Academic

Back to Basics: Restoring the Human Connection to Mortgage Finance

By Emma Coleman Jordan

John Donne warned that ?no man is an island.?  Wall Street financial wizards have conducted their businesses as though the complex financial products that generated billion dollar compensation packages also created a protective mote beyond public accountability. In the interdependent, now collapsing, world of global finance home mortgages were abstractions.  During this decade, the basic human connection between lender and borrower in consumer finance was cut and thrown away as a quaint, easily discarded vestige of a bygone era.

In 1981, at the beginning of the era of retail banking deregulation, I wrote the first state consumer protection law for California to stop the banking practice of holding customers deposits to earn money by delaying credits to the customer?s account by ?playing the float?.  This abuse crept into retail banking because the full market effects of lifting the previous interest rate ceilings were poorly understood.  Follow-up regulation was necessary to close a window of market failure. Just as in the current crisis with subprime loans, competition could not and did not do the job after deregulation.

The way to get out of this mess will require four things: public recognition of the scope and scale of the backlog of home mortgage-related defaults, return to basic human connections in home mortgage lending, aggressive consumer protection, and insistence on generous capital cushions (rainy day funds set aside to buffer unexpected losses).

Bring all the bad loans out of the dark recesses of investment and commercial bank balance sheets into the light of public review.  We cannot fix it until we see it.  Second, back to basics.  Remember that houses are homes, not abstract transactions that can be made profitable with unreasonable levels of leveraged/borrowing to lend to homebuyers.  I am not advocating return to the horse and buggy days of lending.  There is still a role for more conservative securitization, in which packages of home mortgages are sold to the restructured Fannie and Freddie, and a well-regulated private market. However, preserving the connection between originator and borrowers is more likely to reduce fraud and consumer abuse.

This will require political and economic leadership to encourage Americans to return to a tough, unpleasant discipline of saving.  At the heart of the current meltdown is a stark reality, America is the world?s biggest debtor in both the public sector, budget deficits and the private sector, financial institutions and corporations.  The U.S. financial system is now at the mercy of foreign sovereigns and institutions that are sitting on enormous piles of cash, much of it from the sale of products and oil that we bought from them.

Visibility

Shifting the bad loans and the financial instruments based on these loans, onto the balance sheets of commercial banks will not solve the problems we face.

In the new pea and shell game, Bank of America has become the new private shell of choice.  B of A, the nation?s largest bank, holds 10% of all deposits. B of A first absorbed Countrywide Mortgage Bank, the biggest and most problematic subprime lender, with a loan from the Fed; this week it absorbed Merrill Lynch, with benefit of a waiver of a Fed rule that is designed to protect FDIC insured banks from lending to investment bank subsidiaries.  Bank of America, its depositors and the FDIC are not the long-term solution to the accumulated pile of loans in default.

In August, the inventory of unsold foreclosed houses reached 750,000. With the takeover of Fannie and Freddie, the federal government will be the owner of some of these properties.  These unsold foreclosures are depressing the home equity of the rest of us.  RealtyTrac, a real estate value-tracking firm estimates that one out of every six houses for sale in America is a bank-owned foreclosure.  Shelia Bair, Chair of the Federal Deposit Insurance Commission testified to the House Financial Services Committee today that: ?[T]he backlog of foreclosures and the credit crunch have combined to depress housing prices and homeowners equity dramatically. Steep home price declines are an important dynamic that drives up foreclosure rates. Falling home prices reduce homeowner equity, which then makes it more difficult to refinance or sell a home, leading to lower sales and higher delinquencies.? Zillow estimates that 29% of homes are worth less than their outstanding mortgage balance.  These owners have little incentive to keep making mortgage payments.  Why not walk away and return the key? Short-sales will only add to the glut of unsold homes, driving prices down even further.

Back to Basics

The relationship between the house as collateral for a loan and the many layers of complex new financial products grew ever more strained as the regulatory ground rules became a passive backdrop to a rapidly changing environment that featured three factors that converged to turn routine home loans into an international financial crisis.   I know that it is not fashionable to talk about human values in the same sentence as global money, but maybe that is the real problem.  Where is Jimmy Stewart when we really need him?

Modern financial titans, like Sherman McCoy, the central character of Bonfire of the Vanities, Tom Wolfe?s piercing account of Wall Street and the junk bond excesses of the late eighties, have now unwound with a single wrong turn in New York City, carrying them from the heights of money, power and privilege on Wall Street to the anger and rage of the ordinary folks in Brooklyn. Wolfe?s metaphor of the fateful mistake helps us to see how connected we are, even though some may deny that connection.

Last weekend, the bonfire raged out of control on Wall Street. This time, the wrong turn took place more than ten years ago when the first experiments with bad loans were pushed on poor and unsophisticated borrowers who lived in communities that had previously been starved, through redlining, from receiving any loans at all. Target practice in poor communities proved the viability of the abusive terms: no exit fees, pay what-you-want arms, liars loans, low teaser rates, balloon payments. These same terms were them quickly adapted to middle and upper middle class borrowers in search of a vacation home.

Within 5 years, Wall Street hedge funds perfected the lending techniques first used in poor communities. Houses that people depend on for shelter became poker chips in a high stakes game of liars? poker.  The late Federal Reserve Governor Edward Gramlich warned that the introduction of ?huge new sources of capital and financing of largely unsupervised subprime mortgage lenders? have caused recent problems with subprime loans.

Consumer Protection

Gramlich argued for reestablishing the connection between the lender and the borrower through banning the most objectionable provisions and through a mandatory ?suitability rule? which would require lenders to make loans that are matched to borrowers? economic profile and ?in the borrower?s best interest?. The link between the borrower and the ultimate holder of the loan could be further strengthened by expanding existing rules to impose on the holder liability for fraud, or other problems with the process.Capital Requirements

The current crisis has been driven by the lack of adequate levels of cash available in the U.S. economy to absorb the losses from defaults.  Sovereign wealth funds have filled this cash gap, becoming the lender of last resort for cash strapped commercial and investment banks, such as Citibank, and Merrill Lynch, only nine month?s ago.  The sovereign funds of Abu Dhabi, Singapore, and China were among a collection of funds that first came to the rescue of Merrill Lynch and Citigroup.  China?s four biggest listed banks decided to scale back drastically their purchase of Fannie Freddie securities, triggering the government takeover of Fannie and Freddie just five days later.

Conclusion

Describing the mortgage meltdown is easy, proposing a solution less so.  For all the talk of ?moral hazard? and ?market discipline? these are after-the-fact buzzwords that are a Rorschach test of whether you believe that the government should play an active, aggressive a role in controlling the risk-taking and profit-seeking party , just as the guests have just started to arrive and loosen their ties.

* To read more from Prof. Jordan on these issues, see her recent article in the American Banker or view her recent blog entry over at the Georgetown Law Blog. 

ShareThis

Full post as published by BlackProf on September 23, 2008 (boomark / email).