As discussed in a previous post, based on the total number of Americans with a credit score of 649 or lower, up to 35% of all Americans are effectively locked out of the refinance or purchase mortgage market for the foreseeable future (see One Third of All Americans Unqualified). In the past, borrowers who did not meet the minimum credit and income criteria for a conforming loan were able to obtain nontraditional or subprime mortgage loans, typically at a higher rate of interest.
It has been generally recognized that high cost, inappropriate mortgage products marketed on a mass scale contributed, in part, to the mortgage crisis. Lenders promoting highly leveraged, high rate mortgage loans to borrowers with poor credit and no capacity to repay would be hard pressed to explain how such loans could possibly promote sound homeownership. Due to the role of nontraditional lending in causing the housing crash and recession, the industry has effectively been legislated out of business.
Should Subprime Lending Be Allowed?
Some policy makers are now considering whether the prohibition of certain mortgage products has caused a significant reduction in credit availability to customers able to repay and understand high-risk mortgage products. Removal of restrictions on nontraditional mortgage products, coupled with counseling and financial education, might allow borrowers to make informed financial decisions while evaluating the risks, costs and benefits of a nontraditional loan. These issues were recently examined by Charles Evans, President of the Federal Reserve Bank of Chicago, in a speech before the Indianapolis Neighborhood Housing Partnership.
Commenting on the risks of highly leveraged or unaffordable home purchases, Mr. Evans stated:
Thus it was very destructive when, in the early part of this decade, dubious underwriting practices and mortgage products inappropriate for mass consumption became more common. It is difficult to understand how loose underwriting, high degrees of leverage and the broad marketing of exotic and often very high-cost mortgage products can promote homeownership. Moreover, partly as a result of these practices, we’ve seen an unprecedented housing market collapse that contributed to a very deep recession marked by many lost jobs. And now homeownership has declined for six straight years.
Mr. Evans noted that “While economists usually give great respect to individual choice, in this case it seems that many borrowers made poor choices” and were abetted by lenders into choosing exotic mortgages without regard to their income or ability to repay. While recognizing that “the mortgage crisis was caused in part by the use of inappropriate mortgage products”, Mr. Evans discussed two possible future policy options regarding nonstandard mortgages.
One possibility would be to impose very stringent regulatory oversight that eliminates such products all together. Such a policy would certainly prevent unqualified borrowers from obtaining high-risk mortgage products. However, such specialized products may actually be appropriate for certain people, so such a policy would have some real costs.
An alternative approach would be to place few restrictions on the choices available to borrowers and rely instead on better educating them about homeownership and mortgages. Such an approach might keep those who shouldn’t be in exotic mortgages from getting them while leaving such mortgages available to the small group of people for whom they are appropriate. A big question, however, is whether financial education can work.
Unfortunately, studies done by the Chicago Fed on the effects of financial education offer mixed results. In addition, implementing educational programs on a wide scale would likely be cost prohibitive. Mr. Evans noted that the results of the Fed study correlate highly with “behavioral economics” which “recognizes that people frequently make substantial mistakes in their economic decisions”.
It is highly unlikely that we will see a return of high-risk, nontraditional mortgage lending anytime soon. Although nontraditional lending may have genuine benefits for a small number of qualified borrowers, most of these products have ultimately caused substantial economic hardship for both borrowers and lenders.