PolicyCents

Stress Tests

2009-05-09T11:41:00.000-07:00

No, not those stress tests...the ones that show which major financial institutions are under capitalized under stressful economic times. But rather the tests consumers feel in these uncertain times.

A recent article in the Wall Street Journal on emergency 401k withdrawals got me to ask colleagues in the tax preparation world if this was in issue this year. By and large the answer as yes, and the stories they told profound.

One site here in Madison did taxes mostly for University employees as part of the IRS Volunteer Tax Assistance Program (VITA) and served low-income individuals. The thing about many VITA sites is the tax forms are not that complicated--few clients have to fill out schedules for small businesses or rental properties, or even Schedule A for itemized deductions. Getting through Child and Earned Income Tax credits is much of the work. But this year an employee with around $25,000 in income came in who had cashed out an 401k or IRA tax deferred account. It had at one point risen in value to more than $35,000--a lot for a low-wage worker under 40 years of age. Then by November/December has dropped to $14,000. For this client seeing this drop in value was too much. The media was talking about banks failing and scams where investors lost all of their money. This was not an FDIC insured account and the client feared the worst. The only defensive move in this client's mind was to get that money back ASAP before it was all gone.

He panicked. But it is not hard to put yourself in his shoes and realize in that context, if you don't believe markets will come back, and the media is buzzing about the collapse of the economy, you might have the same thoughts.

Of course finance theory tells us to ignore cyclical swings, dollar cost average, and invest for the long-run, especially for a retirement account that won't be needed for a decade or more. But knowing that and believing that when you and everyone around you is under stress is another matter.

This story is not that uncommon among VITA sites. Sometimes people sold for an emergency expense; some sold in a panic. Either way they sold at what now looks like a bottom of the market. Plus remember they have to pay all the deferred taxes on the initial IRA/401k contributions, plus a 10% penalty. In the anecdote above the client ended up owing about $4000 in taxes and penalties to pull out $14,000. Mind you $14,000 is still more than half his income. If there as an emergency use it might even avoid some tax implications. But most likely that money won't be reinvested at a reasonably long-run rate of return (eg it will go in a savings accounts versus an S&P 500 Index) and will lose value. Or even more likely it will be spent on everyday costs of living and consumption.

A lot of savings "policy" and programs aimed at boosting financial literacy or investing focus on getting in, but not what to do when the market drops 30% in less than one year. When it looks like the bottom is falling out people respond in predictable ways. One implication is that we need to better understand this consumer behavior under financial stress. Maybe this could lead to more supportive products and services to prevent people from letting today's stress get the better of their financial future. Financial insecurity comes from more than just a spreadsheet, but is a state of mind.

Failures of Basic Financial Services

2009-04-24T20:00:00.000-07:00

The Federal Reserve held a conference in April on research in community development. There were several papers on payday lending, tax refund anticipation loans, prepaid cards and other forms of credit. These non-traditional sources of loans may at first blush seem illogical: Why would someone borrow next week's paycheck for a $30 fee when that amounts to a 360% APR on an annual basis? Or borrow their tax refund in October at a cost of nearly $100 for $1500 in 5 months. Why opt out of checking accounts and use higher cost prepaid cards?

The answer it seems, at least in part, is that people are not well served by financial services and using what is available to as best they can. Jennifer Romich and colleagues followed a small group users of prepaid cards using details interviews. It turns out these consumers liked the limits on prepaid cards and generally eschewed conventional checking accounts because they had been burned in the past. Checking accounts have fees on low balance accounts, charges for check printing and from the perspective of these consumers, banks just seem to be out to get them. For people with just enough income to get by several checks may go out that come close to overdrawing the account. Banks generally will cash the largest check first, bouncing several smaller checks. Consumers see this as capricious and vindictive. So they opt out of the system entirely.

Angela Littwin used similar methods to look at high cost credit cards used by low-income women in Boston. In part because Boston has few short term payday loan options (regulations largely ban these loans), credit cards are a key source of credit. Low income families use credit cards as a form of an emergency fund. But they report being frustrated as the card issuer periodically 'gives' them more credit; they feel they would be better off without the option to borrow more. The author suggests new forms of credit cards with simple fees and low balances that the consumer affirmatively selects--and they can set limits on their own use.

Jeremy Tobacman and colleagues look at pay day loans and credit card use. The authors note many payday loan users actually have credit available on their credit cards, yet still use high cost payday loans. They also find that the use of a payday loan is a precursor to credit card default. Thus consumers may be using payday loans because they know they are in financial trouble. The costs of over charging a credit card and/or late fees or even carrying debt over time on a card are such that consumers are allocating their credit across all available options.

One other paper from the conference that is relevant to this discussion is by Peter Tufano and colleagues. They look at income tax filings and clients using advance refund loans. They then track how clients use their refunds among those who took their refund on a stored value card. The #1 item for which the funds were used? Groceries. For many the purchase happened immediately--within a few days. Less than 10% appeared to buy big items or consumer durables (the stereotype of buying a flat screen TV).

These are all insightful papers and deserve more attention than the few sentences offered here. The overall picture these papers paint is that consumers do make mistakes and suffer from mis-information. But they also are doing the best they can with the tools they have available. And it seems many see mainstream banking-- checking accounts and credit cards-- as more trouble than they are worth. Non-traditional users of these accounts are slapped with fees and charges on a regular basis making even a high-cost payday loan a cheaper alternative. It is also clear these products all interact, as consumer trade off one form for another--probably not something regulators pay attention to. Moreover as financial services consolidates and firms look to raise more revenue from basic transactional and small credit services, it seems likely more consumers on the fringe will opt out of mainstream services.

New products and markets are developing to better serve this population. So long as they offer transparent pricing, consumers are likely to be better off for it. A better understanding of the landscape of consumer services in this segment is clearly needed.

Why so few loan mods?

