Preventing Another Subprime Mortgage Crisis

I think this article describes the origins of the mortgage crisis as good as any, and outlines the drawbacks of any bailout. However, I’m interested in the root of the problem. What can we do to minimize the number of foreclosures to begin with?

First, a bit on where we are. Although hard facts are hard to come by, the best data indicates the subprime crisis will continue through this year, and perhaps longer. Picture 6.pngThis chart from an IMF report shows that the majority of subprime loans resets will have ended, but the next three years the rates on a number of option adjustable rate and alternative (“Alt-A”) mortgages will also reset. Although considered better quality than subprime loans, option adjustable rate loans can feature increasing minimum payments if borrowers have been choosing to pay the minimum. The worsening economic picture won’t help, and the dry language of the IMF puts it this way: “borrowers experiencing payment difficulties are expected to have fewer refinancing options, since falling house prices reduce the amount of homeowner equity, while tighter lending standards limit the range of mortgages available to nonprime borrowers.”

What regulations could be considered?

Some argue greater disclosure requirements are needed. An Ann Arbor attorney complains the HUD-1 form, the standard disclosure form for all mortgages, needs improvement:

While RESPA has standardized the information available in mortgage transactions somewhat through the familiar HUD-1 or settlement statement, much of the information is still very hard to decipher and true costs of a loan are often obscured. The Good Faith Estimate that RESPA requires is toothless since there are no penalties for errors, and is often used to bait borrowers with attractive terms that are then switched into unfavorable, expensive loans at closing.

Barack Obama also proposes additional disclosure requirements through something he calls a Homeowner Oblication made Explicit (HOME) score, stating “today’s subprime mortgage problem stems in large part from the lack of easy-to-understand information that borrowers receive from mortgage brokers.” His score would

provide potential borrowers with a simplified, standardized borrower metric (similar to APR) for home mortgages. The HOME score will allow individuals to easily compare various mortgage products and understand the full cost of the loan. The HOME score would also help borrowers understand their long-term obligations and would be required to include mandatory taxes and insurance.

Others place blame on brokers who profit from selling mortgages, and propose broker regulations. This report on the racial disparities in mortgage lending describes the problem well:

Brokers do not work on behalf of the borrower or the wholesale lender or investor who funds the loan. Instead they receive compensation from the borrower in the form of origination fees and points, and often they receive an origination fee from the mortgage banker at the time that the loan is funded. A mortgage delivery system wherein brokers are compensated for making loans but have no long-term interest in loan performance is subject to what economists call “principal agent risk.” A broker (the agent) has little or no incentive to worry about whether the information presented in the mortgage application is accurate as long as the information gathered is sufficient to cause the mortgage banker (the principal) to fund the loan, triggering payment of the broker’s fees (which is not to suggest that all mortgage brokers mislead borrowers; many work hard on behalf of borrowers to match them with the best product). Without a long-term interest in the performance of the loan, brokers are immune from the potential adverse consequences of both failing to match the borrower with the best available mortgage and failing to provide accurate data to underwrite the loan. Both affect the odds that the loan will default, which can have devastating consequences for the borrower.

The article continues to explain reports show broker-originated loans are more likely to default than retail loans, even after controlling for credit and income. A separate study concluded setting a higher minimum net worth requirement for brokers is associated with fewer subprime loans and foreclosures. Rules regulating mortgage brokers vary widely by state, which may explain why the foreclosure crisis has been so uneven by state, with some states being particularly hard hit. I found this map a striking illustration of the uneven pattern.

2007 Foreclosure Rates

However, even while showing that more regulations is statistically associated with fewer foreclosures, the paper cited above showing regulations cut foreclosures warns against possible “unintended negative consequences.” Here’s the crux of the regulation problem — in a quest to maximize home ownership, the federal government has socialized the risk (through mortgage insurance and occasional bailouts) and cut mortgage regulations to push mortgages out to the maximum number of people. Because no market is self-regulating, when lenders go too far taxpayers are left holding the bag in the form of bailouts of banks or the GSEs.

