The dream of home ownership is one that boldly pervades the American physique. From an early age, as a society, we are taught the value and importance of ownership and having a place to call home. In fact, even the United Stated Federal Government emphasizes their focus and commitment to increase home ownership rates through the creation and support of federal agencies and programs like the Department of Housing and Urban Development (HUD) and the Federal Housing Administration (FHA). Through the years, these federal agencies coupled with banks and the increased availability of credit instruments have helped to push home ownership rates to today’s 65% mark. Along the way, the increased availability of debt has created unique challenges for both lender and borrower resulting in the creation of federal and state laws designed to bring equality and transparency to what can sometimes be a complicated home financing process. However, today with an estimated two million foreclosures looming, the previous processes and laws surrounding the lending process are in question. This research paper will delve into the history, background, laws, current debates and the future of credit lending laws in the United States as it relates to home mortgages.
To put in perspective the importance of lending laws and those affected, in 2005 it is estimated that there were approximately 124 Million housing units in the United States with a total value of over $14 Trillion dollars.[1] Steadily, since the 1960’s home ownership rates have risen to their current levels. Helping to fuel this rise in home ownership rates has been the availability of relatively low cost money from mortgage lenders and banking entities. In a standard mortgage lending scenario, the prospective home owner provides a lengthy application to a financial entity that will in turn review the application, amount requested and the asset (home). After review of the various application materials the lender will make a decision on whether or not they will loan funds to the borrower, and under what circumstances, for the purchase of the home. If the borrower’s application for funding is accepted the lender will also provide the interest rate and fees and terms that will be associated with the loan. During the application review the lender will review credit history of the borrower to assess the risk that the bank or other financial institution may be facing. The most common metric today for credit review is the FICO score. After the borrower and lender are in agreement on the terms of the loan the transaction proceeds. The borrower then purchases the home. After closing, the borrower will now owe the lender the amount loaned for the purchase of the house. In effect, the borrower is the owner of the home and the lender is “secured” in their investment through a lien that they have on the asset the borrower purchased. This is also called a mortgagor / mortgagee relationship, with the “mortgagor” being the borrower and the “mortgagee” being the lender.
Historically, loan types that have been common to the industry were amortized loan products, meaning that the borrower with each monthly payment would be paying a portion interest and a portion towards reducing the total amount owed. Other common characteristics of loan types prior to the mortgage and housing boom were fixed interest rates and loan terms of either 15 or 30 years in length. The benefit of this homogenous mortgage environment was simplicity and the relatively easy to understand disclosures regarding the cost of the financing for the borrower. Another important element of this homogeneous and somewhat boring environment for home financing was the expectation by the lender that the borrower would have good credit, a way to demonstrate their income, and sufficient income to afford the house they were seeking to purchase.
With the dawn of the new millennium, the historical norms of mortgage environment started to change in some interesting and retrospectively, very dangerous ways. The once standard fixed interest rates and standard 15 to 30 year terms were replaced with “exotic” mortgages where virtually any option or variable could be changed, amended, or otherwise mitigated. Much of the change in the menu of products offered by mortgage companies was the effect of the momentum in global capital markets that freed up more cash that foreign investors wished to place into US investments. The natural result of this increased capital seeking some consistent return was manifested in more diverse mortgage options and more lenient requirements for borrowers. Included options in “exotic” mortgages were low introductory teaser interest rates (called ARMs), negative amortization loans, and index based loans among others. Another effect of the “exotic” mortgage, either by design or default, was increased loans to sub-prime credit applicants, those traditionally with a below average FICO score. The popularity of these non-traditional or exotic mortgages surged, growing from less than 2% of all loans originated in 2000 to more than 33% of all loans originated in 2006.[2] Scarier still were indicators that over half of the exotic loans in 2005 and 2006 were originated in traditionally high priced markets and being used by predominantly sub-prime borrowers. These factors when reviewed in the hindsight showed an increased gravitation towards exotic mortgages by home buyers that wanted what they could not have. In effect, these home buyers were using exotic and subprime mortgage variants to compensate for a lack of sufficient income or credit to have the type of home they desired. These exotic mortgages gave them an opportunity to purchase their home and live in it, albeit only for a small period of time, until the interest rate reset. The mortgage lenders and brokers that participated in this market also helped to stoke these dangerous flames by ignoring good common sense and helping borrowers believe they could afford a $500,000 home on a $50,000 salary. This overall fear was echoed in a foreshadowing statement in 2006 by Sandra Thompson, the Director of Supervision and Consumer Protection at the Federal Depository Insurance Corporation (FDIC). In her statement she asserted that … “The greater availability of flexible mortgage structures probably allowed price increases to outstrip growth in incomes to a greater extent than would otherwise have been the case.”[3]
Nearly 10 months after the Senate Banking Committee met in September of 2006 the proverbial dam began to show signs of significant structural failure. One of the very first pieces of evidence manifested itself in the form of a disclosure to investors by the global bank, HSBC. In this release, HSBC advised that they would be making provisions for billions of dollars in bad debt related to non-performing loans made to subprime market borrowers. This announcement was followed by numerous gloomy releases from other financial lenders related to bad debt provisions. At this same time large publicly traded mortgage entities like New Century and NovaStar Financial began declaring bankruptcy due to their mounting losses, increasing loan defaults and heightened exposure to the subprime market.