2009-04-12T20:53:00.000-07:00

The HASP effort from the Treasury/White House/HUD has been in play for over a month now. By some measures, lenders are beginning to use the program and at the least there are refinances being made through Fannie and Freddie for loans with loan to value ratios of 80-105% of appraised values ("shallow under water" loans).

In the last week we heard that FHA loans are performing poorly. This created headlines about an FHA 'bailout'...which is not quite right. FHA charges a premium and has generally added to the Federal revenues every year due to a surplus of premiums paid over payouts (there is no "lock box" for Federal programs). In many ways this has been a tax on homebuyers which returned billions to the Treasury. Due to a slew of loans in 2005-2007 where downpayments were gifted by sellers (a blueprint for disaster to all who watched it happen), FHA has a book of loans that is doing lousy. That program has ended and FHA volume overall is robust. FHA may need, for the first time in history, a subsidy for its premiums. Or it could simply to raise its current premiums. But this is not quite a collapse of an otherwise pretty good program.

But the news on loan mods is more modest. Still lenders are slow to get mods approved and seem to still end up doing more foreclosures than alternatives. New data will soon be out from HOPE NOW and some state programs to see if or how fast things are changing.

A recent paper by Christopher Foote, Kristopher Gerardi, Lorenz Goette and Paul Willen on the Boston Fed website (Public Policy Discussion Paper P09-2) with the pithy title "REDUCING FORECLOSURES" has some interesting implications.

The authors argue that loans originated with high mortgage payments relative to income, or at so at "unaffordable levels," are not the main reason that borrowers default. They suggest it is actually household income shocks such as a job loss or income reduction, combined with a declining house price market.

Because investors usually gain more from foreclosures than modifications, the system is set up to pursue foreclosure options even if the borrower may be able to maintain a modified loan. They argue that PSA and securitization agreements are not the barrier to servicers often suggested, and that investors are not putting legal pressure against mods as much as simply are economically better off foreclosing. It would be better for society, borrowers, neighborhoods, etc for more mods to be made, but probably not for specific investors facing a trade off between forms of losses. Both a mod and foreclosure mean a loss. Mods may just prolong the problem in too many cases.

The authors conclude that mods may need to be re-directed. Rather than reducing payments below 31% of income for 5 years across the board, as in the HASP, a better approach would be to focus on the trigger event to get the borrower through until a better income level is achievable, then revert to the prior terms.

It is a nicely written paper and engages a useful discussion of what we ought to consider affordable or "sustainable" lending. It should be noted they do not find income to mortgage payment ratios are not unimportant, just that income:payment at the time the loans is made is not a main driver of default. From other data we know mods that reduce payments tend to perform better over time. In fact the authors repeat this finding. But the situation each borrower is in varies, as does the availability of data on changes in income over time.

One proposal put forth by Steve Malpezzi and colleagues at the Center for Real Estate at the University of Wisconsin Business School is that unemployment benefits could include a temporary housing voucher which pays any amount over 30% of income for making housing payments. The result is a bit like a short term insurance contract against default.

It seems unlikely there will be much momentum for HASP II or even another round of foreclosure prevention policies in the near term. But as housing policy is designed going forward, better attention to what happens when housing and labor markets fall at the same time at scale will be a hard learned lesson.

Solutions to Foreclosure: Looking Across the Atlantic

2009-03-28T19:59:00.000-07:00

The US is not alone in having a housing crisis. Many European and other nations also had a house price run up and bust--many with some forms of expanded high risk lending. The UK has a more homogeneous housing market and also experienced a downturn like the current episode in the early 1990s.

In the UK the foreclosure is called repossession and operates on a national basis as opposed to the US with its state laws administered by county clerks. While lenders generally offer the same workout/modification options to borrowers in default as in the US, if the problem is not resolved then the lender seeks remedy in the courts. The court can grant immediate possession to the lender, but the most common outcome of the judicial process is a ‘suspended possession order’. In short, the debtor puts a proposal to the court to repay arrears over a stated period. If the court considers this acceptable, irrespective of the lender’s willingness to accept the offer, possession of the property is granted to the lender but with the order suspended so long as the payments are made. No further action can be taken by the lender unless the debtor misses a payment.

There are a number of common themes in policy responses in both countries. In UK during 2008 there were a series of policy announcements aimed at reducing levels of repossessions. Four major initiatives include:

(1) the Support for Mortgage Interest scheme, which amended the welfare benefits system to provide improved support to home-buyers with mortgages who lose their jobs;

(2) the Homeowner Mortgage Support Scheme, providing ‘mortgage holidays’ for home buyers who may suffer a temporary fall in income, but are expected to recover at a later date;

(3) the Mortgage Rescue Scheme enabling homeowners facing repossession to remain in their home through a shared equity scheme, whereby a Registered Social Landlord or RSL) will provide an equity loan enabling the householders' mortgage repayments to be reduced; and a related program, and

(4) the Government Mortgage to Rent Scheme whereby the RSL will clear the secured debt completely and the applicant will then become a rent paying tenant of the RSL.

In September 2008 the UK government packaged these and other programs and then announced a ‘Billion pound package for housing’.

Like the US, the UK has increased funding for borrower counseling. In November 2008 it was announced that “£15.85 million ($22) to extend free debt advice [is] to be made available to all consumers across the country” . This builds on expansion of the “debt advice sector” since around 2004, although different to the US, this expansion was initially separate from housing issues and was located in the Government’s anti-poverty agenda (reducing indebtedness). This led to a 2004 action plan for tackling (over) indebtedness (Department of Trade and Industry 2004). The action plan was updated annually and the importance of debt advice has remained a consistent theme. In the 2007 report included: “Free and impartial debt advice is a vital safety net for many vulnerable consumers, improving their ability to manage financial commitments and stave off far more costly consequences” (Department for Business, Enterprise and Regulatory Reform, 2007: 62). In the initial 2004 action plan on indebtedness £45 million ($63) was allocated to increase the supply of free face to face debt advice. While unpacking different spending announcements is complex, somewhere in the region of £80 million ($112) is now committed by the UK Government to increase capacity through to 2011 (Department for Business, Enterprise and Regulatory Reform 2007). As in the US, support is provided both for face-to-face and telephone counseling services.

