Tag Archives: interest rate

Uses & Abuses of Online Marketplace Lending

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photo by Kim Traynor

 

The Department of the Treasury has issued a report, Opportunities and Challenges in Online Marketplace Lending. Online marketplace lending is still in its early stages, so it is great that regulators are paying attention to it before it has fully matured. This lending channel may greatly increase options for borrowers, but it can also present opportunities to fleece them. Treasury is looking at this issue from both sides. Some highlights of the report include,

 

 

  • There is Opportunity to Expand Access to Credit: RFI [Request for Information] responses suggested that online marketplace lending is expanding access to credit in some segments by providing loans to certain borrowers who might not otherwise have received capital. Although the majority of consumer loans are being originated for debt consolidation purposes, small business loans are being originated to business owners for general working capital and expansion needs. Distribution partnerships between online marketplace lenders and traditional lenders may present an opportunity to leverage technology to expand access to credit further into underserved markets.
  • New Credit Models and Operations Remain Untested: New business models and underwriting tools have been developed in a period of very low interest rates, declining unemployment, and strong overall credit conditions. However, this industry remains untested through a complete credit cycle. Higher charge off and delinquency rates for recent vintage consumer loans may augur increased concern if and when credit conditions deteriorate.
  • Small Business Borrowers Will Likely Require Enhanced Safeguards: RFI commenters drew attention to uneven protections and regulations currently in place for small business borrowers. RFI commenters across the stakeholder spectrum argued small business borrowers should receive enhanced protections.
  • Greater Transparency Can Benefit Borrowers and Investors: RFI responses strongly supported and agreed on the need for greater transparency for all market participants. Suggested areas for greater transparency include pricing terms for borrowers and standardized loan-level data for investors.

*     *     *

  • Regulatory Clarity Can Benefit the Market: RFI commenters had diverse views of the role government could play in the market. However, a large number argued that regulators could provide additional clarity around the roles and requirements for the various participants. (1-2)

As we move deeper and deeper into the gig economy, the distinction between a consumer and a small business owner gets murkier and murkier. Thus, this call for greater protections for small business borrowers makes a lot of sense.

Online marketplace lending is such a new lending channel, so it is appropriate that the report ends with a lot of questions:

  • Will new credit scoring models prove robust as the credit cycle turns?
  • Will higher overall interest rates change the competitiveness of online marketplace lenders or dampen appetite from their investors?
  • Will this maturing industry successfully navigate cyber security challenges, and adapt to appropriately heightened regulatory expectations? (34)

We will have to live through a few credit cycles before we have a good sense of the answers to these questions.

Nonbank Servicers Pose Risks for Homeowners

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Christy Goldsmith Romero, Special Inspector General for the Office of the Special Inspector General for the Troubled Asset Relief Program (SIGTARP)

SIGTARP Special Inspector General Romero

The Office of the Special Inspector General for the Troubled Asset Relief Program (SIGTARP) has released its Quarterly Report to Congress (April 27, 2016). The Report focuses on how nonbank servicers raise risks for homeowners participating in the Home Affordable Modification Program (HAMP) of the Troubled Asset Relief Program (TARP). (65) The report states that

Mortgage servicers are the single largest factor in determining whether homeowners applying for, or participating in, TARP’s signature foreclosure prevention program HAMP are given a fair shot, and whether the program runs effectively and efficiently. This is because Treasury has contracted with mortgage servicers to play a predominant role in HAMP, by making the day-to-day decisions related to HAMP that have enormous implications for homeowners seeking relief. Mortgage servicers decide whether homeowners are eligible for HAMP, whether homeowners get a trial run in the program, and whether that trial run should result in the servicer permanently modifying the homeowners’ mortgages. Mortgage servicers decide how the mortgage will be modified, such as whether a homeowner will get a lower interest rate, and if so, what rate. Mortgage servicers decide how much the homeowner will have to pay each month. Mortgage servicers also apply payments they receive, and they make decisions on whether a homeowner should be terminated from the program. Because of this outsized role, all mortgage servicers are required to comply with HAMP rules, and federal laws. Following HAMP rules and federal laws is necessary to protect homeowners from harm.

Non-banks who service mortgages have increased their participation in HAMP, and now play a larger role in HAMP than bank servicers, but that was not always the case.

