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   ARTICLE   |   From Scotsman Guide Residential Edition   |   March 2017

Did Mortgage Reform Miss the Mark?

Focusing on loans instead of education and responsibility did not fix the problem

Did Mortgage Reform Miss the Mark?

The mortgage crisis sparked numerous regulatory changes that addressed actual and perceived causes of the crisis. The effectiveness of these changes varied widely. Some have helped, while others actually hurt lending. We have not seen reforms to one part of the system, however — reforms that actually would have prevented the crisis. All attempts to hit that particular target have failed.

One early reform that missed the mark was the Home Valuation Code of Conduct, or HVCC, which sought, in part, to stop appraisers from colluding with homebuilders and their affiliated mortgage banks. Such fraudulent appraisals were used in some cases to close sales of subdivision homes at inflated prices during the final stage of the real estate bubble. Although addressing a legitimate problem, HVCC had several negative side effects, including increasing costs, decreasing portability and lowering quality, because appraisals are awarded to low bidders.

Many reforms were directed at restricting or eliminating mortgage programs or options that were demonized as causing the crisis. These included subprime loans, negative amortization mortgages, low- and no-doc loans, and interest-only products. None of these are inherently dangerous. They only created problems when given to inappropriate borrowers.

With broad-brush reform essentially eliminating these so-called “dangerous” loans, millions of qualified borrowers were shut out of the mortgage market, and millions of existing borrowers were deprived of the ability to refinance and take advantage of lower interest rates. In addition, cutting millions of would-be borrowers out of the market during the recovery unnecessarily exacerbated the drop in real estate prices by reducing demand. More finely-tuned reforms could have retained the programs and/or options for appropriate borrowers.

Questioning program reforms

Properly used, subprime loans perform a valuable function, allowing borrowers with atypical — and often temporary — problems to obtain mortgages. Some borrowers have limited credit but good jobs. Other may have late payments due to messy divorces. These are the types of borrowers that subprime loans can help. Unfortunately, far too often, originators put borrowers into subprime loans that were inappropriate, which led to the horror stories. Reform effectively eliminated subprime loans even for appropriate borrowers. Some subprime financing, however, is starting to be offered again.

Negative amortization loans, or neg ams, were another favorite target of reformers. As with subprime, the problem was not the loan programs themselves but originators who mislead inappropriate borrowers into using neg ams. Neg am loans are a great choice for borrowers whose income is highly seasonal, such as loggers or construction workers. Reform took away the neg am option, but left a glaring inconsistency. If loans that allow partial negative amortization are so dangerous, how can the federal government guarantee and promote the Home Equity Conversion Mortgage — the Federal Housing Administration’s reverse mortgage program — that is a 100 percent neg am product?

The criticism of low- and no-doc loans is similarly misdirected. Those loans originally had very conservative guidelines. A borrower might need at least 35 percent equity, for example. The de-fault rate in those cases was predictably low.

Low- and no-doc loans only became a problem when the exploding demand for loans to fill residential mortgage-backed securities (RMBS) caused lenders to offer such programs at limits finally reaching 100 percent loan-to-value ratios. This misuse begs the question: Why shouldn’t borrowers with a demonstrated history of financial competence be rewarded with lessened-documentation requirements? There has been some recent, limited re-emergence of low-doc loans, but pricing has been unattractive.

The loss of interest-only loan options was especially harmful and, once again, misguided. Properly used, this option provided the most powerful financial-planning tool offered by the mortgage industry. The problems with interest-only loans occurred when borrowers and originators gave no consideration to any plan for payments other than the initial interest payment. Naturally, after 10 to 15 years of only paying interest, the full-amortization payments would be a huge jump for borrowers who had no viable plan.

As with low- and no-doc loans, some recent loans do offer an interest-only option, but the pricing has been so poor that the interest payments are higher than the principal and interest payments on comparable loans. Sadly, the loss of a viable interest-only option deprives borrowers approaching retirement with a valuable planning tool.

By making predetermined principal payments during the interest-only phase, aging borrowers could preselect a workable retirement mortgage payment without the uncertainty of refinancing, because the fixed-rate interest-only loans would automatically re-amortize at the end of the interest-only period to give the desired retirement payment.

It was the misuse of these loan types and options that caused many of the problems during the housing crisis. Having failed to recognize that distinction, reformers not only eliminated abuses, they also eliminated all the beneficial uses of those loans and options. This has had a significant impact on borrowing capacity and the real estate market. Reform has been the equivalent of banning automobiles because some people drive drunk.

Providing an alternative

So what alternative approach to reform could have prevented the crisis — without the attendant side effects? It has become clear in the aftermath that most problem loans resulted from originators who were unaware of the larger financial picture and put borrowers into inappropriate loans out of ignorance or a more culpable desire to reap the largest compensation.

This front-end problem could be stopped — or at least substantially reduced — if two things were required of all loan originators:

  • Reasonable amounts of financial education and training; and
  • A fiduciary duty toward each borrower.

Even though a home mortgage is the single-largest financial transaction most Americans make, loan originators still have no financial education or training requirements. Thus, few originators can speak knowingly to borrowers or other financial professionals about what loan programs and options best fit a borrower’s financial plans.

What is needed is a system of requirements, such as the Certified Residential Mortgage Specialist program administered by NAMB - The Association of Mortgage Professionals. This certification takes into account formal financial education, financial training and related experience. It is amazing how often, when presented with a novel approach to a mortgage situation, veteran financial professionals with even 30 to 40 years of experience say, “I never knew you could do these things with mortgages.”

Although mortgage brokers must obtain licenses in all states, the prerequisite training does not cover matching loan products with borrowers’ financial plans. It is more about mortgage laws and compliance. The Nationwide Multistate Licensing System and Registry added testing and continuing education requirements, but those deal almost exclusively with the technicalities of loan programs and processing, and bank loan officers remain exempt.

There are no requirements that originators learn even the basics in areas such as accounting, taxes, estate planning, financial planning or insurance. Unless originators obtain their own financial education, their usefulness to the financial-planning team is greatly reduced.

No amount of education will help, however, if originators do not have the obligation to apply their expertise for the benefit of borrowers. That is why we also need a fiduciary-duty standard for all loan originators. While that standard already applies to some originators, such as brokers in California, loan officers remain exempt.

Even though borrowers may think they are being professionally advised by their originators, most of these mortgage professionals have no duty — let alone a fiduciary one — to their borrowers. Most originators remain free to sell whatever loan will generate the largest commission.

Significantly, the U.S. Department of Labor recently published a proposed new requirement that advisers on retirement plans will now have a fiduciary duty. While the Trump administration has at least temporarily withdrawn that proposal to study in light of broader changes to financial regulation, if advisers on plans with as little as $10,000 to $20,000 should have a fiduciary duty, should not loan originators — where the typical loan size is more than $300,000 — be held to the same standard?

Education without a fiduciary duty is as ineffective as a fiduciary duty without financial education requirements. Too often during the bubble, California brokers — who had a fiduciary duty — put borrowers into inappropriate programs without even realizing it because of their lack of financial education. For origination reform to be truly effective, substantive financial education and training requirements must be coupled with a fiduciary-duty standard — and this dual requirement must apply to all loan originators.

•  •  •

The limited focus presented here should not in any way be construed as minimizing the magnitude of misconduct elsewhere in the mortgage system — in loan documentation, marketing, underwriting and securitization — which contributed to the housing crisis. Rather, the point has been to assert that had borrowers been advised by educated fiduciaries, most of the inappropriate borrower-loan matches — and resulting defaults — would never have occurred. Thus origination reform is the single-biggest step we can take to prevent another mortgage crisis.


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