In the US about $200 million was provided on 2008 as part of the National Foreclosure Mitigation Counseling Program. In addition HUD provides about $50 million for housing counseling, some portion of which is directed towards housing debt.

Like the US, the UK policy response is perhaps far less than the need. For example, in the UK the Mortgage Rescue Scheme applies only in some local areas, and it is estimated it will help just 6,000 households over two years. Both the Support for Mortgage Interest Scheme and Homeowner Mortgage Support Scheme are based on such complex qualifying rules. This is parallel with US experience such as with the FHA Hope For Homeowners program. Congress made the terms strict, in order to prevent the appearance of abuse, including a requirement that 50 percent of any future gain in the home’s value would go to the government—which reduced incentives for use.

A recent Survey by ACORN suggests the US HASP program may more success. In this survey three-quarters of the top lenders say they will participate in the program. Of course, as unemployment rates keep going up no modification could help those homeowners without income to be able to remain in place.

Both countries are engaging in a range of policy experiments. Neither has great data to build on, nor the time to develop pilots before trying new ideas. But stronger research comparing each county’s experience has the potential to help develop better responses in both.

Homeowner Affordability and Stability

2009-03-03T21:35:00.000-08:00

It seems no one likes any ideas being put forth on any economic issue these days. The alternative of just letting banks, companies and homeowners just 'go under' is increasingly argued to be the optimal long-run choice. But doing nothing is a choice too. Certainly some will be worse off if nothing is done. And some maybe better off if something is done. So now we get into debates about who pays the costs and who gets the benefits, and if plan A has more impact than plan B. But doing nothing no longer seems to be a politically or economically viable choice.

Today we learn the details of the HAS plan - that is the Homeowner Affordability and Stability plan first announced in February by the Treasury Dept. The HAS plan is the newest iteration of foreclosure prevention. Round I was largely voluntary efforts by industry and resulted in some good press and the creation of a national hotline for borrowers in trouble. Round II stepped up the voluntary efforts, layered on some FHA loan products (which ended up being almost un-usable), money for foreclosure counseling and a few regulatory moves around the margin. In the end a few people in default were helped but it would be hard to prove there as much impact, beyond the efforts of the FDIC to offer loan modifications to borrowers of loans from the failed bank Indy Mac, which the FDIC itself took over.

The HAS plan has a number of components, some of which are quite vague if not innovative. But it boils down to 2 main efforts: (1) refinance underwater loans held by Fannie Mae and Freddie Mac and (2) facilitate loan modifications for borrowers "at risk".

Fannie and Freddie are under government conservatorship. They require government subsidy to operate at this point and seem willing to take on the risky proposition of refinancing borrowers who owe more than their home is worth. The catch is the borrower also has to have high payment ratios such that affording the mortgage is in question; just being in a declining home value market is not enough. It looks like the implementation of this will also require some indications of (a) hardship like job loss or income reduction and (b) re-underwriting the loan to prove the borrower can actually pay going forward. It is likely many will apply and only a fraction will qualify. And remember by definition Freddie and Fannie borrowers are better credit quality, not subprime or in the category of various 'exotic' loans.

The danger is making the rules too narrow and then no borrowers are helped. (See "Hope For Homeowners" the FHA refinance product which is the poster child of protecting a program from abuse by making the terms so strict no one could use it.) On the other end is making the program so easy to qualify for that a high share of these newly refinanced loans default. Or worse from a PR perspective, some 'undeserving' borrowers get a deal. When the guy in Miami with 3 condos slips through and gets a loan it will be sure to be in the press.

The second part of HAS is not refinancing loans but modifying the terms of existing loans. This relies on the efforts of private lenders. It is voluntary on the lenders' part, but in reality every major mortgage lender is depending on TARP or some other form of government support, so not taking part in HAS would be a poor move politically. Again details are forthcoming, but here are some components:

- payments to servicers to make mods. This addresses a major problem in the market. Even if the lender and borrower may be better off with a modified loan, the servicer may be financially better off pushing foreclosure. $1,500 may not be enough to change the calculus, but it at least forces a second look at modification options.

- cost sharing for lowering payments. Lenders are required to take a hit by lowering interest rates and/or principal to get payments to 38% of income, then split the cost with Treasury of getting payments down to 31%.

- incentives for performance. Borrowers who agree to a mod can get up to $1000 per year for 5 years for principal reduction. Not a huge amount but perhaps again it lines up borrowers to make an extra effort.

- opportunity to re-capture some revenue later. After 5 years the modification can start to increase interest rates and payments as economic conditions improve. This could prove to be a problem if the economy stays soft. Let's all hope 5 years is not overly optimistic. One could imagine this date being pushed back if so.

- insurance against further home value declines. This is the most cutting edge and least well defined. Basically FDIC insures the lender in case home values drop more and the home goes further under water.

The Treasury is releasing guidelines for modifications. The idea is to again focus on borrowers with hardships, either in foreclosure or at risk of it. Payments will be lowered and in some cases principal forgiven. This will be a 'new' kind of modification in many ways. The press has jumped on data from the OCC that shows 50% or more of mods re-default. But mods in 2008 often increased monthly payments and/or principal, so this should not be a big surprise. Alan White's recent data suggest the types of mods proposed here will perform much better, with short-run defaults of 20% or less.

Will all of this work? Compared to what? We have learned a lot in the last few months and the HAS incorporates some important lessons. A major issue remains investors in securities. There is no legal consensus on how loan terms being re-written filter up to how securities divide up losses in principal and interest payments. Lenders and servicers may still fail to offer mods because of fear of legal issues with investors.

