The Advantages of ARMs

photo by Kathleen Zarubin

The Wall Street Journal quoted me in Why Home Buyers Should Consider Adjustable-Rate Mortgages (behind paywall). It opens,

While many out-of-the-mainstream loans got a black eye in the subprime debacle, today’s versions have been shorn of the toxic features—such as negative amortization and prepayment penalties—that tripped up many borrowers during the housing bubble a decade ago.

Plan to move

Experts say today’s adjustable-rate mortgages, or ARMs, as well as interest-only loans, are especially suitable for borrowers who expect to move before any rate increases can wipe out the savings in the early years. They’re also useful for sophisticated borrowers wrestling with uneven income, borrowers who expect their income to rise, or borrowers who are willing to bet they can invest their mortgage savings for a greater return elsewhere.

“Many of the mortgage products that some may have thought slipped into extinction, such as interest-only loans, do still exist today, but in far less volume” than in the heyday of the subprime era, says Bill Handel, vice president of research and product development at Raddon Financial Group, consultant to the financial-services industry.

Adds David Reiss, a law professor and academic program director at the Center for Urban Business Entrepreneurship at Brooklyn Law School: “The benefits of non-30-year, fixed-rate mortgages are legion.”

A sweet spot

Many borrowers can find a sweet spot, for example, in the so-called 7/1 adjustable-rate mortgage, which carries a fixed rate for seven years before starting annual adjustments. With a typical rate of 3.75%, the monthly payment on a $300,000 loan would be $1,389, compared with $1,449 for a 30-year, fixed-rate loan at 4.1%, saving the borrower $5,040 over seven years.

Even if the loan rate then went up, it could take two or three years for higher payments to offset the initial savings, making the mortgage a good choice for a borrower likely to move within 10 years. Once annual adjustments begin, they are generally calculated by adding a fixed margin to a floating rate, such as the London interbank offered rate.

“ARMs are very underutilized,” says Mat Ishbia, president of United Wholesale Mortgage, a lender in Troy, Mich. He expects the 7/1 ARM to account for 15% of new mortgages within the next few years, up from less than 5% today. Historically, ARMs become more popular as interest rates rise, making savings from the loan’s low initial “teaser rate” more attractive, he notes.

Enlarging The Credit Box

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The Hill published my column, It’s Time to Expand The Credit Box for American Homebuyers. it reads,

The dark, dark days of the mortgage market are far behind us. The early 2000s were marked by a set of practices that can only be described as abusive. Consumers saw teaser interest rates that morphed into unaffordable rates soon thereafter, high fees that were foisted upon borrowers at the closing table and loans packed with unnecessary and costly products like credit insurance.

After the financial crisis hit, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The law included provisions intended to protect both borrowers and lenders from the craziness of the previous decade, when no one was sufficiently focused on whether loans would be repaid or not.

The Consumer Financial Protection Bureau (CFPB) promulgated the rules that Dodd-Frank had called for, like the ability-to-repay and qualified mortgages rules. These rules achieved their desired effect as predatory mortgage loans all but disappeared from the market.

But there were consequences, and they were not wholly unexpected. Mortgage credit became tighter than necessary. People who could reliably make their mortgage payments were not able to get a mortgage in the first place. Perhaps their income was unreliable, but they had a good cushion of savings. Perhaps they had more debts than the rules thought advisable, but were otherwise frugal enough to handle a mortgage.

These people banged into the reasonable limitations of Dodd-Frank and could not get one of the plain vanilla mortgages that it promoted. But many of those borrowers found out that they could not go elsewhere because lenders avoided making mortgages that were not favored by Dodd-Frank’s rules.

Commentators were of two minds when these rules were promulgated. Some believed that an alternative market for mortgages, so-called non-qualified mortgages, would sprout up beside the plain vanilla market, for good or for ill. Others believed that lenders would avoid that alternative market like the plague, again for good or for ill. Now it looks like the second view is mostly correct and it is mostly for ill.

The Urban Institute Housing Finance Policy Center’s latest credit availability index shows that mortgage availability remains weak. The center concludes that even if underwriting loosened and current default risk doubled, it would remain manageable given past experience.