I support more aggressive measures than are generally discussed. Hard limits should be set on the terms of the most usurious “exotic” mortgages, brokers more tightly regulated, and some loans prohibited. The Center for Responsible Lending is rare in their support of prohibitions of certain loans to people with bad credit.

Of course, many argue additional reforms are needed in the financial markets to restrain the market demand for bad mortgages, but this goes way beyond my expertise. What regulations do you think are needed?

Author: Rob Goodspeed


  1. The source of the problem you say? The answer is simple, but not palatable. Remove the conflicts of interest from the transaction and the service providers will regulate themselves.

    And it is that simple. Currently appraisers and home inspectors are dogged with concern about not providing information that might kill a deal and thereby a commission for their referral source. They are rightfully afraid that they will be blacklisted.

    One Stop Shopping (One Stop Robbing) is nothing more than an exploitation of a client’s trust. Instead of shopping and comparing ancillary services for their clients, the Realtor simply steers his clients into the most expensive ancillary service, that they happen to own, thereby removing price competition and checks and balances that come from independent competition. Even some attorneys are doing this “for” their clients.

    Dual agency is an abandonment of the client when they need you the most. Imagine having full representation from your Realtor up until the time you find the property you actually want. But because the property you want is listed by your broker, your broker is all of sudden throttled and isn’t allowed to do anything to detriment of the other side… A huge percentage of consumers don’t have to imagine this as it has happened to them. Oh, but they received a disclosure that most Realtors don’t even understand…

    Conflicts plague the industry. Realtors, lenders, attorneys and other service providers don’t need to have their hands in all the ancillary services. And real estate companies don’t have to be mega brokers that create higher likelihood of dual agency transactions.

    Attorneys do thorough conflict checks before they undertake representation in order to avoid representing both sides of the deal. And they are trained in conflict management. Realtors might not even have a high school education.

    Remove the conflicts and the independent players will represent their clients not their pocketbooks.

  2. Doug, thank you for your comment. I agree there are too many conflicts of interest in the industry, however I am unclear on what you propose. What must change to eliminate the conflicts?

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  4. I am a mortgage broker and everyone in the process of someone buyer a home works for commission, up to and including banks and direct lenders. I believe the advantage with mortgage brokers is that the customer has a closer relationship with these people. We as brokers have a fiduciary responsibility to them and work very hard on their behalf. I will admit there are bad apple brokers as with any other
    business in the United States but to punish, blame or do away with brokers because of a very few is wrong. The problem is not brokers —
    in the United States a product or multiple products are created when there is a need or customer base for same. It is called “economics”.
    I did not create the product, I merely supply the demand. I follow the
    guidelines, whether FHA or when it was available, subprime loans. We
    carefully gather the documentation for such loan, meet the stipulations
    and I make sure the borrower can, I believe, make the necessary payments. When the loan is approved, I am still with the customer at
    closing and continue to counsel them on the importance of their obligations of homeownership including payments. We are mortgage brokers cannot foresee, as lenders cannot, that hardships may happen;
    i.e., loss of job, sickness and these people, whether prime of subprime
    cannot make their payments. In other articles I have read people did
    not understand their ARMs. We fully explain these types of mortgages and to my dismay, don’t listen or care all they are interested in is their
    payments. ARMS were meant to be used for people to get rid of their
    debt, have an increase in salary, etc. during the first fixed term. They
    promise they will do the same, but do not and will not be willing to
    buckle their belts a little tighter; thus default. We have become a country of entitlements and now everyone looks to some entity to blame. Well, I have made mistakes in my life and so have these people. We all must pay the piper. I have bellied up and so must they.
    I worry about the customer from the time I get a file until I close it and after. The stress is driving me out of the business and the business needs more caring and concerned people like me in it.

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