In the short run we can count on consumers being confused. Phone lines and websites to lenders will be overwhelmed. The HOPE hotline and housing counselors like will see a deluge of clients looking to understand what they can do. It is unlikely servicers--who are already grossly over their capacity to deal with loan workouts--will smoothly launch HAS mods. And then the process for administering government subsidy to lenders/servicers on a loan by loan basis has the potential to become a bureaucratic mess (FHA has done it for years; many lenders and FHA employees will debate both sides of how well this works).

Given a stream of strongly negative data on the housing, employment and banking front, the bottom of this crisis may not yet be in sight. Let's hope HAS has more impact than its predecessors.

Update: Here are the details... More detailed than many expected... The new piece is documenting 'hardship' which clearly intends to avoid 'underserving' borrowers from getting help. Also a "1-strike and you are out" for re-default. And, an emphasis on using the FHA Hope for Homeowners loan program. Now let's watch the implementation...

Foreclosure Mediation

2009-02-11T19:24:00.001-08:00

A number of states and localities--OH, CT, NY, Philly among them--are experimenting with foreclosure mediation as an alternative way to settle foreclosure disputes. Of course from a lender's perspective there is no dispute--the contract was broken and foreclosure is the avenue to seek remedy. But the reality is foreclosure takes a long time and is costly to the lender and borrower. Some share of borrowers could remain in the loan if the loan terms are modified. How the modifications happen really matters, and mediation prior to foreclosure could help make that happen.

The mediator is a 3rd party, typically someone with legal training but outside the courts. Both sides (borrower and lender) have to make good faith efforts. Using a 3rd party a solution (modification or sale of home w/o foreclosure) could be found. It saves money and the potential harm to neighboring properties, not to mention the borrower and his or her credit record.

How would it work? Lenders could be required to offer mediation before foreclosure can proceed. Borrowers have a time limit to respond. Then the mediation has some limited time to be completed. Ideally the loan is restructured to avoid foreclosure or the borrower buys time to market and sell the home privately.

The critique of mediation is borrowers may be at a disadvantage. It is becoming clear not all loan mods are the same. A loan mod that moves fees to the final payment in 20 years and lowers the interest rate for a few years has less than a 50-50 shot at success. A mod with principal reduction has better odds - maybe as much as 80% will succeed. Mediation may result in naive borrowers agreeing to mods with weak terms and few net gains. One could imagine discretion on the part of lenders resulting in disparate impacts by race, income, location or in all three dimensions.

Enter the role of education and counseling. Prior to the mediation the borrower has to so some homework. Ohio's program has such a requirement. How well borrowers can be trained to explore their options is an open question, but it beats going in unarmed with a sophisticated lender.

There are lots of problems - like dealing with high volumes of foreclosure filings, getting borrowers to pay attention at all, compensating mediators and counselors, getting lenders/servicers to create mods that really can succeed given investor and legal issues with mortgage securities--just to name a few.

To be sure, if a mortgage cram down bankruptcy provision is passed at the Federal level, lenders may seek alternatives such as mediation with open arms. And anything that attempts to get the borrower to take action before the auction is socially valuable, even if the mediation does not result in a mod. Given the slow pace to restructuring individual mortgages we have seen so far, the mediation approach may have potential.

More Incentives to Borrow

2009-02-11T19:16:00.000-08:00

The stimulus package contains so much it is hard to parse it all out. But there are several provisions to encourage consumer borrowing - notably to buy a first home and a car. The first-time buyer tax credit for homebuyers is actually an oldie but goodie. Every economic slowdown the Home Builders and allies promote such a credit. The tax deduction for 1 years worth of car loan--and deduction of sales tax for an auto purchase is a new one. Certainly it makes borrowing to buy a car more attractive, especially if you can pay off the loan in year two and avoid all that non-tax advantaged interest. Will consumers take the bait? Will lenders gin up loan volumes, or just make loans to prime credit borrowers? Don't be suprised if consumers and lenders still are conservative. If not, then the lessons of the last two years will have been too quickly lost. Ideally lending will return slowly and carefully on both the supply and demand side. There could be a real danger to an artificial boom...another lesson which may all to quickly be forgotten. We'll just have to wait and see.

Follow up: for fun (and sadly true):
http://www.hulu.com/watch/1389/saturday-night-live-dont-buy-stuff

Burn the Mortgage

2009-02-03T18:55:00.000-08:00

Back before subprime loans and the mortgage meltdown...before MBS and CDOs...there was a time when people actually set a goal of paying of their mortgage and then burned the note in celebratory fashion. The mindset was that debt was bad and getting the home paid off was a great success.

In the last 2 decades a parade of experts have created lots of reasons not to pay off the mortgage. First, rates were cheap. You'd have to be silly not to borrow at 6% if the S&P 500 returned 10%. Second, mortgage interest is tax deductible. The after tax cost of borrowing is even lower than the note rate. And it feels good to take that fat income tax deduction. Third, carrying debt into retirement is no big deal since you can always work and your investment income will be more than adequate anyway.

The mortgage industry, from street level brokers to Wall Street analysts and DC lobbyists, embraced the idea that not only should Americans carry a mortgage, they should refinance to get a lower rate, take out equity for consumption or even lengthen the term to reduce payments.

Maybe its time for consumers to turn their backs on the mortgage. Here are a few reasons.

(1) Paying off the mortgage is like insurance. Yes, you could in theory work or cash in investments to meet payment obligations, but what if you cannot work and/or your assets are depreciated? Paying off the mortgage protects you from getting trapped. In effect the house pays your rent for you no matter your situation once you pay off that note. Plus if you put more equity in going "under water" is less of a problem.