*     *      *

HAMP and its related programs have become a lucrative business and reliable source of income for non-bank servicers. Treasury pays mortgage servicers for every homeowner who receives a permanent mortgage modification in HAMP. Nonbank mortgage servicers have received $1.1 billion in Federal TARP dollars from Treasury through the HAMP program.

As non-bank servicers increase their role in HAMP, the risk to homeowners has also increased. Non-bank servicers have less federal regulation than banks that service mortgages. Some of the largest non-bank servicers have already been found to have violated laws in their treatment of homeowners, and have been the subject of enforcement actions by the federal or a state government. Some of the largest non-bank servicers also have been found to have violated HAMP’s rules in their treatment of homeowners. This increased risk to homeowners must be met with increased oversight to ensure that homeowners are treated fairly, and that HAMP and its related programs are effective and efficient. (65, notes removed)

Regulators and other government agencies have been taking a hard look at servicers recently (take a look at this and this). It is important for federal regulators to get their oversight of servicers right because they can and do cause mountains of misery for homeowners when things goes wrong.

Couples Leave Money on Closing Table

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photo by Dustin Moore

Geng Li, Weifeng Wu and Vincent Yao, three Fed economists, have posted a research note, Do People Leave Money on the Table? Evidence from Joint Mortgage Applications and the Minimum FICO Rule. The authors state that there “is mounting evidence that households make suboptimal savings and investment decisions” and find that

many mortgage borrowers appear to have failed to apply for mortgages that give the lowest interest rates. Specifically, we find that nearly 10 percent of prime borrowers who applied for their loans jointly could have lowered their mortgage interest rate at least one eighth of 1 percentage point if the mortgage was applied for by the applicant with a higher credit score and an income high enough to qualify for the mortgage. Furthermore, among the joint applicants with a lower credit score below 740, for whom mortgage interest rates are most sensitive to credit scores, more than 25 percent could have significantly reduced their borrowing cost by having the individual with a higher credit score apply. This is due to the fact that when lenders price mortgages with joint applications, the interest rates are determined by the lower score of the two–often known as the minimum FICO rule. We estimate that such borrowers could reduce their annual interest payment by between $220 and $1,400. Consistent with the existing literature, we find that couples who appeared to have left money on the table tend to have lower credit scores and be much younger and less financially sophisticated. (1, emphasis added)

This note provides an example of just how complicated the mortgage underwriting process is, particularly for less financially sophisticated borrowers.

One wonders if the CFPB should take a look at this. Should lenders be required to evaluate if joint mortgage applicants would get a better rate if only one of them ended up taking out the mortgage? And when the answer is yes, should lenders be required to share that information with the applicants? I can think of a variety of reasons why that should not be the case (not the least of which is that it could leave just one member of the family holding the bag if things go south), but it might be worth exploring this question more systematically.

Principal-ed Forgiveness

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photo by Vic

The Federal Housing Finance Agency announced a new program to implement principal reduction for seriously delinquent, underwater homeowners who meet the following criteria:

  • Are owner-occupants.
  • Are at least 90 days delinquent as of March 1, 2016.
  • Have an unpaid principal balance of $250,000 or less.
  • Have a mark-to-market loan-to-value ratio of more than 115% after capitalization. (1)

The program’s “modification terms include capitalization of outstanding arrearages, an interest rate reduction down to the current market rate, an extension of the loan term to 40 years, and forbearance of principal and/or arrearages up to a certain amount to be converted later to forgiveness.” (1) Once the borrower completes three timely payments, the principal forbearance amount can be forgiven.

This program can help just a small proportion of homeowners who have been underwater on their mortgages. Most importantly, it is being implemented years after the foreclosure crisis swamped the nation’s housing markets. But as can be seen from the criteria above, it is targeted just to homeowners with below-average principal balances on their mortgages and who are severely underwater. There are all sorts of political reasons that principal reduction was not a key component of the post-crisis housing finance reform agenda. But it is worth asking now — should we deploy it more quickly in the next crisis? What would be the principled reasons for doing that?

Many argued that principal forgiveness would reward homeowners for making bad, even immoral, decisions. With the benefit of hindsight, it would have been better to put that questions aside and ask what the best policy option for the country would have been. If outstanding principal balances could have been aligned more closely to the new normal of the post-financial crisis economy, the recovery could have proceeded more quickly.

