Editor's note: This is Part 1 of a two-part series.
Reading proposed legislation designed to "reform" the mortgage market is usually a depressing experience for me. Most of the proposals would take us further away from, rather than closer to, a competitive system that works for borrowers. This is certainly true of HR 1728, called the Mortgage Reform and Anti-Predatory Lending Act, which was winding its way through Congress when this was written.
Virtually every section of HR 1728 bears the fingerprints of consumer groups and/or mortgage lenders. Legislators and their staffs operate under the illusion that by adjudicating between these groups, they can achieve a balance between the interests of borrowers and those of lenders. This is an illusion because most of the policies espoused by consumer groups further the interests of consumer groups, not those of consumers. Consumer groups look to entangle lenders in a maze of complex rules and potential liabilities, which provide opportunities to counsel and litigate for borrowers, and make special deals with selected lenders.
The tragedy is that neither lenders nor consumer groups want to make the market work more effectively, because a well-functioning competitive market would both force down prices and reduce the need for consumer groups.
The mortgage market works poorly because borrowers know so little relative to the loan originators they deal with. Economists call this the problem of information asymmetry. There are two major tools for overcoming information asymmetry: mandatory disclosures, which are discussed below; and transaction simplification rules, which are discussed next week.
Under mandatory disclosures, government mandates by law that lenders must disclose what borrowers need to know to negotiate on an equal basis. We have had mandatory disclosures for three decades, however, and it has not helped borrowers in the slightest. Mandatory disclosure has raised lender costs, lengthened transaction periods, but for the most part has left borrowers as confused and overwhelmed as before. Indeed, judging from the many hundreds of letters I have answered on the subject, the required disclosures in many cases have created more, rather than less, confusion.
The reasons are well known to everybody familiar with the process, including many of the consumer groups. The total volume of disclosures is excessive, overwhelming borrowers; a large proportion of disclosed items is garbage of no value to borrowers; some disclosed items are irreconcilable with others because they originate with different agencies; and none are abreast of the current market.
The major source of these problems is the early decision by Congress to make itself the source of many of the items subject to disclosure. The garbage disclosures all come from Congress. As just one example of many, the requirement that every transaction must show the sum of all scheduled monthly payments over the term of the loan, which is a completely useless number, is in the law.
Congress is also responsible for entrusting the two most important disclosures - Truth in Lending and the Good Faith Estimate of Settlement - to two different agencies (HUD and the Federal Reserve Board), which have never succeeded in reconciling them. And of course, there is no possible way to keep disclosures up to date when substantive changes require new legislation.
The remedy is obvious. Congress should remove itself from disclosure operations and eliminate all existing congressionally mandated disclosures. Sole responsibility for all mortgage disclosures should be entrusted to one agency, which would have the legal authority to set and revise the rules as needed. This is the approach taken a few years ago, to good effect, in the United Kingdom.
The approach taken by HR 1728, in contrast, leaves the current disclosure system in place, adding a new set of mandatory disclosures to the pile. Under one of them, lenders will be obliged to disclose "the comparative costs and benefits of each residential mortgage loan product offered, discussed or referred to by the originator." Compliance with this rule alone, ignoring extensive other new disclosures stipulated in HR 1728, would probably double the size of the garbage pile dropped in the lap of hapless borrowers. Needless to say, none of the existing garbage disclosures are eliminated.
The cardinal sin of any disclosure system is overload, because borrowers have limited time and limited attention span. Disclosing too much is the same as disclosing nothing because nothing is absorbed. Adding even a badly needed and well-designed new disclosure to an existing pile of garbage disclosures does nothing but increase costs. An agency whose sole business is disclosure would quickly learn this, but Congress never will.
Next week: Improving the market with transaction simplification rules.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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