What Goes Around Comes Around: How Government-Induced Relaxed Lending Criteria Helped to Create the Mortgage Market Collapse

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To hear Congress and our presidential candidates tell the story, the recent collapse of the mortgage industry, which has fueled the largest number of property foreclosures since the Depression, was entirely the result of the greed of banks and mortgage brokers.  In fact it was the politicians themselves who created the mess, and who are now looking to enact punitive measures against brokers and banks to satisfy the public need for a scapegoat.

    In the 1990s, the last time a Clinton was in the White House, special interest groups and Democratic Congressional leaders criticized the mortgage industry for redlining urban areas, thereby by-passing minority applicants who, they claimed, were unfairly being denied the opportunity for homeownership.  Bowing to the enormous political pressure, and facing the first raw data from HMDA reporting that reflected "underrepresentation" of minorities in the mortgage market, underwriting standards and criteria were relaxed.

    In fact, as Economics Professor Stan Liebowitz of the University of Texas Business School has pointed out recently, "no sooner had the ink dried" on the initial HMDA reports, when the Boston Fed issued new guidelines for mortgage lenders, designed to eliminate what it called "arbitrary and outdated criteria that effectively disqualif(ies) urban and lower income minority applicants."  Of course one of the problems of taking raw data and using it to create policy, is that often the raw data fails to define the whole picture. Prudent governing sometimes requires patience and clarification of important information. As it turned out through a closer analysis of HMDA results, many lower income and minority applicants were shut out of the mortgage market precisely because they were unqualified economically to shoulder the financial burden of a home mortgage payment, due to income and credit problems.  Instead of designing economic policies to correct the cause (i.e. create more opportunities for higher income, credit counseling and education) the government did what it does best: it created a dramatic, quick fix.  It encouraged the marketing and processing of "sub-prime" loans.

    Relaxed underwriting standards meant that credit history, income, assets, savings history, and the overall ability to repay, would be removed from the equation (or its significance reduced), and products would be permitted that avoided the fundamental criteria of good lending practices.  Lenders were thusly encouraged to offer products, and underwrite loans in a manner that would be "unbiased," not as to color, ethnicity, or national origin, but irrespective of financial soundness and the ability to repay.  Thus the industry found itself in the unenviable position of being pressured to grant loans to people who were told they did not have to demonstrate the ability to repay, while any demonstrative failure to make minority and urban loans, as reported under HMDA, threatened regulatory retaliation.  

    Now that the regulators created the mess how do they respond?  By pointing fingers at the industry, demonizing the very mortgage brokers and lenders who did everything they could, under existing guidelines, to meet the expectations and directives to make homeownership available to everyone.  The sub-prime loan, once the preferred solution to perceived economic disparity, is now a term of derision and outrage.  How far we've come!

    Out on the stump, the hypocrisy is evident.  Hillary Clinton, whose husband was President during the relaxation of lending criteria (when it was a "good thing"), now accuses the industry of "predatory lending" and "greed" for having used relaxed lending criteria (now that it is a "bad thing").  Mrs. Clinton is not alone in her new found concern for borrowers.  All the remaining candidates, including Romney. Obama, and McCain, have suggested drastic federal intervention in the mortgage market as a method to protect the victims they themselves had a hand in harming.  Everything from bankruptcy assistance, judicial restructuring of mortgage terms, and frozen rates, to Billions in federal government foreclosure bailout monies are being suggested.

    I have a better idea.  Let the market alone and let capitalism work.  Each side had reason to want the relaxed guidelines, Wall Street, Lenders and originators wanted the business, borrowers wanted the homes and investment properties, and the federal government wanted to satisfy special interest groups.  Each side has suffered as a result. People need mortgages, lenders and originators need business, the government wants the economy to rebound. Slowly products are coming back, the inefficient lenders are going out, inexperienced and fraudulent brokers are unemployed, and borrowers who were drunk on the real estate boom are sobering to the realities of responsible credit and debt decisions.  The market will come back, but a restructured mortgage market overloaded with new, dramatic and punitive government regulations and requirements will resemble the type of knee-jerk reaction that got us here in the first place.     

    Andrew L. Liput has been a corporate and bank attorney for more than 20 years, most recently as Senior Vice President and General Counsel to US Mortgage Corp. He is an owner of Repurchase Resolution Specialists, Inc. based in New Jersey. www.repurchasespecialists.com

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