Since the beginning of the crisis, the debate on financial regulation has focused on placing limits on financial services firms’ behavior, based on the idea that the government has to protect Main Street from Wall Street. Recent history suggests that bankers lack the incentive or will to avoid unsustainable, economically disastrous, and downright predatory behavior.
But just as a securities trader can focus on short-term profits and
ignore the incremental systemic risk
introduced with each transaction, the average American often
ignores the incremental risk he incurs with his own financial behavior — each credit card
opened, or each mortgage refinance. If we acknowledge that bankers lack the will-power to judge how much is too much*, then we must acknowledge the same failing in the common man, who lacks the banker’s financial background.
The average American deserves protection not only from Wall Street, but also from himself. What if, hypothetically, we imposed regulations on individuals similar to those imposed on banks? Here are three ideas for saving average Americans from our own worst impulses.
First, the government should require borrowers to make at least 20% to 30% down payments (twice what Congress is asking) on residential real estate, unless the potentially borrower has income and/or savings sufficient to cushion against significant home price depreciation. Interestingly, after I began this experiment, the FHA announced “more stringent” requirements for certain borrowers, as the WSJ points out:
The FHA will keep minimum down payments at the current 3.5%
level for most borrowers. But the agency will require riskier borrowers
with credit scores below 580 to make a minimum 10% down payment. While
the FHA doesn’t have a credit-score cutoff, most lenders require a
minimum 620 score.Some housing analysts have pushed for higher down payments on
FHA-backed loans, and a bill in Congress would raise down payments to
5%, from the current 3.5%.
It looks like the Government is making steps in the right direction, but I don’t think its nearly enough. First Fair Issaic
reports that ~13% of the general population has a FICO score below 600,
while Experian reports ~20% are below 619. I’m curious why the new FHA rules would require the riskiest 10% – 20%
of borrowers to put only 10% down when buying a home (whether credit
scoring is an accurate or appropriate measure to use is another
story). Most data suggests
low-“quality” borrowers are long-term risks for lenders, and this is especially pertinent since the subprime meltdown. Thus, the government should mandate that high-risk
borrowers must exhibit verifiable and stable high income and/or put
down 20% if not 30% equity at closing.
Critics of this approach may
argue that riskier borrowers compensate lenders by paying higher
interest rates. But the same critics often fail to acknowledge that
bringing more equity to the table generally helps the borrower — with a
larger cushion against declines in home prices and lower monthly
payments. A higher interest rate hurts
the borrower by imposing higher monthly payments, the bulk of which
will be allocated to interest for the first few years of the loan,
often the riskiest ones. Indeed, we’ve seen that ARM recast/resets
have accelerated delinquencies, and in some cases, defaults.
This approach would correct biases — like
borrower over-confidence — that are often discounted or ignored by lenders. If a potential borrower can’t afford the higher
down-payment, they should find an affordable rental in the short term. Chances are the amount they’d spend on rent
will actually be roughly the same (and perhaps, less than the) amount
of interest many low-quality borrowers would otherwise pay in interest
over the first few years of the mortgage, when only a tiny portion of
the monthly payment gets allocated to principal reduction.
Second, we should implement interim safety limits over the course of the loan. For example, if a borrower already has 6x debt/income and wants to
take-on more debt, he or she would have to either put up more
cash or exhibit increased earnings so that ratio wouldn’t increase with
a higher loan balance. If the borrower doesn’t have the cash on-hand
or higher earnings, they can reduce their discretionary spending for a
few months (years) to repay their existing debt. Such regulation would
not only protect existing lenders from increased default risk, but it’d
protect borrowers from predatory lending standards. It’s
fair to ask what would happen under these regulations in an
“emergency” situation? Here, I’m not sure, but riddle me this: how
many such situations are caused, or at the very lease exacerbated by
years, if not decades of financial irresponsibility?
The third and most crucial regulation is that
loan originators should be required to scan copies of official
client-provided income, indebtedness, and net-worth information to a
clients’ electronic file. The originating broker should be
responsible for personally inputting this information into the firm’s
loan application system and, verifying its accuracy. Then,
based upon government-imposed maximum indebtedness, coverage, etc, the
originator could decide, based-upon their own scoring, how much debt
the borrower is capable of handling, any amount up-to, but not
exceeding the government-regulated number. These firms should have
strict compliance and internal controls, empowered internal and
external audits, and random federal inspection to ensure they aren’t
abusing regulations, as well.
In much of my prior work I’ve expressed significant skepticism of our government’s ability to not only create effective regulation, but to
enforce it with any success, especially during those times when its
needed the most. While I’m no fan of creating more government
bureaucracy, I don’t see a reasonable alternative. As much as I’m loathe to admit
it, the laissez faire approach has failed. We return to the status quo at our peril.
Would all this added red tape make it more difficult than in
2004-2006 to obtain credit? For many people, absolutely. But look what happened when we let firms and
individuals obtain virtually as much debt as
they cared to take-on. We came precariously close to destroying the
entire global financial system! Surely, GDP growth may suffer as
expectations for consumer spending and home-price appreciation revert
back to non-bubble-period means, but we’d be making a marginal
sacrifice today in exchange for a much safer financial system down the
road, one that would be far less at-risk of credit-fueled boom/bust
cycles.
The ideas expressed here are admittedly nowhere near perfect. But the financial regulation debate deserves honesty. We must accept the fact that the crisis
wasn’t caused just by bad actors on Wall Street, but by Main Street, as well.
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*I’ll be the first to admit that one would be hard-pressed to make the case that Wall Street is even tangentially concerned with the “greater-good,” so long as its making money. While he’s even more cynical than I, The Epicurean Dealmaker captured what many observers fail to realize:
Investment bankers have almost no interest in why things are the way they are. Rather, they spend all their considerable intellectual and psychological resources on understanding how they can take advantage of the way things are.
This may be a bit of an over-simplification, seeing as TED, myself, and several others who work(ed) in Finance do exactly that which apparently we do not, but as the recent FCIC hearings illustrated, TED’s description certainly seems to apply to those at the very-top of the game.
