Mortgage Mistakes
The government-knows-best-approach is misguided at best.


John Berlau

Every day, as news about the credit crunch unfolds, it seems like a new term is added to our financial vocabulary. First, there were subprime mortgages. Then, there were mortgage-backed securities, and collateralized debt obligations. Now, we’re hearing about “structured investment vehicles” and “Level 3 assets.”

If these terms are complex even for the experts, it goes without saying that so is figuring out an appropriate policy response. The basic problem is ineffective disclosure and transparency, both for some individual borrowers, and to a greater extent among investors who packaged, bought, and sold mortgages in the securities markets. But there are no easy answers on how to get there.

Yet there are simple answers concerning what not to do. First principles do not disappear when there is an economic rough patch. In fact, that is when they are most important in dealing with the problem at hand.

And one of the first principles of the conservative, or center-right coalition, is individual economic freedom in the decisions affecting one’s livelihood. Among all types of conservatives, there is widespread support for education vouchers that empower parents to pick the best schools for their children, personal accounts to allow workers to control a greater amount of their retirement saving, and low taxes so that individuals and families can use more of their hard-earned money for their — and not the government’s — priorities.

Looking at these first principles, at least one legislative “fix” for mortgage and credit problems has an easy answer — that of “nay.” The government-knows-best approach of Barney Frank’s (D., Mass.) “Mortgage Reform and Anti-Predatory Lending Act,” likely to come to a vote on the House floor this week, is on a collision course with the principle of economic freedom, that is the aim of so many policies conservatives have pushed.

There’s plenty of evidence that Frank’s bill would sharply curtail new mortgages and the ability to refinance, thus making both mortgage problems and the credit crunch more severe. The main problem with this bill lies not in its unintended effects, but in its stated intentions to restrict borrowers’ choices. Utilizing elements of an approach that nanny-state groups, such as the Center for Responsible Lending, call “suitability,” the bill goes beyond requiring improved disclosure, and beyond regulation of subprime mortgages. Instead, it gives the government virtually unlimited power to ban any mortgage it deems “unsuitable” for an individual’s economic circumstance. The underlying assumption of this, and similar “suitability” proposals, is that borrowers are stupid and must be protected from themselves, even when the terms of a loan are clear.

In Section 122, the bill states explicitly that mortgage lenders and brokers must ensure that mortgages are “appropriate to the consumer’s existing circumstances.” The bill never exactly defines “appropriate,” but says that a loan will be “presumed to be” so only if the borrower “has a reasonable ability to repay and receives a net tangible benefit” from the loan. “Net tangible benefit” mandates are applied to refinancing as well.

The terms in Frank’s bill are as broad as they are vague, and, no matter how they might be interpreted by regulators, would have the effect of limiting ability for consumers to obtain their preferred mortgages. How is the government to know whether a loan has “net tangible benefits” for an individual borrower? The law originally contained an explicit requirement that lenders offer consumers the “best terms for a mortgage loan for which the consumer qualifies,” and this would no doubt be a standard housing advocates will urge regulators to adopt.

But proponents of “best terms” and “net benefits” mandates overlook the fact that borrowers have financial goals other than housing. A certain type of loan could cost less over time, but if it requires larger monthly payments, it may hinder a homeowner’s ability to perform other costly endeavors such as saving for retirement, sending a child to college, or building a small business. Author and noted financial adviser Ric Edelman argues that for many borrowers, “big mortgages…mean you retain lots of cash that you can then invest,” while “small mortgages…leave you with little or no cash left over for investing.” Other financial advisers disagree with Edelman, but this very disagreement among experts in the field, shows the folly of the government trying to determine whether a loan has a “net tangible benefit,” as this bill would require.