Author Archives: David Reiss

Should CFPB Be a Nudge?

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Cass Sunstein, until recently the Administrator of the White House Office of Information and Regulatory Affairs, has posted an early draft of  Nudges.gov:  Behavioral Economics and Regulation.  While it touches on real estate finance only indirectly, it provides a nice follow up to yesterday’s post on financial education.  Sunstein writes that it “It is clear that behavioral findings are having a large impact on regulation, law, and public policy all over the world . . ..” (2)  For the purposes of residential mortgage regulation it is worth restating some of the central findings of behavioral research:

  • Default rules often have a large effect on social outcomes. (3)
  • Procrastination can have significant adverse effects. (3)
  • When people are informed of the benefits or risks of engaging in certain actions, they are far more likely to act in accordance  with that information if they are simultaneously provided with clear, explicit information about how to do so. (4)
  • People are influenced by how information is presented or “framed.” (4)
  • Information that is vivid and salient usually has a larger impact on behavior than information that is statistical and abstract. (4)
  • People display loss aversion; they may well dislike losses more than they like corresponding gains. (5)
  • In multiple domains, individual behavior is greatly influenced by the perceived behavior of other people. (5)
  • In many domains, people show unrealistic optimism. (6)
  • People often use heuristics, or mental shortcuts, when assessing risks. (7)
  • People sometimes do not make judgments on the basis of expected value, and they may neglect or disregard the issue of  probability, especially when strong emotions are triggered. (7)

Sunstein tentatively concludes — although I would certainly state it more strongly — “it would be possible to think that at least some behavioral market failures justify more coercive forms of paternalism.” (10)

The Financial (Mis)Education of Lauren Willis

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Lauren Willis has posted Financial Education:  Lessons Not Learned and Lessons Learned.  This is a sobering, even depressing, overview of what we know about the efficacy of financial education.  This is an extremely important topic because the CFPB has identified financial education as a core part of its mission in its Strategic Plan (see Outcome 2.2).

Willis asks, “Does financial education work as hoped?” (125) She answers her own question:  “Empirical evidence does not support the theory. Some (but not all) studies show a positive correlation between financial education and financial knowledge or between financial knowledge and financial outcomes. But no strong empirical evidence validates the theory that financial education leads to household well-being through the pathway of increasing literacy leading to improved behavior.” (125)

Some of her her other important conclusions (based on a thorough review of the literature) include

  • “the only statistically significant effect of mandatory personal financial training on soldiers was that they adopted worse household budgeting behaviors after the training than before it.” (126)
  • “Youth who took a personal finance course in high school do not report better financial behavior several years later than youth who did not take the course.  Adults who attended public schools where they were required to take personal financial courses were found to have no better financial outcomes than adults who were not required to take such courses.” (126, citations omitted)
  • One “reason financial education is unlikely to produce household financial well-being is that consumers’ knowledge, comprehension, skills, and willpower are far too low in comparison with what our society demands.” (128)

Willis’ conclusions should caution against assuming that financial education is a proven method to reduce the impact of predatory practices in the consumer finance sector.  The CFPB has shown a willingness to test the efficacy of its approaches.  Hopefully it will do so with its financial education initiiatives too.

Reiss on Fannie and Freddie Multifamily Contraction

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GlobeSt.com interviewed me (and others) about Federal Housing Finance Agency Acting Director Edward J. DeMarco plans to reduce Fannie and Freddie’s multifamily finance volume by 10% from last year’s levels:

Also consider this, says David Reiss, a professor of Law at Brooklyn Law School who has published papers on the GSEs: “We are living through a very abnormal time when the federal government dominates the market for single family and multifamily mortgages.”

This is neither necessary nor optimal, he tells GlobeSt.com. “It is not necessary because there have been long stretches in the past when the government had a much smaller role in those markets. And other credit markets operate well with no or a much smaller government footprint.”

This is not to say that there is no role for the federal government in the multifamily mortgage market, Reiss continues — just that it is far too large at this point in time. “If the reduction in the GSE footprint is telegraphed over a reasonable time horizon to the other market participants, this change should be taken in stride by the multifamily market,” he predicts.

 

Second Circuit Finds Plausible Claims of Widespread Misconduct in RMBS Offering

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The Second Circuit ruled in New Jersey Carpenters Fund v. The Royal Bank of Scotland Group et al. on a number of issues, but of interest to me are the sections dealing with allegations of misrepresentations.

The Court writes that “numerous courts, including the First Circuit in Nomura, have concluded that misstatements of an underwriter’s guidelines are not ‘so obviously unimportant’ that they are immaterial as a matter of law. Id. at 162; see Nomura, 632 F.3d at 773; J.P. Morgan, 804 F. Supp. 2d at 154; IndyMac, 718 F. Supp. 2d at 510; Tsereteli v. Residential Asset Securitization Trust 2006-A8, 692 F. Supp. 2d 387, 392-93 (S.D.N.Y. 2010). We agree. The Series 2007-2 Trust consisted primarily of a pool of mortgage loans and interests in the properties that secured those loans. Investors would profit from their interests in the Series 2007-2 Trust only if the trust could recoup a sufficient portion of the balance of those loans. Thus, a ‘substantial likelihood’ exists that a reasonable investor would want to know whether those underwriting the loans had adhered to the procedures in place for evaluating ‘the capacity and willingness of the borrower[s] to repay the loan[s] and the adequacy of the collateral securing the loan[s].’ J. App’x at 370. Given the apparent importance of this information, we conclude that, at this stage of the proceedings, the alleged misstatements and omissions are not immaterial as a
matter of law.” (25-26)