Now would be the time for the FHFA to implement regulations to deal with the next great recession. If principal forgiveness makes sense under certain conditions, let’s identify them now and then have an easier time of it down the road.

Creative Credit Union Mortgages

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Credit Union

DepositAccounts.com quoted me in Types of Institutions in the U.S. Banking System – Credit Unions. It reads, in part,

What You Need to Know About Credit Unions

For more than 100 years, credit unions have been providing financial services to their members. Forget about what you thought you knew about credit unions. Long gone are the days when credit unions were seemingly only a “bank” for government employees. Today some 100 million Americans are member-owners of 6,900 credit unions and credit unions have more than $1 trillion in assets.

The Credit Union National Association (CUNA) defines a credit union as a non-for-profit, member-owned financial cooperative, democratically managed by its members, and operated for the purpose of promoting thrift, providing credit at competitive rates, and providing other financial services to its members.

Simply put — credits unions are about their members, not profits.

 *     *     *

How are credit unions different from banks?

“They are structured very differently. Credit unions don’t issue stock or pay dividends to outside shareholders, so they are not beholden to outside third party interests,” says Steve Rick, chief economist of CUNA Mutual Group, an insurer and maker of financial productions within credit unions.

Each person who holds an account is a member, and each member has one vote, “rather than the voices of only the powerful few stockholders heard at for-profit banks. And all earnings go straight back to members in the form of favorable interest rates and lower fees that other for-profit institutions can’t beat,” he adds.

Banks are governed by paid shareholders and voting rights depend on the number of shares owned. Earnings go to outside bond and stockholders in the form of dividends.

As cooperatives, credit unions are part of a broader cooperative community that shares philosophies around benefiting their member owners. One of the core missions of the credit union system is to educate its members on financial issues to ensure their financial health.

“It’s worth noting that credit unions can offer creative types of mortgages that should be explored by first-time and experienced homebuyers alike. The PenFed Credit Union, along with some other credit unions, has a 5/5 ARM that adjusts every five years. A product like this combines aspects of a fixed rate mortgage (fewer, but not the fewest) surprises about payment sizes, with aspects of an ARM (lower, but not the lowest) interest rates,” says David Reiss, a Brooklyn Law School professor specializing in real estate.

Failure to Refinance

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photo by GotCredit

Benjamin Keys, Devin Pope and Jaren Pope have recently had their Failure to Refinance paper accepted in the Journal of Financial Economics.  A version of the paper can be found on SSRN. This academic paper has a lot of relevance to many a homeowner. The abstract reads,

Households that fail to refinance their mortgage when interest rates decline can lose out on substantial savings. Based on a large random sample of outstanding U.S. mortgages in December of 2010, we estimate that approximately 20% of households for whom refinancing would be optimal and who appeared unconstrained to do so, had not taken advantage of the lower rates. We estimate the present-discounted cost to the median household who fails to refinance to be approximately $11,500, making this a particularly large consumer financial mistake. To shed light on possible mechanisms and corroborate our main findings, we also provide results from a mail campaign targeted at a sample of homeowners that could benefit from refinancing.

 The authors conclude,

Our results suggest the presence of information barriers regarding the potential benefits and costs of refinancing. Expanding and developing partnerships with certified housing counseling agencies to offer more targeted and in-depth workshops and counseling surrounding the refinancing decision is a potential direction for policy to alleviate these barriers for the population most in need of financial education.

In addition, the magnitude of the financial mistakes that households make suggest that psychological factors such as procrastination, trust, and the inability to understand complex decisions are likely barriers to refinancing. One policy that has been suggested to overcome the need for active household participation would require mortgages to have fixed interest rates that adjust downward automatically when rates decline To the extent that it is undesirable to reward only those households that are able to overcome the computational and behavioral barriers of the refinance process, policies such as an automatically-refinancing mortgage may be beneficial. Although an automatically-refinancing mortgage contract would be more expensive up-front for all borrowers in equilibrium, it would remove the cross-subsidization in the current mortgage finance system, where savvier homeowners who use their refinancing option when rates decline are subsidized by those households who fail to do so. (20, citation omitted)

I have heard a number of proposals that call for automatically refinancing mortgages. Such a mortgage product would shake up the mortgage market in its current form and require a transition period to figure out how it should be priced. But the net result would certainly benefit homeowners in the aggregate.

