The Mortgage Treason Of The Intellectuals And Regulators

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The new enthusiasm for government regulation of the financial sector often rests on a double standard that sees markets as fever swamps of irrationalism and government as the well of refreshingly rational guidance. Unfortunately, there’s no justification for this view of things.

In fact, regulatory pressure helped get us into the mess we’re in. Sometimes this was an unintended consequence of regulations. Think risk capital requirements encouraging banks to manage risk through credit default swaps or off-balance sheet vehicles. Sometimes it was an intended consequence–such as the government pressuing bankers to make loans on “flexible” underwriting standards.

The role of regulators in creating the mortgage crisis is lost on those who befuddle themselves with statistics about high price loans or literalism about what the words of a statute require. These are the kind of people who would see a murderer leave a dark room with a bloody knife, but demand to see an Excel spreadsheet before they would believe anything untoward had taken place in the darkness. Fortunately, normal people can recognise evidence when they see it.

The latest bit of evidence of regulatory pressure for lax underwriting comes from the 1998 “State of The Nation’s Housing” report from Harvard University’s Joint centre for Housing Studies. It’s interesting to pay attention to these early studies. Before the housing bust, intellectuals who favoured regulation had problem admitting what they now vigorously deny–that regulations contributed to lax lending. In 1998, the Harvard study explained that regulatory pressure to make home buying more accessible to low-income and minority households had resulted in “flexible” lending standards.

The study goes on to explain how a number of innovations were accomplishing this regulatory goal. Now they look like a recipe for toxic mortgages. The Harvard guys praised:

  • Option ARM mortgages
  • Low down payments
  • Mortgages originated to be refinanced
  • Automated mortgage lending

The next time someone tells you that our current mess could have been resolved by more regulation or rational limits dreamed up by intellectuals, remind them that regulators and intellectuals were pushing for the very kinds of mortgages that have proved so troublesome.

Here’s an excerpt from the Harvard study.

In addition to a buoyant economy, the overall housing industry owes its enduring vigor to
innovations in mortgage finance that have helped not only expand homeownership opportunities,
but also reduce market volatility. Under market and regulatory pressure to make homebuying
more accessible to low-income and minority households, financial institutions have revised     
their underwriting practices to make lending standards more flexible.
In the process, they have
developed several new products to enable more income-constrained and cash-strapped borrowers
at the margin to qualify for mortgage loans.
     Lenders first began offering adjustable-rate mortgages in the early 1980s when interest rates
climbed sharply (Table A-5). With initial rates significantly lower than those on standard 30-year
fixed-rate mortgages, adjustable mortgages accounted for nearly two-thirds of all home loans
originated in 1984. Although the one-year adjustables made ownership initially more affordable
to a larger pool of potential buyers, they also passed on the risk of interest-rate increases to
borrowers each time the mortgage reached its annual anniversary. In the early 1980s, though,
borrowers viewed this as an acceptable trade-off because interest rates were skyrocketing.
     Now that both mortgage interest rates and home price inflation are at much more modest
levels, financial institutions are offering a growing array of adjustable-rate products to meet the changing needs of both businesses and households. Today, adjustable mortgages are configured with a wide variety of initial adjustment periods, interest rates, and adjustment indexes (Fig. 6).

  Lower downpayment requirements have also helped to reduce the upfront cash burden that
prevents many potential buyers from purchasing a home. For example, the downpayment
requirements on some loans have been reduced
to less than 5 per cent. In addition, most of the
new mortgage products allow sellers to contribute to closing costs, and some waive cash reserve
requirements when the loan is closed. Lenders are also selectively raising the maximum   
mortgage payment a given income can carry
, and allowing borrowers to use timely payment of
rent and utilities to establish a credit record.
     At the same time, innovations in information technology have allowed mortgage lenders to
streamline their operations, thereby reducing both the cost and time required to process loans.
The combination of more mortgage products and lower transaction costs helps to keep buyers in
the market even when interest rates rise. Homebuyers can now a pick a mortgage product that
best suits their income and risk tolerance when they buy. They can then readily switch, at
relatively little cost, to a more desirable product as economic or personal circumstances change.

     This is not to say, however, that housing markets are no longer vulnerable to broad downturns
in the economy. Prospective homebuyers must still feel confident about the future before they
make a long-term investment in a new home. And rising interest rates can still force marginal
borrowers out of the homebuying market.

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