Thursday, March 24, 2011

Suitability and Duty of Care

Most of the mortgage world is fixated on the new loan originator compensation standards being mandated next Friday by the Federal Reserve Board.  Last night, Daily Finance featured an article by Charles Hugh Smith entitled "New Mortgage Regulations Could Bruise Housing Market."  This  article was the first non-industry article that I have seen on the subject of the new loan originator compensation rules and the damaging effect that they are likely to have on the housing market.  I was truly amazed at the tone of the article and the fairness and open mindedness that Smith showed toward our industry.  It was very refreshing.

Still, when we focus simply on the compensation portion of the new rule, we are missing some key points of the regulations going into effect April 1, 2011.  The rule's language contains prohibitions on "steering" and it also creates a suitability standard for loan originators, and ultimately these two provisions may prove more troublesome to originators than the compensation portions of the new rule.

First I want to say that we are not the only industry dealing with this problem.  As part of Dodd Frank, many different financial services providers are dealing with the consequences of having a "fiduciary duty" to their clients.  Right now the SEC is crafting rules applying fiduciary duty to investment advisers.

But suitability standards create special obstacles for mortgage loan originators because they not only interfere with an individual borrower's right to make his own financial decisions about the type of mortgage that he wants, but they also contradict Fair Housing laws which require that originators treat all borrowers the same by providing equal access and opportunity to housing for all borrowers.  If we are held accountable for making sure that a borrower's loan is "suitable" for his situation, how can we provide all borrowers equal access to housing?  Simply put, we can't.

The problem with suitability is that it is a very subjective determination.  If Sally has been on her job for six months and is earning $90,000 a year, she may qualify for a 15 year mortgage, which is cheaper for her than a 30 year mortgage.  Perhaps Sally moved back in with her parents after college to save this money to buy her house.  The problem is that Sally has never owned a home before, so even though her credit is good, it is limited.  So is the fifteen year mortgage that Sally wants really suitable for her since she is a first time home buyer who is actually unfamiliar with the expenses of home ownership?  Would a thirty year note actually be more suitable even though it is more expensive in the long run?  What if in a year Sally is laid off and can't get another job in the area so her house gets foreclosed on?  Maybe it would have been more suitable for her not to buy a house at all; maybe she should have just rented a house for a while until she had more time on her job. Maybe as a single woman Sally should not be buying a house at all; maybe she should wait until she is married or in a relationship so that she will have a second income to help make the payments on the house. (You see where I am going with this.)

The Equal Credit laws were created so that loan originators cannot make arbitrary decisions about an individual's credit worthiness based on race, religion, sexual orientation, age or familial status.  Under the standards set by those laws, borrowers either qualify based on guidelines or they don't.  It is not the loan originator's job (or right) to make further determinations about their overall worthiness to purchase a home or to refinance a home.  We can give advice (as I often have based on experience when I see someone making a decision I think might be unwise).  But in the end the decision is the borrowers--not mine.  And that is exactly as it should be.  After all, the borrower is the one making the payment.

I wonder how many of us would like to live in a world where all professions had a "suitability" standard.  How many of us would like to go shopping for a new dress if the sales lady had a legal obligation to tell us that we look terrible in it, or that the color clashes with our hair color.  After all, if I get home in that dress and realize how awful it looks on, I am likely to never wear it again, and possibly not to pay the charge card I put it on, which could result in a financial loss for the credit card company.  The sales lady would have to ignore the rather obvious fact that whether or not I look terrible in my new dress is largely a matter of opinion--I might feel beautiful in it, and my new boyfriend might agree with me rather than the sales lady.  Or what if the waiter at the restaurant had a "suitability" standard as he served us our lunch.  Maybe I really want the ravioli, but he can tell by looking at me that I need to lose weight so he will agree to serve me only the salad with balsamic vinegar.  If he has a duty of care, he would not want to be responsible for ill health brought on by poor lifestyle choices and eating habits.

Ridiculous, you say.  A mortgage is arguably the largest financial purchase that most people make over a lifetime, and it is a complicated transaction, so borrowers need to be protected from possible bad choices.  It is just foolish to compare buying a dress or buying lunch to buying a home.  Really?  I pulled some statistics off of this week showing that the average American owes credit card balances of over $14,000.  How much of that outstanding balance was spent on foolish, or unnecessary purchases?  We hear constantly about heart disease, diabetes, and the cost of poor health to our society as a whole.  How many of those problems are brought on by poor dietary choices.  Fashion is a complicated industry; nutrition is complicated.  Does the level of complexity of the issues involved drive my ability to make choices about my own life.

Where does it stop?  If we can determine for another person what home loan is suitable, who is to say that someone will not determine for all of us what other choices we can make? And as give up the responsibility for our choices, we also give up the freedom to make decisions which can benefit us in the future.

When we first started the mortgage company, one of my first goals was to get us a license in the state of New Mexico.  To get that license, I had to get a bond, and to get the bond I had to have a financial statement prepared by a CPA.  My father, who was also my business partner, knew a CPA through a group he was involved with, and he asked him to prepare the financial statement.  Our finances at the time looked awfully sad--we had no money except for an IRA totalling a little under $11,000 that I had cashed in to open the business.  We had a six month lease on an office that we paid $245.00 a month for (to include utilities and a typewriter.)  We had no industry experience, no customer base, no reserves to draw on.  We could not even afford a computer for our first eighteen months in operation.  My dad's acquaintance prepared the financial statement--which he charged us for, of course-- and at the end of the statement he put his notes.  "This company probably will not be open in one year."  I was furious--we might be small and we might be broke, but I knew we were going to make it and I was not going to send out a financial statement that said otherwise.  I promptly hired a different CPA to prepare a financial statement without the editorial opinions, I sent it to the bonding company, got our bond, and got our New Mexico license.  We were on our way.

That was 13 years ago next Friday.  I am grateful every day that the first CPA was wrong.  I am even more grateful that my future was not determined by another person's opinions regarding what was suitable for us.

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