Rates up in ARMs

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Marriner S. Eccles Federal Reserve Board Building

TheStreet.com quoted me in Fed Hike Means Adjustable Rate Mortgages Will Rise and Increase Monthly Payments. It opens,

The first interest rate hike by the Federal Reserve in nearly a decade means consumers can no longer take advantage of a zero interest rate environment. Particularly challenged will be homeowners who have adjustable rates and stand to face higher mortgage payments.

Record low mortgage rates are set to be thing of the past as the Fed raised rates by 0.25%, which appears to be a nominal amount initially. Of course, consumers need to consider the cumulative effect of the central bank’s decision to increase rates periodically over a span of two to three years. The consecutive rate hikes will affect homeowners with adjustable rate mortgages when they reset, which typically happens once a year.

“The initial interest rate move is very modest and consumers will see a corresponding increase in their credit card and home equity line of credit rates within one to two statement cycles,” said Greg McBride, chief financial analyst for Bankrate, the North Palm Beach, Fla. based financial content company. “The significance is in the potential impact of whatever interest rate hikes are put into effect over the next 18 to 24 months.”

The Fed will continue to raise rates several times next year since yesterday’s move is not a “one and done” move, said Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pa. The Fed will likely follow with a series of three to four rate increases in 2016 if the economy continues to improve. The central bank could raise interest rates to a total of 1.0%, which will cause mortgage rates, auto loans and credit card rates to rise in tandem.

Adjustable rate mortgages, or ARMs, are popular among many younger homeowners, because they typically have lower interest rates than the more common 30-year fixed rate mortgage. Many ARMs are called a 5/1 or 7/1, which means that they are fixed at the introductory interest rate for five or seven years and then readjust every year after that, said David Reiss, a law professor at Brooklyn Law School in N.Y. The new rate is based on an index, such as the prime rate or the London Interbank Offered Rate (LIBOR), as well as a margin on top of that index. LIBOR is used by banks when they are lending money to each other.The prime rate is the interest rate set by individual banks and is usually pegged to the current rate of the federal funds rate, which the Fed increased to 0.25%.

The prime rate is typically used more for home equity lines of credit, said Reiss. LIBOR is typically used more for mortgages like ARMs. The LIBOR “seems to have had already incorporated the Fed’s rate increase as it has gone up 0.20% since early November,” Reiss said.

“The prime rate is influenced by the Fed’s actions,” Reiss said. “We already see that with Wednesday’s announcement that banks are increasing prime to match the Fed’s increase.”

The main disadvantage of an ARM is that the rate is only fixed for a period of five or seven years unlike a 30-year fixed rate mortgage, which means that monthly payments could rise quickly and affect homeowners on a tight budget.

Over the course of the next couple of years, the cumulative effect of a series of interest rate hikes could take an adjustable mortgage rate from 3% to 5%, a home equity line of credit rate from 4% to 6% and a credit card rate from 15% to 17%, said McBride.

“This is where the effect on household budgets becomes more pronounced,” he said.

Homeowners should start researching mortgage rates and refinance out of ARMs and lock into a fixed rate, said McBride. The 0.25% rate increase equals to a payment of $0.25 for every $100 of debt.

Since many factors impact the interest rates of mortgages, consumers need to examine the actual benchmark used by their lender since some existing interest rates already priced in some of the anticipated rise in the federal funds rate, said Reiss. While ARMs expose the borrower to rising interest rates, they typically come with some protection. Interest rates often cannot rise more than a certain amount from year to year, and there is also typically a cap in the increase of interest rates over the life of the loan.

An ARM might have a two point cap for one year increases if the introductory rate of 4% increased to 6% in the sixth year of a 5/1 ARM, he said. That ARM might have a six point cap over the life of the loan, which means a 4% introductory rate can go to no higher than 10% over the life of the loan.

 Based upon the current Fed increase of 0.25%, a homeowner with a $200,000 mortgage would pay an additional $40 a month or $500 a year when the rate resets.

“While this is not chump change, it is also not immensely burdensome to many homeowners,” Reiss said. “The bottom line is that it is worth figuring out just how your ARM works so you can understand what your worst case scenario is and then plan for it.”