The Court further writes that “knowledge that the borrowers had low credit scores and that many of the mortgages had high loan-to-value ratios would make a reasonable investor more, rather than less, interested in whether NMI [one of the Novastar defendants] had adhered to its processes for evaluating ‘the capacity and willingness of the borrower[s] to repay.’ J. App’x at 370. Accordingly, for the reasons described above, we conclude that the alleged misstatements and omissions are not immaterial as a matter of law.” (28)

The cumulative effect of the cases (see here for another example) arising from the Subprime Crisis is that broad carve-outs from representations will not protect parties from claims of misrepresentation.  This seems to be an example of schoolyard law — in the good sense.  Just because you crossed your fingers, it doesn’t mean that you weren’t lying.

 

 

 

Rakoff Rules Again for an Investor Against a Securitizer

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Judge Rakoff explains his denial of the defendants’ (various Bear Stearns, JPMorgan and WAMU entities) motion to dismiss the suit. The suit alleges that the defendants “made fraudulent representations regarding the riskiness of he securitizations and the underlying loans” upon which the plaintiffs (Dexia and FSA entities) relied to their detriment. (5)

A judge does not typically do much fact-finding in a denial of a motion to dismiss, but there are still some interesting bits:

  • “a reasonable fact-finder could conclude that” disclosures about exceptions to underwriting guidelines “suggested to a reasonable investor not the systematic deviation from established underwriting standards alleged by plaintiffs, but rather a low level of occasionally non-compliant loans in the loan pools that could be subject o repurchase.”  (11-12) This is important.  It means that disclosures must be relatively specific as to the level of risk that the investor will face by deviations from stated underwriting objectives.
  • Judge Rakoff also reiterates that underwriters and others involved in securitizations must at least believe themselves the representations that they make. (15)  The fact that the investors are sophisticated does not matter:  “even a sophisticated party may reply on the representations of another where the facts misrepresented  were ‘peculiarly within the Defendants’ knowledge.'” (19, quoting Allied Irish Banks, PL.C. v. Bank of Am., N.A., No. 03-Civ. 3748, 2006 WL 278138 (S.D.N.Y. Feb. 2, 2006))
  • “Judge Rakoff did make one tentative finding of fact:  “the confidential witness statements incorporated into the Amended Complaint, combined with the documentary sources, support a strong inference that the defendants knew that the mortgages included within the loan pools were not of the quality represented in the offering documents.” (17)

The cases arising from the financial crisis stand for the important (but hopefully uncontroversial) principle that material lies and omissions can be fraudulent even among sophisticated parties.  This might make the most sense in Latin:  caveat emptor for sure, but there has to be some bona fides.

 

(Hat tip to Peter Liem)

 

More on Housing America’s Future

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I blogged about some of the big themes in the Bipartisan Policy Center’s Housing America’s Future report.  Today, I take a closer look at their position on housing finance in particular:

The report states that “it is highly unlikely that private financial institutions would be willing to assume both interest rate and credit risk, making long-term, fixed-rate financing considerably less available than it is today or only available at higher mortgage rates.” (42) This statement is far from uncontroversial.  First, the jumbo private label-market had originated 30 year fixed rate mortgages.  There is at least some tolerance for a product in which the private sector bears both credit and interest rate risk.  Second, the fixation on the 30 year fixed mortgage product is counter-productive.  The typical American household moves every seven years.  In an invisible way, pushing people into 30 year fixed mortgages can harm them.  Think, for instance, of a young couple moving into a one bedroom condominium unit.  The odds that they will be there for 30 years without ever even refinancing to get a lower interest rate or to access the equity they built up is miniscule.  But that couple will be paying an interest rate premium to have their interest rate fixed for that whole thirty years.  That couple would likely be better served by a 5/1 or 7/1 ARM which would balance a low interest rate in the near term with the risk that they stay longer than expected and pay a higher interest rate in the long term.

The reports fixation on put-back risk (46) is a canard.  There is no need to regulate in this area.  Now that private parties are aware that it is a serious issue, they will negotiate accordingly.

The report’s concern with “uncertainty related to pending regulations and implementation of new rules” also seems misguided. (47)  The housing finance system just went through a near death experience.  Of course there is some uncertainty as we plan to take it off of life support.

The report’s position that any “government support for the housing finance system should be explicit and appropriately priced to reflect actual risk” is right on, but the devil will be in the details. (48) How can we set up a system in which political interference won’t distort the pricing of risk?  The government does not have a good track record in this regard.

More anon . . .

Rakoff Rules for Monoline Insurer Against Securitizer

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Judge Rakoff ruled for Assured Guaranty against Flagstar and awarded Assured more than $90 million.  The 103 page order is a pretty compelling read as it is a careful review of a battle of the experts and has lots of details about the loans in two Flagstar securitizations.  Some interesting bits:

  • the third-party due diligence providers, the Clayton Group and the Bohan Group, “were only expected to flag issues if something in the loan files appeared ‘ridiculous.’” (18)
  • the court found that many of the loans had “blatant” defects. (75)

Ultimately, the court found “that the loans underlying the Trusts here at issue pervasively breached Flagstar’s contractual representations and warranties.” (91)  The court’s findings may have unexpected relevance to other burning issues coming out of the financial crisis, such as whether these securitizations complied with the REMIC rules.