Thursday, May 27, 2010

Free to Choose: Consumer Advocates Take on the Consumer

When ACORN's chief organizer, Bertha Lewis, speaking to a group of young people, told them that it takes courage to admit to being a socialist, no one in the mortgage community should have been surprised. We, after all, were used to dealing with ACORN and its constant complaints about the mortgage industry and the broker industry. Now ACORN is basically irrelevant--at least for this moment, but many other consumer advocacy groups have a powerful voice in Washington D.C. and they are setting policy which is affecting small business owners today and will affect all consumers of financial products in the near future after SB 3217 is reconciled with the House bill and then signed into law by the president (which is expected to happen by the fourth of July.)

Today I want to look at a study completed by the Center for Responsible Lending entitled "Steered Wrong: Brokers, Borrower, and Subprime Loans," which was published in April of 2008 and can be found on the Center for Responsible Lending's website at I found this 54 page study and its findings fascinating, and I think in light of everything that is happening around us today, the study is worth sharing.

The study, which is filled with official looking charts and graphs and numerous algebraic equations, puts the blame for the mortgage meltdown squarely on the shoulders of mortgage brokers. The Center for Responsible Lending wants us to know that it is not loose lending practices, or Community Re-Investment Acts, or scant oversight of Fannie Mae and Freddie Mac which caused the problems--it was mortgage brokers by themselves, plus nothing.

The study claims that brokers steered borrowers into subprime mortgages who could have qualified for prime mortgages, and in doing so cost them additional fees and higher interest rates which ultimately caused their homes to go into foreclosure. To support this theory, the report cites a study comparing loans of similar interest rates some of which were originated by brokers and others by retail originators. Now, without actually seeing the data and the files themselves, it would be impossible to make a precise comparison, but I can tell you with all certainty that there are reasons besides greed and heartlessness that borrowers used to go to into subprime loans. For example, two borrowers might both have a 660 credit score. One of the borrowers might have this score because he paid a few accounts thirty days late last year, but he now has 12 months of timely payments for all accounts on his credit report. Assuming that his income qualified him for the loan, he could probably get an automated underwriting approval for a prime loan. However, the other borrower might have a 660 credit score because he had a four year old medical collection for $10,000 which he could not afford to pay. This borrower would not qualify for a prime loan even though his other credit might be fine, because prime loans required that collections be paid at closing. (Even at the height of laxness, Fannie Mae and Freddie Mac never allowed unpaid collections over $5000.00.) So that borrower could either wait three more years for the collection to drop off his credit, or he could take a subprime mortgage at a higher interest rate and plan to refinance later. The study does not appear to consider any factors other than just the credit score, the debt to income ratio, whether the loan was considered full documentation, etc.

Nestled in among the charts and graphs are paragraphs editorializing about the role of the broker: "Brokers react to market incentives predictably; they seek to maximize both the number of loans they originate and their revenue per loan. However, since charging too much per loan could drive away potential customers, brokers must find the optimal balance between these two factors. We posit that brokers shift this balance according to their perception of a customer's credit profile." (page 4). "Homebuyers and homeowners have therefore trusted their brokers as mortgage professionals to help them choose a suitable loan. This misplaced trust has likely been a factor in the current foreclosure crisis." (page 5).

The report acknowledges that all states license mortgage brokers and that licensing requirements include criminal background checks, bonding, and educational experience requirements. But, this is not sufficient, according to the report, because "licensing statutes act primarily as enforcement mechanisms for substantive protections but do not actually establish protections themselves." The report fails to mention that retail originators--with whom it compares the brokers--were not required to be licensed at all until the SAFE ACT was implemented. But it asserts that retail originators are more likely to treat borrowers more fairly because of reputational risk and federal and state auditing requirements.

"Importantly, though their customers routinely rely on them as experts to help select lenders and loan products, mortgage brokers often assert that they are independent contractors and not agents of either borrowers or lenders." (page 6) Mortgage brokers asserted that because states like Texas had a form which borrowers were required to sign that said that we were independent agents and not agents of the borrowers or lenders. This form was mandatory in every file, and it was meant to clarify to the consumer the relationship between the broker and borrower. But a very large part of Center for Responsible Lending's hypothesis is that borrowers cannot and should not be trusted to read and understand forms.

The report states that "rational choice theory...assumes that people faced with choices will choose the best option based on their own set of preferences and constraints." However, the Center does not agree. "A 2007 study by Harvard University researchers finds that borrowers have a limited ability to analyze and compare multiple, complex mortgage products. The study finds that the complexity of mortgage pricing hampers both the borrowers' ability to assess risk and to comparison shop."(page 7)

This is reminiscent of the current Assistant Secretary of the Treasury's writings as quoted by Senator Richard Shelby, "Disclosures are geared towards influencing the intention of the borrower to change his behavior; however, even if the disclosure succeeds in changing the borrower's intentions, we know that there is often a large gap between intentions and actions...Product regulation would also reduce cognitive and emotional pressures related to potentially bad decision making by reducing the number of choices." Translation: Consumers can't be trusted to make the best decisions for themselves, no matter how much disclosure they have, so regulators and consumer advocacy must protect the consumer by limiting their choices. And since mortgage brokers represent a "one-stop shop" which offers many choices to borrowers, they are bad.

Now to the fascinating part. According to this study, borrowers in prime loans get a better deal with a mortgage broker than they do with a retail originator. "Finding Four: Prime borrowers who obtained loans from brokers generally experienced no additional costs compared to retail...Generally stronger credit borrowers with brokered loans that carried lower LTV ratios experienced savings compared to their similarly situated counterparts who received retail loans...Table 9 shows that in general, prime borrowers who obtained loans from brokers experienced no additional costs compared to those who received their loans from a retail lender." (page 25).

It gets better. "In six DTI/LTV combinations associated with borrowers with stronger credit profiles (credit scores greater than 720) retail loans are actually more expensive in the higher FICO scores...In fact the one year results displayed in Table 7 show that brokered loans carry lower interest costs to even more subsets of borrowers." (page 25) "Meanwhile, for a few subsets of prime borrowers, brokers seem to deliver some savings, though the magnitude of these savings is quite modest, ranging from $900-$1600 per $100,000 borrowed over the loan term." (page 31).

Wait a minute! Brokers are cheaper on prime loans? Considering that today in 2010 there is no subprime lending, and only prime loans are available, that makes the broker channel the cheapest option for consumers, or in the worst case at least no more expensive than retail options based on the Center's own study. If we are cheapest, doesn't that also make us the best? Why then is Barney Frank calling for death panels for non-depository lenders? And why are all of the recommendations from this report to be used in connection with subprime loans which no longer exist being implemented today as part of financial reform? Why is the word "mortgage broker" almost an obscenity?

Because we repesent choice and personal responsibility. Brokers offer choices, and in a world where borrowers are not trusted to read and understand disclosures and make their own choices, agents of choice must be done away with. The consumer is no longer free to choose and the business person is no longer free to offer choices, because people with choices will sometimes make the wrong ones. But they also have the opportunity to take risks, and to make choices that will move their lives forward.

The Bureau of Consumer Financial Protection's mandate is to give consumer advocacy groups such as ACORN, the Center for Responsible Lending, and myriad other groups who have signed onto Americans for Financial Reform a seat at the table when creating new rules that govern lending, disclosures and policies as it regulates brokers and banks. And since the Bureau's budget is entirely discretionary, they can fund whatever agencies and organizations they like, which means that we might even see a resurrected, fully funded ACORN back in the spotlight.

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