The CFPB can take steps to increase the credit box from its current size. The “functional credit box” refers to the universe of loans that are available to borrowers. The credit box can be broadened from today’s functional credit box if mortgage market players choose to thoughtfully loosen underwriting standards, or if other structural changes are made within the industry.

The CFPB in particular can take steps to encourage greater non-qualified mortgage lending without needing to amend the ability-to-repay and qualified mortgages rules. CFPB Director Richard Cordray stated earlier this year that “not a single case has been brought against a mortgage lender for making a non-[qualified mortgage] loan.”

But lenders have entered the non-qualified mortgage market very tentatively and apparently need more guidance about how the Dodd-Frank rules will be enforced. Moreover, some commentators have noted that the rules also contain ambiguities that make it difficult for lenders to chart a path to a vibrant non-qualified mortgage line of business. Lenders are being very risk-averse here, but that is pretty reasonable given that some violations of these rules can result in criminal penalties, including jail time.

The mortgage market of the early 2000s provided mortgage credit to too many people who could not make their monthly payments on the terms offered. The pendulum has now swung. Today’s market offers very few unsustainable mortgages, but it fails to provide credit to some who could afford them. That means that the credit box is not at its socially optimal size.

The CFPB should make it a priority to review the regulatory regime for non-qualified mortgages in order to ensure that the functional credit box is expanded to more closely approximate the universe of borrowers who can pay their mortgage payments month in, month out. That would be good for those individual borrowers kept out of the housing market. It would also be good for society as a whole, as the financial activity of those borrowers has a multiplier effect throughout the economy.

Consumer Protection, Going Forward

photo by Lawrence Jackson

Warren, Obama and Cordray

The New York Times quoted me in Consumer Protection Bureau Chief Braces for a Reckoning. It opens,

Mild-mannered, lawyerly and with a genius for trivia, Richard Cordray is not the sort of guy you picture at the center of Washington’s bitter partisan wars over regulation and consumer safeguards.

But there he is, a 57-year-old Buckeye who friends say prefers his hometown diner to a fancy political reception, testifying in hearing after hearing on Capitol Hill about the agency he leads, the Consumer Financial Protection Bureau. Republicans would like to do away with it — and with him, arguing that the agency should be led by a commission rather than one person.

And with a Republican sweep of Congress and the White House, they may get some or all of what they wish.

Mr. Cordray, a reluctant Washingtonian who has commuted here for six years from Grove City, Ohio, where his wife and twin children live, is the first director of the consumer watchdog agency, which was created in 2010 after Wall Street’s meltdown. By aggressively deploying his small army of workers — he has 1,600 of them — Mr. Cordray has turned the fledgling agency into one of Washington’s most powerful and pugnacious regulators.

The bureau has overhauled mortgage lending rules, reined in abusive debt collectors, prosecuted hundreds of companies and extracted nearly $12 billion from businesses in the form of canceled debts and consumer refunds. In September, it exposed the extent of Wells Fargo’s creation of two million fraudulent customer accounts, igniting a scandal that provoked widespread outrage and toppled the company’s chief executive.

And, according to Mr. Cordray, he and his team have barely scratched the surface of combating consumer abuse.

“We overcame momentous challenges — just building an agency from scratch, let alone one that deals with such a large sector of the economy,” Mr. Cordray said in an interview at his agency’s office here. “I’m satisfied with the progress we have made, but I’m not satisfied in the sense that there’s a lot more progress to be made. There’s still a lot to be done.”

But his future and the agency’s are uncertain. Democrats in Ohio are encouraging Mr. Cordray to run for governor in 2018, which would require him to quit his job in Washington fairly soon, rather than when his term ends in mid-2018. Champions of the agency are imploring him to stay, arguing that if he leaves, the agency is likely to be defanged, its powers to help consumers sapped.

Opponents of the bureau just won a big legal victory: The United States Court of Appeals for the District of Columbia Circuit said last month that the structure of the Consumer Financial Protection Bureau was unconstitutional, and that the president should have the power to fire its director at will.

