Just because several horses already have disappeared over the hill, closing the barn door isn’t necessarily a bad idea. More may be coming in from the corral and you wouldn’t want them to gallop away too. But to secure an open door, you don’t need 20-penny nails. A simple hook may do.
The Federal Reserve has announced new rules limiting mortgage lending. Are these prudent measures to correct obvious defects in current practice or an ill-conceived overreaction by an institution criticized for past misjudgments? That may depend on your politics.
Libertarians question any government regulation of mortgage lending. Individuals should be free to knowingly enter into any contract they choose, they argue. Government should enforce contracts, but should not interfere in details of private agreements.
At the opposite philosophical pole, some believe government exists to protect people from becoming preyed on by avaricious businesses. They believe that government should ban any practice that may pose difficulties for mortgage borrowers — but that lenders should not react to such restrictions by limiting their lending.
Most people fall somewhere in between. Lenders should be allowed to offer — and borrowers to accept — a range of mortgage terms just as an appliance store offers different models of dishwashers. But the advantages and disadvantages of a loan may not be apparent to borrowers as are those of an appliance. Fraud and abuse are possible. Freedom to contract must be balanced with limits on abuse of unequal power.
Most economists generally agree on the need for balance. Imperfect information can cause free markets to fail, causing inefficiencies and injustices. Moreover, if virtually unrestricted contracting between willing parties can cause economywide financial disruption like we are experiencing right now, regulation may be necessary.
But economists also warn restrictions on lending practices are likely to 1) increase interest rates and 2) reduce access to mortgages, especially for less creditworthy borrowers.
People who are not able to pay a loan should not take one out. But when that outcome follows from regulation rather than lender or borrower choice, some worthy potential borrowers inevitably will be excluded too. It is impossible to separate wheat from chaff as finely as one would like.
Consider specific aspects of the Fed rules:
Mortgage loans to risky borrowers must require that insurance and real estate taxes be put in escrow. The intent of this requirement is to ensure that poor-credit borrowers understand the full monthly costs of homeownership. It also protects loan collateral by ensuring the property won’t be hit by tax liens or have its value destroyed by fire or wind.
Ironically, some consumer organizations calling for new restrictions on mortgage lending are the very ones that once campaigned to protect consumers from mandatory escrows.
But on the whole, this is not an onerous requirement. It may correct an information problem and it is not likely to increase interest costs for all borrowers.
A second rule prohibits lenders from making mortgage loans without proof of the borrowers’ income. This ends the “liar” loans common during the housing boom. As a mandatory return to prudent practice, this rule is pretty innocuous. Few loans are being made without income documentation today. This requirement is largely window dressing, to prove the Fed is doing something.
The provision banning prepayment penalties for risky mortgages is more questionable. Here there is a clear trade-off. Force lenders to absorb all the risk of interest-rate declines, and they will charge higher interest rates generally. This is not some sinister conspiracy, but an inevitable market response.
Depending on how broadly this provision applies, it may also sharply reduce the availability of adjustable-rate loans. These loans are the core of current problems, so a reduction in them may be good. But they also have been useful for millions of responsible borrowers. This provision has an element of discarding the baby along with the bath water.
The rules also ban making loans without considering the borrower’s ability to make payments. This echoes longstanding rules requiring insurance agents and brokers to sell products appropriate for their clients. These are honored as much in the breech as in the observance, so consider this window-dressing as well.
On balance, the new rules may be an improvement. But nothing can substitute for prudence by both lenders and borrowers.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.