How to Fix Mortgage Lending: Rein in The Regulators


Over at Barry Ritholtz’s “The Big Picture,” Bill Black has been publishing a series of posts on how mortgage lending should be regulated. Black, who is the author of “The Best Way to Rob A Bank Is to Own One,” does an admirable job at pointing out how pervasive fraud arises and undermines market discipline.

Unfortunately, his proposals for changing the mortgage lending system to counter fraud just won’t work.

Black’s basic contention is that the assumption by economists that anti-fraud regulation need not be a serious part of financial regulation is dead wrong. He persuasively argues that accounting control fraud played a large role in both the most recent financial crisis, the Enron era scandals and the S&L crisis (although I think he goes to far in explaining fraud as the driver of these scandals). And he's correct that the assumption that reputational risk is enough to prevent fraud is mistaken.

But when it comes down to providing a list of rules that would reduce fraud and the severity of financial bubbles, Black stumbles. Black provides 12 rules. The seventh rule, which is central to his whole scheme, is that it should be “unlawful for any private entity to base any aspect of a loan officer or agent’s compensation on the basis of the volume of loans presented, originated, or approved rather than on the quality of the loans.”

This sounds like a fine rule but it fails on a number of levels.

In the first place, it is very difficult to judge the quality of loans. Back during the housing bubble, many fine people were advocating that down-payments were unnecessary. As recently as last year, the FHA was approving loans that essentially needed no down-payment at all because the government’s home buyer tax credit made the down-payment. The FHA insists these were good loans.

Keep in mind that the historical data on subprime loans showed that the tendency of borrowers to default was more than made up by their resistance to refinancing. From a lender’s perspective, then, the risk of subprime lending was far smaller than you might think because prepayment risk—and therefore interest rate risk—was negligible. If you also assumed continued rising home prices, the risk got even smaller since the expected recovery rate on defaults was quite high. This was one of the reasons that subprime mortgage-backed securities were popular—they seemed to offer steady income streams less likely to be interrupted in low interest rate environments.

Now, of course, we all know that things didn’t turn out as predicted. The risk of default of subprime loans was far higher than expected. The recovery rates in defaults across nearly every type of loans was far lower than expected.

The truth is that what is or isn’t a “quality” loan is an entrepreneurial guess—until the loan is either paid off or goes into default. There is no way a regulator or a private entity can know for certain what counts as quality because the complexity of market circumstances and the unpredictability of the future.

More importantly, the policies of our government that are aimed at preventing discrimination in home lending mandate paying for loan volume. It is simply not enough for a lender to show that its policies are race neutral or aimed at achieving a higher quality of loans—they must show that they are achieving the goals of racially balanced lending. To put it differently—they must meet racial quotas on volume.

Historically, banks have struggled to be able to keep up with the fair lending demands of regulators. Bank of America , in fact, discovered that its local loan officers in California were so reluctant to make certain loans that it had to deny them the ability to turn down any loans. All rejections got processed back in Charlotte, North Carolina. The goal was to increase loan volume to meet regulatory racial quotas.

As recently as this past December the National Community Reinvestment Coalition announced that it planned to sue banks that required that borrowers who sought FHA backed loans had FICO scores higher than the minimum score set by the FHA. In other words, banks face litigation that seeks to convert a floor set by the FHA into a ceiling for underwriting standards.

Despite the meltdown of mortgages, our government continues to wage a campaign against lending standards that could produce quality loans. If Black really wants to change the incentives in lending, he should start by adding a new central rule to his list: “The government will be forbidden from implicitly or explicitly requiring that any loan be made to anyone, or from rewarding any private or public entity for making a certain volume or percentage of loans to any population group.”

What Black has stumbled over is his own blindness to the complicity of regulators in the housing bubble. The assumption that the government’s role in fostering bad lending practices was minimal would be wonderful if true. Unfortunately, it is unsupported by the evidence. And there is no way we can even get started at fixing the operations within mortgage lenders until we fix the pressures brought on mortgage lenders by government lending goals.


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