The agency is challenging the decision — which was made in a lawsuit brought by the mortgage lender PHH Corporation that contests the consumer bureau’s authority to fine it — and that has temporarily stopped the decision from taking effect. But the ruling has kept alive questions about whether too much power is concentrated in Mr. Cordray’s job, and whether the agency should be dismantled or restructured.

Mr. Cordray, who also battled on behalf of consumers in his previous jobs as Ohio’s attorney general and, before that, its treasurer, is praised in some circles as enormously effective, wielding the bureau’s power to restructure some industries and terrify others.

The bureau has “helped save countless people across the country from abusive financial practices,” said Hilary O. Shelton, the N.A.A.C.P.’s senior vice president for advocacy and policy.

Even the regulator’s frequent foes — including Alan S. Kaplinsky, a partner at Ballard Spahr in Philadelphia, who says the agency often overreaches — acknowledge its impact.

“I’ve been practicing law in this area for well over 40 years, and there’s nothing that compares to it,” Mr. Kaplinsky said. “Every company in the consumer financial services market has felt the effects.”

The Consumer Financial Protection Bureau has nearly replaced the Better Business Bureau as the first stop for dissatisfied customers seeking redress. It has handled more than a million complaints, many of which it has helped resolve.

*     *    *

The housing crisis dominated the bureau’s early days. When Congress created the new overseer, it also dictated its first priority: making mortgages safer. The deadline was tight. If the bureau did not introduce new rules within 18 months, a congressionally mandated set of lending guidelines would automatically take effect.

The bureau made it with one day to spare.

It banned some practices that had fueled the crisis, like home loans with low teaser rates or no documentation of the borrower’s income, and steered lenders toward “qualified” loans with a stricter set of safeguards, including checks to ensure that customers could afford to repay what they borrowed.

After much grumbling — and many dire forecasts that the new rules would limit credit and harm consumers — mortgage lenders adjusted. They made nearly 3.7 million loans last year for home purchases, the highest number since 2007, according to government data.

“It seems like the financial services industry has figured out how to adapt to this new regulatory regime,” said David Reiss, a professor at Brooklyn Law School who studied the effects of the bureau’s rule-making. “We’ve moved from the fox-in-the-henhouse market in the early 2000s, where you could get away with nearly anything, to this new model, where someone is looking over your shoulder.”

Monday’s Adjudication Roundup

Good Data Makes Good Mortgages

The CFPB issued a proposed rule about increasing the quality of information that lenders report about mortgage applications. The press release regarding the proposed rule states that these changes will ease the reporting burden on lenders, and that may very well be true. But the contested part of these rules relate to the type of information to be collected:

  • Improving market information: In the Dodd-Frank Act, Congress directed the Bureau to update HMDA regulations by having lenders report specific new information that could help identify potential discriminatory lending practices and other issues in the marketplace. This new information includes, for example: the property value; term of the loan; total points and fees; the duration of any teaser or introductory interest rates; and the applicant’s or borrower’s age and credit score.
  • Monitoring access to credit: The Bureau is proposing that financial institutions provide more information about underwriting and pricing, such as an applicant’s debt-to-income ratio, the interest rate of the loan, and the total discount points charged for the loan. This information would help regulators determine how the Ability-to-Repay rule is impacting the market, and would also help the Bureau monitor developments in specific markets such as multi-family housing, affordable housing, and manufactured housing. The proposed rule would also require that covered lenders report, with some exceptions, all loans related to dwellings, including reverse mortgages and open-end lines of credit.

Lenders are not going to like this, because this new information may be used against them in a variety of ways — in Fair Housing lawsuits, by the CFPB in enforcement actions, by members of Congress seeking to increase credit access to various constituencies.

I like this because regulators and academic researchers have been hamstrung by limited and stale data on the fast-moving mortgage market. The mortgage market is often driven by the short-term profit-seeking of private actors and by special interests pushing their agendas with the Executive and Legislative Branches.  Good data can inform good decision-making that can ensure that the housing finance system is vibrant and provides sustainable credit for households over the long term.

Comments on the proposed rule are due by October 22, 2014.