This is part two (of two) of your crash course on problems and solutions in the mortgage markets. Here’s part one. There is also a great op-ed on the financial market impacts of these mortgage market problems. It ran in today’s Financial Times, and was coauthored by two Administration officials: Treasury Undersecretary for International Affairs Dave McCormick, and Treasury Undersecretary for Domestic Finance Bob Steel.
In addition to the policies the President proposed to help some homeowners struggling with their mortgages, he also discussed several important policy changes intended to reduce the chance that these problems recur. We call the whole package of policies the HOPE program: HomeOwner Protection Effort.
There’s been enormous innovation in the mortgage sector. This has made credit more affordable and more available to millions of people. The vast majority of them will be fine. The public debate will focus on those who are not.
Before we discuss solutions, let’s make sure we understand why the subprime problems happened. I discussed this in the last note, but want to supplement that description here.
There are two important causes:
- Mortgage innovation resulted in some borrowers getting in over their head. Some borrowers didn’t understand what they were buying when they got an ARM with a low teaser rate. In some cases, lenders didn’t provide adequate disclosure. Other borrowers got the disclosure they needed, but didn’t understand it. In still other cases, borrowers didn’t accurately disclose their financial condition. Many borrowers got mortgages that they would be able to refinance only if housing prices continued to appreciate. Some of them knew this, others did not. After the fact, its hard to tell who fits into which category.
- There are also broader financial market practices underlying the recent problems. The growth of subprime markets was partly driven by investors awash in capital, searching for yield and relying on credit ratings and new securitization practices.
I’ll group the policy answers into the same two categories. The first could be called homeowner protection. In another context, it might be called consumer protection.
- The financial regulators have issued new guidelines to enhance disclosure when you buy a mortgage. The Federal Reserve expects to propose a new disclosure rule by the end of the year. Like the Mulroney sticker on a new car window, better disclosure up front means more well-informed buyers. In particular, a borrower needs to know about potential future increases in monthly mortgage payments.
- These regulators are also tightening mortgage lending standards. They have published new guidance to subprime lenders. The most important element of this guidance is that a lender should determine that you qualify under the higher interest rates expected after the reset, and not just at the low introductory teaser rate. And the Fed is working on a rule to ban certain egregious mortgage products and lending practices.
There’s a certain amount of unavoidable tradeoff here: tighter lending standards mean fewer loans will be issued. Fewer loans makes it harder for existing borrowers to refinance (bad), but it reduces the likelihood that new borrowers will get into trouble (good). It’s a balancing act.
As we work through subprime difficulties over the next year+, it’s important to remember that expanded credit and financial innovation are generally good things. Innovation in credit markets has allowed lenders to diversify their risk and expand credit to many who in the past would never have been able to borrow. This has meant higher homeownership rates, more poor people owning cars, and more people being able to afford college. Expanded access to credit, accurately scored and provided by responsible lenders to well-informed borrowers, helps expand access to financial opportunities to a broader swath of the American public. Credit is not and should not be just for the rich. Clearly, however, some lenders behaved inappropriately in the subprime market, so some tightening of lending standards makes sense.
- We’re also dusting off RESPA reform, aka the Real Estate Settlement Procedures Act. This fall, we will propose RESPA reforms that would promote comparative shopping by consumers for the best loan terms, provide clearer disclosures, limit settlement cost increases, and require mortgage brokers to fully disclose their fees and closing costs.
- We’re promoting financial education and counseling. The President will be creating a council on financial literacy, and we’ve got money in our budget for groups like NeighborWorks that help borrowers understand their financial options.
In addition, we’re looking at a couple of financial market issues. We’re using a group called the President’s Working Group on Financial Markets, chaired by Treasury Secretary Hank Paulson, to examine some of the broader market issues underlying recent mortgage problems. One thing this group will do is review policy issues surrounding credit rating agencies. The Working Group includes Fed Chairman Ben Bernanke, SEC Chairman Chris Cox, and Commodity Futures Trading Commission Acting Chairman Walt Lukken.
Finally, Dave and Bob write about some international steps that Secretary Paulson is taking with his counterparts in other leading industrialized nations. Please see the op-ed for more on this topic.