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Wednesday, March 28, 2007

Regulating Mortgage Markets

There are both costs and benefits to financial innovations such as subprime mortgages. Can regulation reduce the costs without affecting the benefits?:

'Irresponsible' Mortgages Have Opened Doors to Many of the Excluded, by Austan Goolsbee, Economic Scene, NY Times:  "We are sitting on a time bomb," the mortgage analyst said — a huge increase in unconventional home loans like balloon mortgages taken out by consumers who cannot qualify for regular mortgages. The high payments, he continued, "are just beginning to come due and a lot of people ... now risk losing their homes because they can’t pay the debt."

He would have given great testimony at the current Senate hearings on subprime mortgage lending. The only problem is, he said it in 1981 — when soon after several of the alternative mortgage products like those with adjustable rates and balloons first became popular.

When Senator Christopher J. Dodd, Democrat of Connecticut, gave his opening statement ... at the hearings lambasting the rise of "risky exotic and subprime mortgages," he was actually tapping into a very old vein of suspicion against innovations in the mortgage market.

Almost every new form of mortgage lending ... has tended to expand the pool of people who qualify but has also been greeted by a large number of people saying that it harms consumers and will fool people into thinking they can afford homes that they cannot.

Congress is contemplating a serious tightening of regulations to make the new forms of lending more difficult. New research from some of the leading housing economists in the country, however, ... suggests that regulators should be mindful of the potential downside in tightening too much.

A study conducted by Kristopher Gerardi and Paul S. Willen from the Federal Reserve Bank of Boston and Harvey S. Rosen of Princeton, Do Households Benefit from Financial Deregulation and Innovation? The Case of the Mortgage Market ..., shows that the three decades from 1970 to 2000 witnessed an incredible flowering of new types of home loans. These innovations mainly served to give people power to make their own decisions about housing, and they ended up being quite sensible with their newfound access to capital.

These economists followed thousands of people over their lives and examined the evidence for whether mortgage markets have become more efficient over time. Lost in the current discussion about ... the subprime market is the fact that someone with a low income now but who stands to earn much more in the future would, in a perfect market, be able to borrow from a bank to buy a house. That is how economists view the efficiency of a capital market: people’s decisions unrestricted by the amount of money they have right now.

And this study shows that measured this way, the mortgage market has become more perfect, not more irresponsible. ... As Professor Rosen said in an interview, "Our findings suggest that ... the innovations in mortgages over 30 years gave many people the opportunity to own a home that they would not have otherwise had, just because they didn’t have enough assets in the bank at the moment they needed the house."

Of course, basing loans on future earnings expectations is riskier than lending money to prime borrowers at 30-year fixed interest rates. That is why interest rates are higher for subprime borrowers and for big mortgages that require little money down. Sometimes the risks flop. ...

The traditional causes of foreclosure, even before there was subprime lending, were job loss, divorce and major medical expenses. And the national foreclosure data seem to suggest that these issues remain paramount. The latest numbers show that foreclosures have been concentrated not in places where real estate bubbles have supposedly been popping, but rather in places whose economies have stagnated — the hurricane-torn communities on the Gulf of Mexico and the industrial Midwest states ... where the domestic auto industry has suffered. These do not automatically point to subprime lending as the leading cause of foreclosure problems.

Also, the historical evidence suggests that cracking down on new mortgages may hit exactly the wrong people. As Professor Rosen explains, "The main thing that innovations in the mortgage market have done over the past 30 years is to let in the excluded: the young, the discriminated against, the people without a lot of money in the bank to use for a down payment." It has allowed them access to mortgages whereas lenders would have once just turned them away.

The Center for Responsible Lending estimated that in 2005, a majority of home loans to African-Americans and 40 percent of home loans to Hispanics were subprime loans. The existence and spread of subprime lending helps explain the drastic growth of homeownership for these same groups. ...

And do not forget that the vast majority of even subprime borrowers have been making their payments. Indeed, fewer than 15 percent of borrowers in this most risky group have even been delinquent on a payment, much less defaulted.

When contemplating ways to prevent excessive mortgages for the 13 percent of subprime borrowers whose loans go sour, regulators must be careful that they do not wreck the ability of the other 87 percent to obtain mortgages.

For be it ever so humble, there really is no place like home, even if it does come with a balloon payment mortgage.

For more along these lines, as well as my views, see here. The post highlights an article by David Leonhardt who says:

[I]t’s important to remember that the mortgage market is following a classic cycle that nearly every other form of consumer credit has also followed. When somebody comes up with an innovation, be it consumer loans, credit cards or creative mortgages, it inevitably leads to an explosion of borrowing that includes a good amount of excess and downright abuse. After the abuse is cleaned up, though, most families end up better off.

And my conclusion on regulation of these markets is similar:

I think we have to be careful not to be overly restrictive and inadvertently prevent worthy buyers from purchasing a home, and therefore I'd err on the side of too many rather than too few loans when thinking about regulating these markets.

With that said, and in response to the question in the introduction, I think there are things that can be done - e.g. reduce fraudulent applications, set the incentives so that profit takes precedence over loan volume, increase the independence of appraisers - that would reduce costs without affecting the positive aspects of these innovations. But, again, we should also be careful not to overreact.

My views are probably shaped from trying to buy my first house back before these product existed and you pretty much had to have 10% down for openers, a tough hurdle to get over (and there were all these rules about what could and couldn't count that made it harder to meet the 10% threshold - a lot of people called loans from parents gifts in order to qualify). Any glitch on your credit record or a ratio that missed a guideline meant the housing market was not open to you. I had a tenure track job, decent credit, etc., a pretty good bet I'd think, but the first time I went to a mortgage broker they pretty much laughed me out of the office. It was kind of humiliating as a young, ignorant and naive late 20- something. It's completely different now, it's much, much better and I would hate to see us take a step backwards.

In my case, I eventually got pretty lucky - the house I was renting went into foreclosure and they accepted 5% down and a pretty good price - it doubled in the next four years - just to get rid of it. I met the 5% down payment by cashing in an IRA from a previous job and accepting the 10% penalty, a "gift" from parents, and everything else I could find and still just barely made it. There can be winners even when the markets are doing poorly. I came out ahead - some speculator in Portland made a bad bet and I ended up with a house that I wouldn't have been able to get otherwise, at least not for a few more years.

    Posted by on Wednesday, March 28, 2007 at 09:58 PM in Economics, Housing, Regulation | Permalink  TrackBack (0)  Comments (23)


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