The cover story from a recent Business Week fairly screamed: “How Toxic is Your Mortgage?” Mortgage credit has been so over-extended that a significant number of people will be unable to repay their loans. No doubt, many commentators will panic and call for additional regulations of the mortgage industry. We might as well start thinking now about the comparative importance of government regulation and personal morals.
The crisis is looming, because so many people have gotten loans that are beyond their realistic ability to repay. Adjustable Rate Mortgages (ARM's) have low “teaser” rates early in the term of the mortgage. Those rates can go up when interest rates go up. Other loans offer 100 percent financing, which means the borrower does not have to make any down payment. Lenders offer interest-only loan payment plans, in which the borrower builds no equity at all.
Every mortgage has some risk, because borrowers take the chance that their incomes won't fall excessively. But these creative financing loans have more than the ordinary income risk. A borrower with 100 percent financing takes the risk that housing prices never fall. If they do, he will be unable to pay off his mortgage, even if he sells the house. A borrower with the Adjustable Rate Mortgage is taking the chance that the interest rates will not rise excessively over the life of the loan.
No-equity or negative equity loans are even riskier. The Option Adjustable Rate Mortgage provides the borrower with “options” for their monthly mortgage payment, including a “minimum payment.” But the minimum payment loan comes with a big string attached: The shortfall between that minimum payment and the interest-only payment is tacked onto the principal of the loan. So, choosing the minimum payment amounts to building negative equity
These loans seem like a great idea to young couples who face steadily rising housing prices and who are dying to get into the housing market. But they only work to the borrower's advantage when housing prices are steadily rising. Once housing prices start to fall and interest rates start to rise, these eager buyers may start to wonder whether they would have been better off waiting a few years to purchase a home.
When large numbers of ordinary homeowners start to default and lose their homes, we will start to hear cries from politicians to add further regulation to the mortgage industry. Those cries will be based on the claim that the poor unsophisticated first-time buyers, at whom these loans were directed, did not really understand the terms of their mortgages. This will sound plausible, because many of these loans are indeed quite complex and confusing.
But I think these calls will be misplaced for one simple reason: The mortgage market is already highly regulated. Buying a house and taking out a loan are both processes that are loaded with pounds of paperwork for all the governmentally mandated disclosures. The current regulation may even be part of the problem. That pile of disclosures can induce a semi-catatonic state: “I see nothing. I feel nothing. I sign my name here. I initial there.” People see those piles of paperwork and assume everything must be all right. The regulation itself induces complacency. I seriously doubt the government can create another layer of regulation that will really protect people against big mortgage mistakes.
What does morality have to do with this problem? People are not being entirely honest. Although there surely are some cases of outright fraud, that's not primarily what I'm talking about. I'm talking about self-deception. People talk themselves into overlooking problems, because they are so eager to achieve their goal of buying or selling a house.
Look how many people must cooperate to make a questionable loan. The realtor has to be so eager to make a sale that he helps the buyers get a loan, any loan. The mortgage broker has to be so eager that he fudges the borrowers' qualifications. The buyers have to be so eager to buy the house that they don't take seriously the possibility of being unable to make the payments down the road.
All of these people indulge in some wishful thinking. The fact is that any one of them can pull the plug on a bad deal.
We don't need another layer of regulation on the mortgage market. We need to enforce the rules we have. And we need to be vigilant and responsible consumers. The government can't protect us from everything.