(2) The tax benefits are not as great as you may think. Interest is a sizable portion of the payment for the first few years and then starts to decline faster over the term of the loan. The property tax deduction remains a significant value even if interest is no longer paid. Several economists have shown eliminating the mortgage interest deduction would have minimal effects on the market (in effect all buyers and sellers expect the deduction and prices adjust accordingly), although it would need to be carefully phased in.

(3) Paying off the mortgage creates a constraint to spending. If you have your money tied up in your house and refuse to take out home equity, you won't be lured into spending that money. Behavioral constraints are important for most consumers and this is a simple way to create one.

(4) Having a mortgage takes your time and energy...and money You have to manage the payments and deal with the lender/servicer, etc. Plus remember you are paying interest. All that is a cost you can avoid. Not to mention any anxiety related to knowing you owe another payment next month. And then refinancing incurs even more real transaction costs. And if the refi is not for a term shorter than the remaining years in the loan, it just lengthens out the time people are in debt.

Imagine a consumer movement that rose up to reject serial refinancing and worked hard to pay off every mortgage early. Think how much more stable consumers, housing, maybe even the economy might be...

But alas, its seems unlikely mortgage burning parties are going to make a comeback. What might help? End the mortgage interest deduction, at least for non-first time buyers and for all forms of home equity loans. Require loan applicants for all refinance loans that are not for a shorter term than their existing loan to attend mortgage counseling. And celebrate those who pay off their loans.

As it is about 24 million of the 75 million home owning households in the US owns their home free and clear with no mortgage. The majority are not rich either - with incomes under $50,000. At the very least they can sleep tonight knowing they are not at risk of foreclosure.

Nationalization Pride

2009-01-22T08:32:00.001-08:00

Tuesday's enthusiasm for the new administration was not reflected in stock prices. Most markets dropped and continue to be on a downslide. Why are investors so pessimistic? Mostly it has less to do with the Obama administration than concerns about major banks such as Bank of America and CitiGroup. Share prices for banking stocks have taken a beating the last year, but in the last few days prices have dropped closer to dangerous sub $5 zones ($3 for Citi and $5 for BofA). WellsFargo and JP Morgan Chase are not far behind. Even with equity from the TARP 'bailout' investors fear these firms lack enough liquidity to absorb more loan losses.

Some estimates suggest US banks have written off $1 Trillion so far (yes "T") and have another trillion to go...so they are only halfway there. As share prices drop the bank's equity erodes further. This makes creditors nervous so they demand higher returns. The cycle continues as just as banks need more capital they are forced to pay more for it. All of this hurts their ability to make loans and truly make markets. It hurts the firms and the economy.

So the rumor now is one of more of these firms will be 'nationalized'. This could take many forms. Shareholders might be wiped out. This strikes some policy makers as sweet revenge. These firms were mismanaged and the shareholders rode that wave to extraordinary profits year after year. In other models shareholders might be weakened but still alive--similar to the Fannie Mae and Freddie Mac 'conservatory' models. Prices would plummet, but the potential for a comeback might exist. In either case the federal government would manage the banks until they could be sold off--probably in smaller chunks.

But while nationalization may seem to be a way to just 'get the mess cleaned up and move on', it is not so easy. FDIC take overs generally result in heavy costs to the Treasury. Viable parts of the business are sold to existing firms at a discount and the losers get government bail outs. This would take some time and quite a lot of money. Not to mention someone to manage these firms.

Even if it saved some firms, it might undermine others. The markets will become nervous about every bank not on the nationalization list and dump it for fear it might go on the list. And in doing so, more firms would need help and the list grows.

Does any of this matter for consumers? Yes and no. Banking will continue, but the cost of services/products will increase. Borrowers on the margin of qualifying for a loan will be further excluded. And for many years shareholders will likely punish any bank that lends to consumers viewed as 'risky'--which could be code for not White or living in an inner city or even a small business. So this is important in the long run to keep an eye on.

And there is always the danger consumers over react and we need a FDR style bank holiday to restore order. Unless the FDIC looks insolvent this is unlikely however.

What are the alternatives to nationalization? Creditors could be wiped out or debt could be re-organized under bankruptcy provisions. The Treasury has already guaranteed some bank debt so that would be an added cost. Of course more cash infusions could be arranged. This did not seem to work last time (in Oct-Nov) but arguably there the Treasury's investment were not big enough. Another $400 billion just might do the trick. But no one really knows. This is all a grand experiment.

A final option is do nothing. Banks will need to look for ways to shore up their balance sheets without worrying about common stock. Making policy based on volatile share prices is probably never a good idea. Maybe the best approach is wait and see.

Did Obama tip his hand in his address Tuesday? He stated our financial crisis reminds us that “without a watchful eye, the market can spin out of control.” He also stated "The question we ask today is not whether our government is too big or too small, but whether it works." Perhaps we will see some bold new approaches in the coming days and weeks. Or maybe the wait and see approach will prove to be exactly the bold action required.

Cram Downs

2009-01-08T11:07:00.000-08:00

There have been several articles about mortgage cram downs of late. Today there are reports major lenders may even be willing to accept a new bankruptcy provision in which judges can reduce mortgage principal owed unilaterally so that lenders must write off any balance above the market value of the home. Even the National Association of Home Builders (NAHB) is now in favor.

This idea has been around for a while--but forcefully opposed by industry. The problems often cited include: lenders won't issue mortgage loans or will raise interest rates; judges won't know what true market values are; borrowers will rush to file bankruptcy just to get out of a loan they should have known better than to take out (moral hazard); the bankruptcy courts cannot handle the volume in the exisiting system; and, only lawyers benefit from this.

What's to gain? First, this is one of the only proposals where consumers get a direct 'bail out.' Second, the mere threat may force lenders to do more loan modifications, and may even give lenders more power to force investors to let them do more modifications. Third, it uses an existing structure to get through a financial problem.