Now some 9 months later, the US Federal Government and state governments have created special investigative committees to understand what went wrong. At issue are two central items, (1) did subprime mortgage companies knowingly lend money to unsuspecting families who would inevitably be put into a foreclosure situation?; (2) did the families that accepted these exotic mortgages know the perils associated with the financing that they were using for their home purchases or refinancings? The first issue speaks primarily towards the greed that manifested itself through many of the industries most successful subprime players, whereas, the second issue speaks directly to the issue of predatory lending on potentially unsuspecting, poorly informed and uneducated borrowers.
Wrapped into the first issue is a veritable Pandora’s Box of complicated circumstances and conflicting interests due to the modern make up of the mortgage industry and the many banks, investment institutions and hedge funds that are involved in the industry today. In a standard mortgage transaction at a company level, the original mortgage lender or mortgage bank would ultimately package up pools of mortgages for sales to outside investment organizations. These pools were called Collateralized Debt Obligations and involved various slices, also called tranches, that were separated according to the resulting yield and effective risk of the borrowers included in that slice. To increase the yield and to speed the velocity of lending, mortgage lenders would often accept extremely risky borrowers where the probability of default was much greater than in a higher credit candidate. In this first issue, the various investigative committees have already begun to find evidence of poor protocols and lax standards at some of the now bankrupt institutions such as Novastar Financial. In a deposition with former Novastar President, Lance Anderson, in a question concerning the companies reported violations of background checks on borrowers and their incomes he responded, “[if income] seems reasonable, then we’re comfortable not verifying it and not using it in our underwriting decision.” Comments such as this one made by Novastar President Anderson speak to a deliberate and ongoing departure from standard mortgage protocols. One is left to believe that from a corporate perspective, the pursuit of profits, and the momentum of the competition only served to increase the adoption of poor mortgage practices that would ultimately result in the demise of some of the industry’s top players.
The second issue, and a core area of exploration of this research paper, deals with legal matters as it relates to the mortgage application, interview and ultimately disclosure process between the mortgagor and mortgagee. The primary law that helps to police companies that extend credit and also protect those who are using credit instruments is the Truth in Lending Act (TILA). The Truth in Lending Act of 1968 is a United States federal law that is designed to help protect consumers by ensuring that companies who are lending money provide clear disclosure. These clear disclosures include key terms in the lending arrangement and also all the costs of the financing that is being provided. The specific regulations that the federal government imposes is contained in both 12 Code of Federal Regulations 226, also called the Truth in Lending Act or Regulation Z, and in 15 United States Code 1601, Title 15 deals with Commerce and Trade, specifically Consumer Credit Protection.
Given the current environment around home mortgages and the high default rates occurring it is important to look at the federal law’s requirements on companies extending credit to borrowers. Highlights of the Truth in Lending Act (12 CFR 226) as it relates to key areas of potential abuse include:
· Section 5 General Disclosure Requirements
This section addresses general disclosure requirements that are required in transactions where credit is being extended. Specifically, the law states that the “creditor shall make the disclosures required by this subpart clearly and conspicuously in writing, and in a form that the consumer may keep”. The subpart goes on to further explain that “The terms finance charge and annual percentage rate when required to be disclosed with a corresponding amount or percentage rate, shall be more conspicuous than any other required disclosure.” Any one that has ever attended a real estate closing knows that the amount of paperwork provided to a borrower is voluminous. The term “clearly and conspicuously in writing” may have been of benefit if the borrower was only reviewing one or two pieces of paperwork. However, this document was one of approximately 100 that may have been signed by the borrower.
· Section 6 Initial Disclosure Statement
This section has significant detail regarding the creditor’s responsibility for detailing information pertinent to the loan that a borrower has taken. Included is information regarding how the creditor shall disclose important information such as: finance charges and calculations, disclosure of periodic rates and under what circumstances these are applicable and to which balances. This section also has language that covers a variable rate plan. Under the “exotic” mortgages, including Adjustable Rate Mortgages (ARMs), that were offered by some lenders the following requirement is stipulated in the CFR, “If creditor is offering a variable rate plan, the creditor shall also disclose: (1) the circumstances under which the rate(s) may increase; (2) any limitations on the increase; and (3) the effect(s) of an increase.
