You pay for failed mortgage innovations with your taxes and your home
When the mortgage industry innovations fail, millions of people lose their homes, and taxpayers fork over billions in bailout aid to foolish lenders and foolish borrowers.
Designing a loan program that borrowers won’t repay but lenders and investors will fund.
Most industries advance and evolve through innovations, sometimes very disruptive ones. However, some industries — like mortgage lending — are prized for their stability. Mortgage lending doesn’t innovate, and as a society, we don’t want it to because whenever mortgage lenders start innovating, trouble is brewing. Most innovations in lending either cause major losses at banks, or in their worst forms these innovations destabilize our financial system.
Consider the “innovation” of the option ARM. This loan allowed people to borrow much, much more than conventional mortgages, and since borrowers could pick they payment they wanted to make, it allowed borrowers to dramatically lower their monthly payments. Sounds like a panacea — and many believed it was. Unfortunately, like most things too-good-to-be-true, the option ARM turned out to be a Ponzi scheme in disguise. It’s widespread use inflated a massive housing bubble, and the credit crunch upon it’s removal caused an epic price crash. The price of this innovation was massive taxpayer bailouts and millions of families displaced from their homes in foreclosure — a high price for a failed attempt at financial innovation.
All mortgage innovations are doomed to fail. Unless you change human nature, there are always going to be people who are too irresponsible to make consistent payments. This is the key to any loan program: Either people do or do not make their payments.
Lenders can reinvent new terms and schedules as often as they like, and it will always boil down to people making payments. When these fancy loan programs contain provisions that make it difficult for people to make payments — like increasing payment amounts — they will default, and the loan program will fail. This is certain.
Fortunately, legislators were wise enough to recognize this when they passed Dodd-Frank and set up the Consumer Financial Protection Bureau. The rules and regulations effectively banned the toxic loan programs and terrible practices that inflated the housing bubble. Of course, since these regulations stand in the way of easy money for the mortgage industry, many people oppose Dodd-Frank and the activities of the CFPB.
I’ve attended several mortgage industry conferences recently and a common theme is that the tsunami of disruption sweeping every other existing industry is about ready to hit mortgage finance. The mortgage industry is basically at DEFCON 1 and the only way we’re going to survive is to MacGuyver our way out of this thing. (If you don’t know who MacGuyver is, you are likely driving the tsunami of disruption. Keep reading — we’re going to need you.)
It will be challenging, but doable, if we’re given the room. I have no doubt that lenders, servicers and investors can engineer new ways to increase responsible homeownership and add fuel to the engine that drives much of our economy.
I have every doubt this is possible. The epic failure of American housing policy over the last 50 years proves that.
But will we have the room?
Sessions at these conferences had titles that brimmed with possibilities — Funding the Homes of the Future and Expanding Credit and Reaching the Next Generation of Homeowners. Great!! Let’s hear about innovative credit scoring, alternative lending solutions, original operational strategies. But then the regulator(s) on the panel would speak, and it became very clear that the very innovation that could salvage the American Dream for many would-be homebuyers is being smothered by regulation.
This effect is magnified by the “regulation by enforcement” practices of the Consumer Financial Protection Bureau. Lenders, servicers and investors don’t just have to worry about the actual rules, but what the bureau might be trying to say through enforcement actions.
Remarks by CFPB Director Richard Cordray at a meeting of the Consumers Bankers Association this week illustrate the problem:
Likewise, our public enforcement actions have been marked by orders, whether entered by our agency or by a court, which specify the facts and the resulting legal conclusions. These orders provide detailed guidance for compliance officers across the marketplace about how they should regard similar practices at their own institutions. If the same problems exist in their day-to-day operations, they should look closely at their processes and clean up whatever is not being handled appropriately. Indeed, it would be “compliance malpractice” for executives not to take careful bearings from the contents of these orders about how to comply with the law and treat consumers fairly.
Some have criticized this approach as regulation by enforcement, but I think that criticism is badly misplaced. Certainly any responsible official or agency charged with enforcing the law is bound to recognize that they should develop a thoughtful strategy for how to deploy their limited resources most efficiently to protect the public. That means working toward a pattern of actions that conveys an intelligible direction to the marketplace, so as to create deterrence that can be readily understood and implemented. The alternative is just a random series of actions that takes a few wild swipes at the bad actors without systematically cleaning up the practices that harm consumers across the marketplace.
Others have framed this criticism as a suggestion that law enforcement officials should think through and explicitly articulate rules for every eventuality before taking any enforcement actions at all. But that aspiration would lead to paralysis because it simply sets the bar too high… we strive to present specific enforcement orders that meticulously catalogue the facts we have found in our very thorough investigations and set out the legal conclusions that follow from those facts. These specific orders are also intended as guides to all participants in the marketplace to avoid similar violations and make an immediate effort to correct any such improper practices.
So, there are rules to follow and then there are “patterns of actions” that lenders, servicers and investors must interpret for themselves.
The interpretation so far? We better play it safe. …
The result of too much regulation is an atmosphere of fear and conservatism that doesn’t leave any breathing room for innovation. Some of the most oft-repeated phrases at the conference, unfortunately, were “driving in the lanes,” or “staying within the guardrails.” People would often put their hands up when they said it, physically demonstrating a narrow path between two barriers.
Yeah, because nothing smacks of innovation like doing the safest thing possible within clearly defined boundaries. I’m sure that’s exactly how Steve Jobs, Mark Zuckerberg and whatever whiz kid is now planning the next disruption would approach it.
The mortgage industry desperately needs new ideas and strategies that aren’t just variations on a theme but represent whole new categories of themes. And it needs these strategies not just for its own enrichment, but for the good of the very consumers the CFPB is worried about. The ones who will still be renters 10 years from now because we’re busy driving in the lanes.
What about the millions of former owners who are renters now because the last round of financial innovation failed so badly? Creating another generation of temporary homeowners to enrich a few bankers doesn’t sound like a good plan to me.
The mindset demonstrated by this woman’s rant is toxic. Following this line of thinking is certain to lead us astray.
The financial innovation meme must die
The lending industry touted its “innovation” with exotic loan products, and they sold those toxins far and wide. These loans achieved the highest default rates ever recorded, so it is safe to say the “innovations” over the last 15 years were a dismal failure. It is amazing that a group of intelligent bankers came up with this loan and expected a positive outcome.
When you really look at the whole “innovation” meme, you see that it is nothing more than a public relations effort to convince brokers the products were safe to sell and borrowers the products were safe to use. It is hard to fathom the widespread acceptance of this nonsense, but that is the nature of the pathological beliefs of a financial mania.
Here is where the lenders lie to themselves and to the general public after a financial debacle like the Savings and Loan problems of the 1980s or the recent housing bubble: they blame the collapse and the high default rates on some outside factor rather than the terms and conditions the lenders created all by themselves.
There are still many out there who believe the high default rates and problems in the housing market in the 90s were caused by a weak economy, which is nonsense. House prices declined for 6 years. The decline started before the economy went soft, and it continued well after it had recovered. People defaulted because they overextended themselves on loans to buy overpriced housing, and toward the end of the mania, many were using interest-only loans.
Whenever lenders start loaning people money with total debt-to-income ratios over 43%, people start to default. When lenders make loans that don’t amortize, borrowers find trouble and default. Whenever lenders start loaning more than 80% of the purchase price, people sink underwater and start to default. This is not new. It happened in the early 90s, and it happened in the 00s for the same reasons: financial innovation.
Isn’t it time we let this dumb idea die?