The "No More Stupid Mortgages" Bill

Chairman of the House Financial Services Committee Barney Frank has proposed legislation to tighten up practices in mortgage lending. Because Frank is more interested in substance than most legislators, his draft has elicited howls from the usual suspects, no doubt a strong indication that it is on track.

Frank’s general aim is to create clearer responsibility and liability along the securitization. In the old days, when you only had borrowers or lenders, you had only a few possible scenarios for the mortgage going pear shaped: borrower lied, bank was stupid something bad happened to borrower (but that should have been factored into bank pricing); something bad happened systemically (again, bank should have considered this possibility). If something goes wrong in this realm, it can usually be determined why, which means procedures can be improved to prevent it from happening again.

But in our Brave New World of finance, with securitization, responsibilities are muddied. Investors rely on lender due diligence when they have no (in fact, a negative) incentive to do it. Ratings are treated as valid proxies for quality when the agencies do no verification of the date given them And as Tanta of Calculated Risk has described at some length, the use of no-doc loans relieves the lender of certain regulatory reporting obligations and turns borrowers into bagholders.

So Frank’s solution is to create liability for certain bad actions that become more likely in a world of securitization, like making stupid mortgages because they will nevertheless generate fees, and doing a once-over-lightly with due diligence.

From the Wall Street Journal:

Rep. Barney Frank (D., Mass.) introduced legislation that would, among other things, prohibit mortgage brokers, bankers and others from steering borrowers toward more-expensive loans in order to receive greater compensation. It would prohibit prepayment penalties on subprime loans and limit prepayment penalties on prime loans.

Mr. Frank said the bill’s goal is to “diminish predatory lending while continuing to support a rigorous mortgage market. It creates a national standard for giving mortgages, originating mortgages, which will cover every mortgage originator,” he said in a conference call with reporters.

Some banking-industry officials fear, however, that the proposal wouldn’t create a uniform standard. It would set the floor for what underwriting standards should be, but states could pass more-aggressive rules. “Without a uniform national standard, this legislation could only serve to foster more confusion in the marketplace,” said Kurt Pfotenhauer at the Mortgage Bankers Association.

The bill would extend some liability to certain parts of the secondary market, an issue known as assignee liability. Mr. Frank said this would ensure that investment banks and other securitizers monitor the quality and underwriting standards of the loans they fund. The bill would create safe harbors, though, shielding secondary-market investors from liability if they follow certain due-diligence and other practices.

The issue of assignee liability will likely be one of the more controversial aspects of the legislation. Federal Reserve Chairman Ben Bernanke has said limited and clearly defined assignee liability could prove beneficial, but Treasury Secretary Henry Paulson has said assignee liability could scare away investors.

The objections are predictably lame. Differing state-federal standards exist with banking regulation, although state powers have been gutted over time. There is no proof that states will set a higher bar if federal standards are reasonable (or that any tougher standards would be truly problematic). And the concept of assignee liability is primarily a device to put teeth into due diligence requirements.

Out of character, the New York Times’ report is more alarmist, and focuses on another aspect of the bill:

House Democrats introduced legislation on Monday that would for the first time let homeowners sue Wall Street firms for relief from mortgages that the borrowers never had a realistic chance of repaying.

Representative Barney Frank, the House Financial Services Committee chairman, expects committee approval next week.
The measure, which is expected to generate intense opposition from the financial services industry, addresses some of the problems tied to the transformation of the mortgage lending industry from an often local business into a trillion-dollar global market for investors in search of higher returns.

The bill is part of a broader measure intended to restrict what lawmakers and consumer advocates consider deceptive and improper lending practices, many of which were common among the millions of soured subprime mortgages to people with low incomes or poor credit histories.

Critics warn that the bill could chill and perhaps freeze a huge source of capital that has helped push homeownership in the United States to its highest level.

The legislation, introduced by Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, would require any mortgage lender to verify that the borrower has a “reasonable ability to repay” based on documented income, credit history and debt level.

“The people who package mortgages and sell them into the secondary market were a major cause of the single biggest world financial crisis since the Asian crisis” of 1997-8, Mr. Frank said, “and it’s unthinkable that we would leave that undisturbed.”….

Under the House bill, people who can show that they never had a reasonable ability to repay the loans would still have to pay for their homes, but would have new statutory power to demand better deals from the lenders. They could demand that their original mortgage lender offer a better loan. Or they could demand relief from the Wall Street firm that bought the mortgage and resold it to investors.

The measure would also restrict several practices that industry critics have long said were deceptive and amounted to “predatory lending.” It would prohibit incentives to brokers for steering borrowers to more expensive mortgages. It would sharply restrict prepayment penalties — something common with subprime loans, which effectively lock borrowers into the loans.

Mr. Frank said the criteria for loans that had no realistic chance of being repaid would include those with monthly payments equal to more than half a person’s income. Lenders who offer loans that do not require the borrower to document his or her income or financial circumstances would also risk challenges.

The basic approach to defining unpayable loans is similar to the guidance that federal bank regulators have long given to loan underwriters at banks.

But about half of all recent mortgages in recent years — and the vast majority of subprime loans — were made by lenders and brokers who fall outside the federal banking system. Many of these are regulated by states, but the rules vary widely and some have almost no restrictions on the tactics that a lender can employ.

Under the new bill, states would be required to set standards for mortgage brokers and lending. States that do not develop a standard would be subject to relatively strict federal standards, to be developed by the Department of Housing and Urban Development, that would require mortgage brokers to act “solely in the best interest” of the consumer.

Frank’s bill is an interesting ploy to force renegotiation of existing loans, although I doubt that any provision that apply retroactively to existing loans will make it into the final version.

Anyone who issues a mortgage for which debt service is more than half of the borrower’s income deserves to have his head handed to him, whether in the form of losses (which of course he no longer suffers thanks to risk transfer) or via being sued. The practical effect of this idea will be to kill the stated income loan, which will not be a great loss.

In an amusing bit of gamesmanship, reported on American Banker (hat tip Bank Lawyer’s Blog), the Fed has pointedly been excluded from the drafting of this legislation, a rebuke for its failure to use its existing regulatory authority (the Home Ownership and Equity Protection Act) to rein in predatory mortgage lending:

A bill by House Financial Services Committee Chairman Barney Frank to revamp mortgage standards would leave the Federal Reserve Board off the list of regulators that would write rules to implement it, according to financial services and consumer advocacy representatives given a sneak peek this week.

Mortgage regulations traditionally fall predominantly under the central bank’s bailiwick, but observers said its decade-plus deliberation over crafting lending rules covering the entire market might have jeopardized its power.

The bill, which Rep. Frank plans to sponsor along with two North Carolina Democrats, Reps. Brad Miller and Mel Watt, is still a draft and likely to change when the committee considers it. Nevertheless, observers said the plan to leave the Fed out of the rule-writing process seemed like a political statement….

Many of the groups who have been working intimately with staff members on the bill said that they viewed the move as an obvious slap intended to embarrass the Fed, but that they expected the agency would ultimately be given rulemaking too…

Michael Calhoun, the president of the Center for Responsible Lending said the omission is “probably stemming from the ‘Use it or lose it’ comment that Mr. Frank made earlier in the year.”