· Section 14 Determining of Annual Percentage Rate
This section sets out specific requirements in how the Annual Percentage Rate (APR) will be calculated. Using this method the federal law tries to ensure that the total cost of credit is represented not just at the initially low advertised rate but at the actual true rate.
· Section 16 Advertising
Another key area of focus into the current mortgage melt-down centers around how lenders built the relationship with their prospective clients and eventual borrowers. Many of the most successful lenders relied upon heavy Internet, Radio and TV advertising to give quick snippets of enticing information regarding how low borrowers could get their payments. Based on the federal law this is where some of the companies truly ran right on the border between legal and illegal practices in terms of marketing their loan products.
Looking at the main federal law regarding consumer credit it is clear that many of the laws were created with the thought that borrowers would have some level of basic understanding regarding the funds they were seeking to borrow. However, in most cases concerning loans made to subprime borrowers with iffy credit histories, this assumption was dead wrong.[4] The borrowers were most of the time bad credit risks precisely because they had not mastered the ability to manage their personal finances in a successful way. Budgeting, savings, interest rates and ARMs, might as well have been in a different language. The cliché that our parents were always fond of reciting seems all too present here, “always read the fine print”. In most all cases, the borrowers were emotionally connected to the property and did not read the “fine print” of all 100 or so documents that they might have to sign at closing. Given the paper storm that is a legal closing, the federal law seems lacking in the kind of details that might have made the required “conspicuous … disclosure” language meaningful.
In 1994, the Truth in Lending Act was modified and Section 32 entitled “Home Ownership & Equity Protection Act of 1994” was added. This law helped to set forth further rights for borrowers to ensure that in high interest loan situations more disclosures and up front education was required.
State laws regarding consumer credit protection also help to establish legal parameters for creditors and borrowers so that prudent lending can occur. However, most of the anti-predatory lending laws that have been authored in about half of the states lack appropriate penalties to significantly alter behavior.
One of the most exciting new pieces of legislation that is currently at the federal level and has not yet passed Senate approval is H.R. 3915 entitled “Mortgage Reform and Anti-Predatory Lending Act of 2007”. This new legislation seeks to amend the Truth in Lending Act (15 U.S.C. 1631 et seq.) and replace with more significant restrictions[5]. Some aspects of this new proposed legislation include:
o More significant licensing requirements for mortgage brokers including national registration system
o Comprehensive disclosures regarding the relationship between the mortgage broker (originator) and the borrower
o Certified statement from the mortgage originator that they have satisfied all applicable requirements under law
o Prohibits steering incentives that compensate mortgage originators for yield premiums that they are able to achieve by placing borrowers into certain higher risk products
In each of the state and federal laws one of the real issues present is what the penalties for non-compliance are. One little know piece of the current federal law, found in the Truth in Lending Act, stipulates that if borrowers are not made aware of their right to rescind then the right to rescind the loan may be enacted for up to 3 years after the loan was originated. In this instance, the borrower would assert that the lender was non-compliant in the loan documentation and if proved factual would be able to rescind the loan. This would potentially cause the lender to no longer have a lien interest in the property, basically rendering the lender an unsecured party in the transaction.
One common fact that is present throughout all the present and projected foreclosures is that somewhere along the line common sense was lost. The culpability of borrower versus lender is somewhat questionable and certainly debatable. However, the real question surrounds whether actual laws were broken in the loans that were provided to the borrowers who are now experiencing high rates of foreclosure. From my findings it is clear that the guidelines as set out by the Truth in Lending Act were followed in almost all instances. It was ethical standards and those un-published rules of engagement that were often times not following. As we see now, the punishment is not a court exacted one but rather an economic one that is punitive to the original conspirators and also Americans as a whole.
The real tragedy may be that as the mortgage industry experienced a game-changing revolution the federal and state legal systems were slow to recognize and help legislate the impact that easy credit and lax lending standards would have on the American economy. The ethical impact of these business scenarios demonstrates the worst that can happen when nearly limitless capital is pitted with companies, brokers and borrowers that don’t understand the power or responsibility that comes with the stewardship of those funds.
In closing, I believe in the coming year significant legislation will be created which will help to create guidelines for brokers, lenders and borrowers so that this scenario doesn’t repeat. The result of this legislation will most likely result in reduced rates of home ownership in the near term and also higher costs and hurdles associated with standard home loans. The good news is that this pull back in credit markets will give all industry participants an opportunity to rethink how credit is extended and how borrowers can be better analyzed, counseled and mentored so their success and achievement of home ownership is a lasting one.
[2] Marketwatch.com, “Exotic Mortgages Sow Confusion”, September 20, 2006, Rex Nutting
[3] Senate Banking Committee hearing on Exotic Mortgages September 20, 2006
[4] Business Week, “Bonfire of the Builders”, August 13, 2007, page 30
[5] Library of Congress, http://thomas.loc.gov/cgi-bin/query/F?c110:1:./temp/~c110WymcYY:e9602: