Richard Thaler has a simple argument for plain-vanilla financial products. Mike at Rortybomb deals with some of the predictable objections. This is also similar to Adam Levitin’s position on credit cards, which I wrote about a while back.
I’m in favor, although I don’t think it will be enough to simply make the vanilla offering available; in that case nothing would stop lenders from paying higher commissions to brokers in order to steer customers toward exploding mortgages.
By James Kwak
The Baseline Scenario 
“nothing would stop lenders from paying higher commissions to brokers in order to steer customers toward exploding mortgages.”
Why would they still offer exploding mortgages if we remove the ability for them to push risk down the road?
The challenge is finding a method to keep competition in the system; freezing the terms of trade almost certainly will favor the incumbents.
Look at it this way: during the years 2001-6, “alternative” loan providers took enormous share from more traditional providers. Indeed, they took so much share that eventually the stodgy old banks felt the need to participate by either buying the new guys or buying the downstream product of the new guys’ work.
The new products – the option ARMs and liar loans and other innovations – were far more PRO-consumer than the 80/20 fixed-rate mortgage they displaced. We know this because (a) customers chose the alternative products; (b) the mortgages created by the new products are underwater.
In other words, there was a transfer of wealth from debt issuers and securities markets to selling houseowners, and in the meantime some number of house buyers gained the utility of occupying houses they could not have otherwise lived in. If the Federal government had not pledged taxpayer dollars to bail out the debt issuers and securities markets from the consequences of their actions, there would be no problem, just money moving from one private entity to another.
The vanilla mortgage will prevent such losses…by the debt issuers and securities markets. That may be a worth goal, but let’s not lose track of who is being protected here.
yes, it won’t be enough, but it would help.
Oh, it makes you miss the old-fashioned Soda Shops. Mr. Kwak, make it a round of vanilla milkshakes for everyone on me. I’ve decided America needs less Tutti Frutti and more Vanilla.
So can you explain what lenders gain by encouraging consumers to sign up for exploding mortgages?
Is the expectation now that they can pretty much engage in tactics that have proven to be failures – because they know the feds will bail them out no matter what?
Because don’t most people think that assembling the toxic asset mountain our financial system continues to teeter on was an explosive failure in business leadership?
Let us recall the address given in April by Paul Volcker at Columbia where he offered his judgment that the only innovative financial ‘product’ that has contributed to greater economic/soicial welfare was the ATM. Doubtless one further reason why Obama has relegated him to an outer orbit of Obama’s policy circle.
Two things, I think. Let’s say we’re talking about Option ARMs that allow you to pay very little starting off and then increase the monthly payment significantly after a couple of years. First, it enables you to lend to people who otherwise would not be able to borrow. More lending, especially at high interest rates, equals more profits. If you can securitize the loans, you don’t even taken on more risk. Even if you can’t securitize them, your are taking on the risk yourself, but you individually (the CEO) aren’t taking on a commensurate level of personal risk.
Second, exploding mortgages require refinancing every few years, which means more fees.
Can you give me your take on this?
Doing a mortgage re-fi to shave a bit of money off the monthly nut.
Did the research. Found a no-cost option with a slightly higher interest rate (but still lower than what we pay now.)
Discovered that the broker/bank wanted to give us a new loan that happened to be a bit more than the balance we owe currently.
The difference happens to coincide with the closing costs to be picked up by the bank. Upon discovering this, we’ve renegotiated the balance down to what we owe, not what what we owe + an amount that would cover the costs to close on a no-cost refinance.
Coincidence, said the broker. Just coincidence. Certainly nothing illegal!
Your thoughts?
Isn’t there a Truth in Lending or RESPA violation in there? They are understating the finance charge.
On paper, they pay back the loan.
However, in that they’re giving me a loan that is more than what I currently owe – with a difference that is nearly equal to the closing costs, they’re (coincidentally) getting more money out of me that happens to equal the closing costs. I don’t see the X number of dollars that is left over after the loan is paid off – leaving me to wonder who DOES see that money…
I doubt it is illegal – it’s just smelly.
I’m sorry – opening line should read – on paper, they pay the closing costs.