There is a long history of the bankruptcy law, revisions and court precedents I won't go into. From an economic point of view having bankruptcy laws are important. They allow firms and consumers to take risks -- think of it a bit like an insurance against financial disaster. (Alternatives like debtor's prison have proved to be less than ideal models.) For various reasons education loans and mortgage loans have received special treatment in bankruptcy. The terms of the loans might be altered in bankruptcy during a repayment period, but the principal cannot be washed away. Cram downs change all that.

Is this a good idea? Well, let's just say it is an idea. Like so many other ideas suggested over the last year to address foreclosures. It will have effects, some intended and some not intended. The key will be to set some limits around how this 'cram down' provision is used. The bankruptcy system would choke if the estimated 8-10 million borrowers who owe more than their home is worth tried to file. Some borrowers would no doubt abuse the system. Judges will make mistakes in marking homes to market values. Some lenders would restrict lending for some time. In the end this is unlikely to be either a disaster or silver bullet...

My guess is lenders are now in favor to (1) throw a political bone as they digest their billions in government investments (2) provide some threat to investors to allow more modifications (3) hope maybe this slows the cycle of foreclosures and falling home values (this is the NAHB's talking point).

The reality is bankruptcy is costly for consumers. Not just the fees (which certainly benefits bankruptcy attorneys, a sector of the profession with some less than reputable actors), but also the damage to credit records which remains for 10 years - 3 more than a foreclosure. And to file consumers have to get counseling prior and take financial education after, account for all income, assets and expenses, and restructure their budget. When they do go back to the credit market they will for sure pay more for credit than before.

Will lenders cut back on lending in the future? Probably, but only at the margins. Low downpayment non-recourse loans seem far less likely for lower-income borrowers, especially those more likely to file for bankruptcy or in historically volatile housing markets. This may not be entirely a bad turn of events.

Will more consumers seek out risky mortgage loans armed with the knowledge of a potential cram down? Probably not. The lure of homeownership remains strong, so few are likely will decide to buy a home only if cram downs are passed.

Some homeowners who are on the fence about defaulting because they owe more than their home is worth may ride out a slump in home values, keep on paying and not file for bankruptcy because they know the costs -- which is exactly the 'insurance-like' role we might hope for.

Other homeowners in real trouble - from a job loss or because of a predatory loan - may really benefit from filing and getting principal reduced (let's hope any illegal predatory loans get prosecuted however).

A few sophisticated borrowers may even be able to use the threat of bankruptcy to induce lender concessions in or before default.

Like so many other strategies proposed in this crisis, only time will tell. A few provisions being suggested may help--such as only for loans made before the cram down law passed and only partial reductions in principal unless there was a violation of lending disclosures. Anything that helps target this to the consumers best served will go a long way.

Foreclosure Assistance

2009-01-05T08:26:00.000-08:00

Much has been made in the media of late about the quality of loan modifications being made and if these really prevent foreclosures or just delay them. The data on re-default of modified loans looks like at least half run into further payment problems. Although we really need to know more about which loans were offered mods and on what terms before reading too much into this. In the past lenders used mods as a 'last resort' to borrowers in deep trouble. For better or worse mods are starting to be used earlier and for more borrowers with a better balance sheet going in. Of course unaffordable payments and being under water (debt>home value) can happen under a mod, too, so we'll never see stellar performance unless the mod cuts principal and interest.

Thanks to my colleagues at MortgageKeeper Referral Services Inc. the data below provides some evidence of the situation borrowers in default face. MortgageKeeper is used by credit counselors and loan servicers--most notably the 888-HOPE Hotline counselors--to make referrals to local services depending on what the borrower talks about on the phone. For example, a borrower who is behind may blame being out of work as a cause of falling into default, so the counselor looks up a number for an unemployment office in the MortgageKeeper database. There are something like 16 service categories for service agencies in MSAs with the highest rates of foreclosure (45 cities and counting). The chart below is based on 67,500 referrals made to borrowers in 2008 (one borrower could have more than one referral). The red bars are as of December, the blue bars as of June.

Source: MortgageKeeper Referral Services, Inc.
2008 referrals to services (67,500 total referrals)

What is notable here are the jumps in the last two categories: Job Training and Heating/Utility Bills. Heating and Utility assistance moved from 1 in 5 to almost 1 in 3 referrals. December's weather likely plays a role here, but clearly this is a major expense stretching budgets (see previous post).

More interesting is the Job Training category. Job training has jumped from 13% to 23% of all referrals. This suggests people are not just unemployed ("Unemployment Assistance" covers that), but looking to change what they do. Obviousily this will take time. It also suggest workers are trying to adapt to changes in the overall economy, as whatever they used to do no longer seems viable. While a small share of all referrals, child care more than doubled to 7% of referrals. This is likely connected as people move into new jobs requiring different child care arrangements or lower-cost/subsidized care.

Note also the incidence of legal services. The exact nature is unclear, but likely related to financial issues - perhaps the mortgage, another source of credit or even intent to file for bankrupty. If proposals to change the bankruptcy law to allow judges to "cram down" changes in mortgages (basically in involuntary modification) this category is likely to grow signficantly.

The Misc/Other category includes issues such as "Substance Abuse" "Reverse Mortgages" "Income Tax Assistance" "Worker's Comp/Disability" "Mental/Family Counseling" and "Pharmaceutical and Medical Costs". In general these have not garnered many referrals however.

What's all this tell us? Well, first that consumers probably need more than just a 'new' loan. They need to get childcare, get re-trained in another field, get organized and back to work. This a bigger task than most lenders are willing to support. Local services can play a role, but consumers need to know enough to take some steps. Second, the data on utility bills suggest basic budgeting is in demand. Consumers should be prepared for higher energy costs each winter. On the bright side falling energy cost ought to lending a helping hand to borrowers trying to stretch their budgets.

