policing of the process. Federal banking regulators can't touch most of the originators, which means that enforcement is left up to the states for the most part, with some coverage from the Federal Trade Commission. On the criminal side, the FBI has said that it has placed a high priority on mortgage fraud investigations, but there is a wide variation on how the field offices actually prioritize it.

The trick for a loan originator is to find borrowers who have just enough ability to pay to avoid default during the period when the ultimate purchaser of the loan can return it to the originator. That way, they keep the fees and don't have to make good on any guarantees. This is a sleazy, sleazy business.
3.18.2007 11:07am
Crig (mail) (www):
I agree with the previous post about fraud being part of the problem. And it's a growing one.

Going back to Zywicki's question: Is it fraud induced or systemic risk?

If it's fraud, would a national licensing program for loan officers make a difference? Currently, there's no evidence (that I can find) that suggests states with loan officer licensing are experiencing fewer cases of fraud.

However, consider the source of the demand for risky mortgages - Wall Street financiers. Wall Street firms and hedge funds have been profiting from the high premium mortgage-backed-securities for years.
3.19.2007 1:55pm