Sorry, I’ll elaborate, as I do see two violations here, TILA and RESPA. (disclosure: this is based on the information given only and not a firm legal opinion based on fact ;) )
If they are increasing what you owe, then yes, they are understating the finance charge. RESPA requires properly filled out HUD forms which would indicate that your payoff is less than the loan amount, which means the remainder comes from YOUR loan funds. If your loan funds are not going to cover the payoff, then they need to be shown to be used for *something*. If it’s closing costs, then those costs must be shown on the Truth in Lending form. TILA dictates clearly which costs are finance charges and which aren’t; if you’re not getting something of value, then it’s most likely a finance charge. If they are not including those finance charges in the APR, then the Truth in Lending form has been calculated wrong, which means you would be entitled to reimbursement, and if it’s systemic (ie. they did this to lots of people) the institution could be subject to penalties.
Truth in Lending: http://www.fdic.gov/regulations/laws/rules/6500-1400.html#6500226.4
RESPA: http://www.fdic.gov/regulations/laws/rules/6500-2520.html#6500res3500.8
If you’re still in the process of closing, I would pursue this….a little documentation goes a long way.
is there a line item where it shows that the closing costs come from *their* funds? Not the funds you are entitled to….
I want to bring everyone’s attention to an article in “New Yorker” magazine. I think someone else had mentioned this article before in another post, but I want to make sure it doesn’t escape people’s attention. The article by Ryan Lizza which focuses on Sheila Bair, head of the FDIC. Miss Bair foresaw predatory lending and subprime loans was a systemic problem YEARS before others noticed, and similar to Brooksley Born’s story she was told to mind her own damned business (even though it was her business).
In my opinion Sheila Bair is an unsung hero. We notice when people screw up, we should also notice when the lone hero is proved right and sing their praises from the rooftops. If we had more bureaucrats like Miss Bair, the word bureaucrat would make us smile. A very Midwestern type woman, I guess she also likes vanilla ice cream. Here is the link to the article.
http://www.newyorker.com/reporting/2009/07/06/090706fa_fact_lizza?currentPage=1
The “Rortybomb” blog should have more posts on this same topic in the near future. I want to compliment James and Simon for adding that link to this site. Good stuff.
I think what might be missing here is that the complexity wasn’t created here to offer more “value add”, but rather to bilk the consumer.
That is, things like “teaser rates” and “balloon payments” weren’t pushed on average consumers to give them better options, but rather to take them for a ride. In the skiing analogy of the post you link to, it’s as if you created a ski run that had hidden holes for skiers to fall into so you could club them and steal their money. In that case, putting a “warning” on those runs would subvert the (devious) purpose. If they had advertised these mortgages for what they really were, no one would have taken them, so from the lenders’ side, the lack of transparency was critical to “product”.
Thus, at least to me, creating this whole concept of “vanilla mortgages” seems a sort of convoluted way of preventing intentionally unethical lending. After all, people didn’t “accidentally” make bad decisions here, they were conned into it, and said “con jobs” should be illegal.
I guess in the end I admit I can’t think of a great way to regulate this since there are some legitimate reasons for say “balloon mortgages”, but it seems to me at least we should “call a spade a spade” here – this isn’t about adding “clarity” to legitimate lending (vanilla), it’s about preventing unethical lending (crunchy frog).
Buffett was on Good Morning America today and said he does not speak much with Obama, post election.
Buffett also said something about TARP not being elegant or something, and said Wall Street should not profit from PPIP, I think. First dash of honesty from him on the credit mess, in my opinion.
Just to clarify. TILA does provide a lengthy definition of “finance charge” but it is not hard to use technical legal distinctions to avoid the requirement to identify something as a finance charge. Calling a charge a “deposit” might be enough to avoid serious regulatory issues.
Second, it appears from the description that the loan simply includes the standard costs of closing, some of which are legitimate third-party expenses (i.e. appraisals, recording, document prep) and some of which may simply be origination fees or other fees charged by the lender.
Anne, did you actually read the documents provided? That’s always a good place to start. Second thing to do would be to ask a lot of questions of your lender -which it sounds as if you did, if they renegotiated.