The Canary Stops Signing: 20% + of Utility Bills are Behind by mid 2008

2008-12-19T21:50:00.000-08:00

The 2008 National Association of Regulatory Utility Commissioners (NARUC)
Collections Report came out this week. This association of state regulatory agencies surveys public utilities - 41 state agencies took part - to document payment problems experienced by residential energy consumers. The Summary Report is online, as well as a state by state tabulation. The headline is 1 in 5 consumers are behind. The share of utility bills that are behind is up a little bit between mid 2007 and mid 2008 (the survey took place earlier this year) and all evidence suggests things are worse now. Utilities may not cut off service in the winter and some sophisticated consumers might exploit this to pay off other bills first and pay utilities later...when spring comes and termination is threatened. Nevertheless the amount past due is also rising, as well as terminations and write offs, all of which are signs of distress.

The major policy at the federal level is LIHEAP (low income heating energy assistance program). This is about $5 billion block granted and distributed at the local level. This NARUC survey suggest less than 5% of gas consumers, and 2.5% of electric, get any help from this program.

Data from MortgageKeeper.org, which tracks what services mortgage default counselors are referring clients to, suggests as many as half of callers with referrals are looking for utility bill help. As winter sets in the trend is very predictable, especially in the Midwest.

There are only so many consumer dollars available to pay off monthly obligations. Proposals to boost LIHEAP or similar programs may have merit not only to help people in a recession but help prevent more mortgage defaults.

This issue highlights the need to better understand how many consumers manage their budgets. Financial education may help, but for some a pattern of trading off bills and late fees due to delinquencies may be rational and deliberate--but risky. Utility companies have robust data on payment patterns, including the form of payment (for example: money orders or cash = unbanked). Moreover utility company data offers information on consumers at all levels of income. Paying more attention to consumers in this market is likely to yield key proxy indicators of what is going on in the economy overall - yet another canary in the coal mine.

Tough Calls: A Mortgage Bailout

2008-12-08T08:22:00.000-08:00

I spent a very interesting day and a half at the Fed last week at Housing and Mortgage Markets Conference. One idea that seems to be gaining momentum is that the Treasury (or FDIC, or FHA or all of these with the Fed) will start to buy pools of troubled loans with the idea of working out solutions to foreclosure. Now the FDIC has something like this with IndyMac- the FDIC took over this failing lender and is experimenting with modifications at scale. But for loans with interests across lots of private securities in the form or MBS (mortgage backed securities) this will not work. And this FDIC program is not getting strong response from borrowers because there is no principal reduction, and most are 'under water'. The FHA Hope for Homeowners (H4H) offers a solution, but lenders/investors must write down the principal balance and taking that loss is not attractive.

So the solution seems to be some method of buying pools, refinancing the loans into lower rate/lower balance mortgages, and then using FHA HFH insurance on the loans to make the loans something private lenders will hold. The result is the private MBS market comes back to life, borrowers who owe more than their home is worth will feel more secure and maybe ride out the house price drop, and home sales may stabilize. It makes some sense.

Problems? Many.

(1) It will be costly. Sure there is an upside if the government holds loans and performance improves. And with H4H any future appreciation of homes goes back to FHA and the Treasury (the borrower writes a check for 1/2 of any gain in value at sale or refinance). But there will be losses. And taxpayers in low foreclosure areas will be subsidizing those in high foreclosure areas with the aim of stabilizing 'national' credit and housing markets.

(2) Mechanism for purchase. How will Treasury pick which MBS pools to buy? It is unclear if the MBS pools have enough information available to make judgments about which pools will create the most bang for the buck. Since no other buyers in the MBS market have the ability to force mass loan modifications it is hard to imagine how pricing will work.

(3) Dealing with borrowers. How will they be contacted and lead into better loans? If deals are offered to all borrowers and borrowers opt in, some speculative borrowers who do not deserve it will latch on. While others will remain ignorant and miss out. Lots of issues remain here and judgments may end up being made about who deserves help. Further imagine sophisticated H4H borrowers who now see prices on the way up...there will be much gamesmanship in just when to sell or refinance to avoid a stiff appreciation penalty. And clearly borrowers who get their principal balance cut MUST pay some price for that...there is a strong moral hazard problem otherwise.

That said, of all the options on the table, this probably has the most merit. It seems very unlikely bankruptcy courts are a good route (timing, cost, volume, precedent, etc). And doing nothing will be very costly for the economy and credit markets. Foreclosure sales may run as high as 1 million out of the 4-5 million home sales this next year. 1 in 5 or 1 in 4 sales by some measures. Higher in some areas. We know forced sales like foreclosure depress home sales and prices (see this paper). It starts to add up fast.

One other theme I heard last week is that this housing market is actually quite normal. Most of the foreclosure problem is in CA, FL, NV and AZ. These states have been through boom and bust before. And the midwestern 'rust belt' is suffering but for a different reason - lack of jobs. It has been in a long term decline for quite a while. The rest of the country has pretty typical patterns in sales and prices for a recession. But because of the very high levels of consumer debt and the fact that that debt was sold and packaged as MBS and other forms of leveraged securities, and the fact that the housing market is moving at a national scale, unlike in past cycles, this one will be longer and deeper than before. There are signs the market will bottom out in 2009, based mostly in the CA, FL, NV, AZ markets' rapid tumble. But it will be a long flat bottom on the upturn, not a fast V-shaped recovery, mostly because credit markets are stuck but also the recession in jobs and investment will continue.

So, the outlook is not great. Policymakers have some tough calls to make. Doing nothing seems a poor course of action. Buying pools of MBS and boosting H4H (and investing in FHA infrastructure by the way) might just be the best available option if the details can be refined. With each passing week more research is coming out, lenders are reporting on new innovations and experiments and market participants are re-evaluating prices and information. The picture is getting clearer, and whatever happens it won't be cheap.

