Nov. 7, 2007 Mortgage Reform Act--Trying to Solve the World's Ills With Rules

To learn about this bill, The Mortgage Reform and Anti-Predatory Lending Act, read the Bloodhound Blog, or the House of Representative's Committee on Financial Services publication of the bill itself.

As usual, Congress has reacted to a problem by trying to solve retroactive bad behavior with new and complicated legislation. Whenever there is some systemic issue that no one can fix instantly, our leaders' reaction is to try to fix it with a new law. I guess the thinking is that if we circumscribe enough of what is "bad behavior" what will be left will be the right behavior. It's a persistent sociological fallacy that always fails. Our history is littered with failure of such laws to fundamentally change behavior.

Having said that, the industry surrounding the sub-prime mortgage fiasco ought to create structural parameters that would dissuade the kind of predatory selling that the mortgage industry succumbed to. Unfortunately for Congress, the culprits are spread across a huge field, ranging from individual mortgage brokers to banks that sell their paper (and with it their responsibility) to securitization as a means to finance lending, and finally, to the securities market itself which drives the whole complex mess.

The law, like all such laws, creates as many problems as it solves. The onus of determining whether a particular loan is appropriate is shifted --but it's not clear exactly who it is shifted to. This is pretty muddy. If a broker sells the mortgage, but the paper is written by a bank, who holds the responsibility? And if a borrower, for whatever reason, defaults on his loan, who's to say whether that is due to the inappropriateness of the loan or the borrower's irresponsibility or an unavoidable change in circumstances? Stuart Saft of The Wall Street Journal correctly points out that this law opens to door to lawsuits preceding or following every foreclosure. Will each and every attempt by a bank to foreclose now require a test for liability litigation? And if the criteria for lending become so restrictive asto leave every mortgageopen to litigation upon default (or even, just when the borrower finds it hard to pay) who would lend anyway?

Another peculiarity of the bill, and one that seems a bit far-reaching given the stated purpose of the law, is that it extends protection to renters in foreclosable properties. Imagine you are a lender holding the paper on a rental property. If the mortgage goes into default but the property is let, the foreclosure proceedings are trumped by the renter's tenancy. This is a potentially mischievous means for defaulting borrowers to cover themselves, but also, even in the most ordinary of circumstances, a potential minefield for lenders. It foretells lots of restrictive lending in which borrowers sign away their rights to rent out their property, not to mention their rights to litigate under the act itself (think about the work-arounds that vendors have found to lock in buyers from exercising their 3 day right of rescission).

There is lots more to uncover in this bill regarding its unintended consequences. But the deeper point from the perspective of the PxP approach is that it is wrongheaded. Core values can't be legislated through rules, because, as we've seen in this exploration, rules engender loopholes to those who aim to violate them. Better yet would be the self-policing of the industry by each component piece. The mortgage industry ought to have a strict code of core values that attaches to licensure. That code ought to imbue brokers with concern for repayment--instead of just the incentive of commissions to get people into loans, even if the first period of interest adjustment is sure to be bank-breaking for the borrower.

The HR Bill does address one issue that needs tackling, albeit in some clearer way.Securitization allows for a great distance between the borrower and those who ultimately hold the paper. There needs to be some way to maintain responsibility throughout the process so that banks, even though they sell off the paper, are still accountable for the fiduciary strength of their lending. Likewise with mortgage brokers and with investment backs that generate and sell securities. And finally, are those who purchase mortgage securitiezs to be held responsible for the quality of the risk assessment in the mortgages that make up their investment instrument? That's a very long arm of responsibility indeed. How would investors assess that? It would require a great deal more documentation and disclosure on the quality of the loans and the criteria used in making them. But that exploration may be best left to another blogger on another day!