If they marketed this to you as a “no-cost” refi but then included the costs in the loan amount, what this really smells like is a potential violation of Section 5 of the Federal Trade Commission Act (or similar state law) which prohibits “unfair or deceptive acts or practices” – because it wasn’t really a no-cost refi because the costs were amortized into the loan amount.
If you take a good look at the revisions to Regulation Z (the Fed’s implementing rule to TILA), you’ll see that, for some loans, they are requiring disclosure of a comparison between a plain vanilla model and the loan applied for.
But what’s really important for people to think about is that the way the regulation was originally writting back in the 1960’s has had a huge effect on the types of products being offered. Before Reg Z, the concept of APR was not standard; lenders would create and market products using their own calculated “rates”. Reg Z was an attempt to standardized those rates so that borrowers would be able to easily compare products from different lenders.
Reg Z did not ever contemplate things like Option ARMs – it was based on the concept of the plain-vanilla 30-year fixed mortgages (which themselves only came into being in the 1930’s as part of the government’s attempt to revive the housing industry after the economic collapse). As lenders created new products, they designed them to fit Reg Z’s (and RESPA’s) requirements for APR disclosures.
And it’s also important to realize that Reg Z did not really apply to the vast majority of mortgage brokers (until the recent amendments) – although if they moved loans through a national bank or other regulated lender they had to make sure that they were not completely outside the rules, their practices were not examined by the regulators, who go into and examine the banks regularly.
We don’t have to slavishly assume that the APR-driven model of lending is the only way to go – it’s just that the lenders have figured out how to make it profitable, and neither they nor the regulator want to incur the costs of moving to another model, like a flat-fee based program.
FYI – we have not closed yet – we were scheduling the closing and I received a good faith estimate of what closing costs would be.
In this doc, closing costs add up to X amount. Document indicates a -X amount at a line called: “Total paid items and subordinate financing.” Closing costs and the “total paid items” are the same.
Total cost of new loan is set for an amount that is more than the same loan we’re paying off, with the difference being virtually the same figure as the closing costs.
When asked why our loan was X amount more than what we’re paying off, the broker said it was what we had discussed some weeks ago (my understanding was that the number was an estimate and would be revised according to what we actually owed.) Only after I pushed did he agree to revise our new loan to more accurately reflect what we actually owe.
In all honesty, not sure I will close on this.
Thank you for this info. Will pursue it further.
Thanks! As I noted above, we haven’t closed yet, so don’t have that volume of paperwork to cull through just yet.
I think that what puzzled me is that when I brought the difference in loan amounts to the attention of the broker, he DID NOT say, “don’t worry about that, we’ll have the loan reflect the payoff.” He said that the loan amount was something we had discussed and agreed on earlier and it would be hard to change. He never said that the bank would cut us a check for the difference.
My recollection of the earlier call was that the loan amount we had discussed was an estimate and would be revised closer to closing to more closely reflect the loan we’re paying off.
After initially saying it would be too hard to change the loan amount, he has agreed to lower the amount of the loan to a figure closer to what we’re paying off, but I’m not sure what would have happened if I hadn’t asked him about it.
Will continue to look into it.
To James – again, this business model you describe seems strikingly similar to the one that last fall required Henry Paulson to say “We need trillions to bail out the financial system or there won’t be an economy on Monday.”
“More lending” using instruments that allow lending to “people who otherwise would not be able to borrow” and the securitization of such loans led to catastrophic failure of the financial system. Or at least that’s how it was pitched to Main Street.
So again, despite the short term profit for lenders and access to borrowing that people cannot really afford, I wonder why the pursuit of questionable loans continues unabated, since it was something that led to disaster last year.
The conclusion I have drawn from seeing the results of the development of the ridiculously complex, opaque, and nearly unfathomable creative investment vehicles is this: They benefitted (and will continue to benefit) none but those who develop them (and even that benefit is completely questionable, at this point). Since they don’t benefit garden variety (or, arguably, even institutional) investors, why do we continue to permit their existence. The only ones in favor of a continuation of this financial fecal material seems to be the plutocrats and oligarchs and their lobbyists. What does that tell us?