What was the egregious lender offense that required the creation of the Consumer Financial Protection Bureau? They allowed borrowers to choose mortgage loans with a lower monthly payment.
This generally meant that rather than the nominal principal balance incrementally declining in the early years, it stayed flat – interest-only loans – or modestly increased, a process called negative amortization. The genesis of these loans was HUD-sponsored research in the 1970s to deal with the effects of inflation on the fixed-payment mortgage insured by the Federal Housing Administration.
The fixed-rate mortgage only protects borrowers from inflation when it is unanticipated: lenders and investors responded to anticipated inflation by raising the required mortgage rate. But a fixed payment mortgage requires paying now for inflation in the future. The rise in the required real – inflation-adjusted – mortgage payment during the early years became known as the "tilt effect."
HUD funded a study by the Harvard-MIT Joint Center for Financial Studies and published a subsequent book "Alternative Mortgage Instruments in an Inflationary Environment" in 1975 that suggested a variety of alternative mortgage designs. All had one thing in common: a lower initial payment resulting in either no amortization or negative amortization. By the time these ideas worked their way through the HUD bureaucracy, inflation was on the decline, but FHA's market share had already fallen.
Interest-only mortgages were popular during the 1920s housing boom, but disappeared during the Great Depression. Wells Fargo and Washington Mutual were among the first banks to reintroduce the loans at the start of this century, particularly in areas where house prices had grown the most, such as California, where Golden West S&L introduced the so-called pick-a-pay loan in 1982. As the point of such mortgages was to make housing more affordable, most borrowers chose the lowest payment.
While these worked better in an inflationary environment, the credit risk is increased if inflation is less than expected. But, as housing prices continued to rise during the recent housing boom, such mortgages made sense for consumers as the Federal Reserve, which, as both the consumer and systemic regulator, denied a bubble – and politicians sanctified lenders for offering them to promote political housing goals.
The Fed as we now know was quite wrong. The bubble burst, default rates soared and politicians then crucified lenders. These loans only had a marginal impact on negative equity and, hence, borrower default and loss severity. Low down payments both required and enabled by political housing policy were the major cause of the housing price bubble and subsequent default as well as the resulting severity of loss.
The qualified mortgage requirement of the Dodd-Frank Act requires the lender to determine the borrower's ability to repay the loan, with fines, civil liability and potential class-action liability for a failure to do so, reflecting the diagnosis that unethical lending practices were the cause of the financial crisis. As the most important predictor of a borrower's subsequent default is the size of the initial cash down payment, increasing the down payment requirement was the logical policy implication of the QM requirement.
But then the act's co-author, recently retired congressman Barney Frank, amended the bill on the House floor to state that the CFPB can issue regulations modifying the QM rule "upon a finding that such regulations are necessary or proper to ensure that responsible, affordable mortgage credit remains available to consumers in a manner consistent with the purposes of this section."
In early 2013 the CFPB issued the QM regulations. Loans with no or negative amortization were excluded, but in deference to affordable housing advocates, the definition allows loans with no borrower savings for a down payment. Mortgage instrument design and evaluation of credit risk has, as a consequence, been transferred from lenders and prudential regulators to a consumer advocate regulator. Mission regulation has once again trumped prudential regulation, a mistake that served as the root cause of the last financial crisis.
Like the Fed, the CFPB has virtually unlimited funding with no congressionally approved budget, and this is over and above all the funding for the existing federal, state and local consumer regulators and protectors. The various proposals for reform including replacing the director with a five-person board, providing a congressional appropriations process and giving prudential regulators veto power over CFPB rulemaking will all fall short.
The CFPB incorporates political denial and cover-up in its DNA and is predestined to be overbearing, which will only hurt borrowers in the long run.
Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates and an executive scholar at the Burnham-Moores Center for Real Estate of the University of San Diego.