Monday, August 16, 2010

The Game Changers

One day ahead of the Treasury Department's scheduled summit to work with members of the lending community and consumer advocacy groups to develop new disclosures for mortgages and credit cards, the Federal Reserve today published several new rules, including a new rule changing the truth in lending form to better disclose ARM adjustments, and a new rule banning originator compensation through interest rates (yield spread premiums). The ban on yield spread premiums, which will go into effect April 1, 2011, is ironic given that the Dodd-Frank bill included an amendment requiring that origination fees be capped at 3% and that the originator be paid either through lender-paid compensation or borrower-paid compensation but not both. The ruling today is merely a final nail in the coffin of the wholesale origination industry as a whole, which is staggering under the weight of testing and licensure requirements for each originator, mounds of new disclosures, and ever-tightening underwriting requirements.

The first announcement, though, which was that there will be additional changes to the truth in lending form which will better disclose ARMs (adjustable rate mortgages)and the transfer of mortgages from one servicer to another, seems to be a moot point since the Treasury and the new Consumer Financial Protection Bureau are charged with the job of creating a new form to replace both the good faith estimate and the truth in lending form.

I think everyone who works in lending and real estate would agree that the number of forms that we are now using in our industry borders on the ridiculous. Last week, I had to have one borrower sign three separate forms explaining that he would receive a copy of his appraisal at closing. It turned out that the form I had him sign at application had been discontinued by his lender and was no longer in use, although it contained essentially the same information as the other two forms. And there is no doubt that borrowers today have "form overload." They get so many disclosures saying essentially the same thing with ever so slightly different wording that they have no idea what they are seeing and after a short time they stop reading everything.

Supposedly, the new forms from the Treasury Department are going to simplify this process. But I am not at all certain that simplification is the true goal of this exercise. For instance, a paper entitled "Behaviorally Informed Financial Services Regulation" authored by a University of Michigan Law Professor named Michael S. Barr, along with two co-authors, which was published in October of 2008 and is available on line through the New America Foundation, suggests that we don't need better disclosure in terms of content--rather we need disclosure that changes both lenders' and borrowers' fundamental behaviors. Such a set of disclosures would do more than inform the borrower about the cost of a specific loan or the consequences of a specific loan product. Such a disclosure would actually change the game of lending for both the borrower and the lender alike, making the potential consequences so ugly for the lender that they would hestitate to take the risk of making loans outside of a very narrow box.

Why does this paper matter? Because in 2009, Michael S. Barr was appointed Assistant Secretary for Financial Institutions in the Treasury Department. These days, Barr is not just an academic teaching and writing theory; he is actually implementing it in real world settings as a proponent of financial reform and now a voice in the new disclosures that the Treasury Department is hoping to craft.

The theme of the paper is that current regulation focuses on two models. The first is disclosure of fees and costs to the consumer. The second model is anti-usury laws which prohibit loans which are considered exploitive and predatory. Barr and his co-authors believe that both approaches are severely lacking. "The [disclosure} model relies on fully rational agents who make intelligent choices...But these neoclassical assumptions are misplaced and in many contexts consequential...Individuals consistently make choices that they themselves agree, diminish their own well-being in significant ways...By contrast...usury laws and product restrictions start from the idea that certain prices or products are inherently unreasonable and that consumers need to be protected from making bad choices...but product regulation may in some contexts diminish access to credit or reduce innovation of financial products...Moreover for certain types of individuals, some limitations may themselves increase consumer confusion regarding what rules may apply to which products, and which products may be beneficial or harmful." And that is crux of the argument of this paper--traditionally mortgage disclosures have been aimed at presenting information to the borrower with the idea in mind that he can make his own informed decisions if given correct information. But Barr's point is that consumers do not make good decisions when allowed to make choices, so behaviorally informed regulation must change the choices they are allowed to make.

For instance, having required forms that the borrower must sign within a certain number of days, as we do now with the good faith estimate and the truth in lending form, allows the lender to say that he is following the law if he has presented these forms to the borrowers and had them sign them. But the borrower may not understand the form, even if he or she did sign it. Therefore, Barr recommends a completely different approach. Rather than a "rules based" disclosures such as we have in the Truth in Lending Act and the Good Faith Estimate where the lender is required to give certain forms containing specific information to a borrower within a given time frame, Barr wants to change the system to a "standards based" system of disclosure which will be largely determined after the loan has closed. "Rather than a rule, we would deploy a standard, and rather than a [pre closing] decision about content we would permit the standard to be enforced after loans are made. In essence, courts or expert agencies would determine whether the disclosure would have, under common understanding, effectively communicated the key terms of the mortgage to the typical borrower."

Therefore, if the borrower is not satisfied with his loan, the fact that he has signed three hundred forms explaining it is not going to protect the lender. In the new standards-based world of disclosure, no lender or originator will be able to merely comply with a set of rules. The standard will become whether the borrower really understood what was explained to him. And that, Barr says, actually becomes more clear after the closing as the borrower learns to live with the payments. "In essence, courts or expert agencies would determine whether the disclosure would have, under common understanding, effectively communicated key terms of the mortgage to the typical borrower." Of course, he acknowledges that this will be a very expensive process in the beginning as litigation costs skyrocket. However, he assures us that over time, "through agency action, guidance, model disclosures, 'no action' letters and court decisions, the parameters of the reasonableness standard would become known and predictable." That's comforting, I suppose. But then again, he told he was going to change the rules of the game.

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