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Mortgages & The Unnecessary Crisis

July 14, 2008 should be remembered as a notable date in the long history of mortgage lending. The federal government gingerly stuck its regulatory foot into the warm waters of consumer advocacy and for the first time enacted rules which would protect borrowers. Not all borrowers, of course, and nothing that would materially disturb the status quo of a lending system that under the watchful eyes of federal regulators is now on the brink of failure.

Under the Home Ownership Equity Protection Act (HOEPA), the Fed has the power to fight “unfair and deceptive acts or practices” or, as they’re called, UDAP. In fact, the Fed has had such power since 1994 and therein lies the rub.

The purpose of financial regulation is to create something of a level playing field. In real estate, for example, you can’t have a “net” listing. Yes, such listings could produce big profits for brokers, but state regulators across the country have banned such arrangements because of their obvious potential for abuse.

Federal regulators, in contrast, have traditionally taken a cautious approach to lenders but in the past few years they left the financial marketplace untouched and the result has been obvious: You didn’t have option ARMs or the widespread use of stated-income loan applications in the past because previous administrations telegraphed their positions to lenders: You can go so far, but no further.

Until the second Bush Administration the deal with the lending community was this: You can make profits, big profits, but use some care and caution otherwise we’ll be forced to create a bunch of regulations that will reduce your revenues. In other words, a gentleman’s agreement of sorts, an unspoken arrangement that worked fairly well for everyone.

The Bush Administration has a different view. It is not a “conservative” perspective — remember, no lender issued option ARMs when Ronald Reagan was in office — instead, with Mr. Bush we have a radical and absolutist political philosophy which argues that unfettered markets are the sure solution to all problems.

Under the Bush approach if a lender makes dim-witted loans and doesn’t bother to effectively underwrite mortgage applications the marketplace will respond. There’s no need for government action because in time loans will fail and shareholders will lose money.

The Bush regulatory theory may be worth debating in some seminar regarding abstract political philosophies, but in the real world we are each inter-connected. If large numbers of lenders make large numbers of foolish loans, it’s not only shareholders who suffer, it’s the value of our house that falls when neighbors are foreclosed.


Given the radical and extreme thinking of the past few years, we are now seeing radical and extreme responses. To right the financial ship of state — if that is possible without further dislocations — the federal government has now embarked on an economic path normally associated with third-world countries. For instance:

  • The federal government over the summer of 2008 quickly and with little debate established the right to buy Fannie Mae and Freddie Mac. If this were being done by governments in Malawi, Cuba, Venezuela or Rumania, we would be talking about “nationalization” and all that the term implies.
  • The Securities and Exchange Commission over the summer applied special rules to prevent short-selling — but only for 19 favored companies. In effect, we replaced the free-market system with two classes of corporations, those protected from short-sellers and those which are not.

  • The Federal Reserve has made hundreds of billions of dollars in friendly loans available to selected banks and private entities on Wall Street. These loans are secured by assets of dubious quality — if the quality were so good then surely such assets could just be sold on the open marketplace. Meanwhile, legislation to help 400,000 borrowers with toxic loans was stalled for months because of alleged worries that the cost might total $4 billion.

The tragedy here, the disgrace here, is that none of this was necessary.

Go back to the new Federal Reserve rules introduced over the summer of 2008. They are weak and timid; most “protections” only apply to “high-priced” loans, meaning not prime or ALT-A financing.

But imagine if the new standards had been instituted in 2002 and 2003: For instance, the new rules say that lenders must “verify the income and assets they rely upon to determine repayment ability” when making “high-priced” loans. In other words, stated-income loan applications are out for subprime borrowers. Would there be a subprime crisis today if such baseline standards had been introduced when they were actually needed?

What makes no sense is the lack of anger. If Canadian trade regulations caused $500 billion or a trillion dollars worth of damage to the U.S., the entire country would be irate. But if a few federal bureaucrats, zealots and elected officials produce the same result, no one seems especially distressed — and that should worry us all.

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Published originally by The Real Estate Professional and posted with permission.

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