FHA's Role in the Mortgage Market

2008-11-30T03:25:00.000-08:00

The December 1 2008 issue of Business Week includes a cover article "The Subprime Wolves are Back". The theme of the piece is that former subprime mortgage brokers and mortgage bankers are now pushing FHA mortgage products. The article suggests FHA will create another $100 billion in taxpayer liabilities due to the higher levels of risk FHA is taking on.

It is a good piece and Business Week actually has done quite a bit of pro-consumer journalism on issues of consumer credit. The content and tone of this article raises is worrisome in several respects, however.

Remember FHA was created in the Depression to insure mortgage loans. FHA-approved lenders can make loans on which they can more or less count on FHA approving a mortgage insurance policy. FHA insurance covers most of any losses a lender might take on a foreclosed loan. The lender ends up paying about $3,000 in costs regardless, so it is not 100% insurance, but pretty close. FHA loans are also more costly to make due to added forms and regulatory processes. So this is not a free lunch for lenders.

But FHA will allow smaller downpayments -as low as 3% - and will permit borrowers to receive loans even if they have less than perfect credit. FHA loans will allow a borrower to access credit sooner after bankruptcy (1-3 years) or a past foreclosure (3 years) than prime loans. FHA historically has not been credit score driven but few FHA loans go to borrowers with credit scores below 580. Borrowers pay an insurance premium - both at the close of the loan and as part of the monthly payment.

In the last decade FHA has generated far more in premiums than it paid out in claims. In 2000 the annual FHA 'surplus' was over $16 billion. Of course all of this went right into the Federal budget - like most programs there is no 'lockbox' for future liabilities. In some years the FHA actually paid out a mutual benefit payment to insureds - and there were many proposals to use the FHA surplus to cut premiums (which happened) or to set up a set-aside fund for affordable housing (which did not). Of course the rise of subprime cut into FHA's business. In 2006, before the bubble burst, policymakers were trying to re-invent FHA since its market share plummeted from about 1 in 5 loans to 1 in 20 loans. The current credit crisis has spawned some new FHA products - like Hope for Homeowners (H4H in HUD-speak). This product allows borrowers who owe more than their home is worth to refinance for a smaller loan, if the lender will write off the remainder. Loan volume has been slow, as you might imagine lenders are not eager to write off loan amounts. There's no free lunch here, either, since homebuyers share half of any future home price gains with FHA.

The Business Week article misses a few points in my opinion. First, FHA has always had issues with fraud. The Sopranos even based an episode on FHA fraud. Mortgage brokers continue to be a problem because they act without skin the the game. The FHA insurance is not the problem, although FHA may be slower to move against problematic lenders than private mortgage insurance companies (this is anecdotal - I have not seen evidence on this). The problem continues to be the structure of the brokerage regulatory structure where states have little ability to oversee individual brokers. FHA adds complexity to the transaction and may create a wedge that makes lenders and borrowers feel they can get away with shadier tactics, but FHA is not a problem by itself.

The second issue the article touches on but fails to detail is FHA's own capacity. The new administration will soon nominate a new FHA commissioner. Most of the recent commissioners of the last 2 decades have been very capable administrators who generally were not pure political appointees. This is a big agency and includes a majority of the staff of the entire department of HUD. It deserves a prominent role with other agencies at the table in addressing the credit crisis. And FHA's aging staff and systems need support, training and replacement.

Finally, the tone of this article suggests that low-income and credit blemished borrowers will all end up in foreclosure. Even among the worst books of business in subprime 2 out of 3 borrowers have not defaulted. FHA's standards are higher and as designed FHA really is supposed to be a credit backstop for smaller first mortgage loans for owner occupants trying to on their feet in the housing market. Some borrowers - especially borrowers from minority communities who historically mistrust banks - trust the FHA brand and prefer FHA insured loans. FHA charges a premium and based on audits these premiums should be able to cover any required payouts. Even if they don't and require a year or two of additional federal budget allocations, years of the FHA 'surplus' likely more than offsets any shortfall during this credit crisis.

It's easy to disparage a government program with ongoing liabilities, especially one involving mortgages. FHA single-family mortgage insurance is generally a good program. As the credit market tightens it is plain old mortgage insurance programs are becoming more important. Its more exotic (and temporary) programs like H4H remain small and mostly experimental. Hopefully FHA administrative capacity will be enhanced and the cases of fraud and lenders with a history of problems will be fixed in the near future. .

Health Insurance as a Personal Finance Issue?

2008-11-19T16:54:00.001-08:00

(I don't keep up with law journals but seem to keep commenting on them.)

Christopher T. Robertson, Richard Egelhof, & Michael Hoke have a forthcoming an article "Get Sick, Get Out: The Medical Causes of Home Foreclosures" in the health law journal Health Matrix (issue 18 (2008): pps 65-105). The authors sent me a preview copy and it is intriguing.

They surveyed about 2,000 borrowers in 4 key states- California, Florida, New Jersey and Illinois. They pulled data from foreclosure filings with the goal of finding out what got borrowers into trouble. Only 7% of the valid addresses responded, or about 128 borrowers. Not a large sample and the authors concede there could be some bias introduced by low response rates. They do provide some evidence non-response bias is minimal and in any case I am not sure it casts too much doubt on key findings.

Prior studies suggest health problems are associated with financial problems. Overall, this study finds 7 out of 10 respondents had some medical issue in the last year prior to foreclosure being filed. Only 1 out of 3 borrowers blamed their default on rising mortgage payments (or ARM 'resets') and less than 16% said their loan was always unaffordable. Most were facing a combination of a drop in income and unexpected expenses. And most had equity in their home--the "underwater" mortgage story is not what they found even in CA & FL. Only 15% reported being upside down on their mortgage.

46% reported an injury or illness in their household as causing the default. 27% were prevented from working at all due to this and 23% cited high medical bills. Most (more than 2/3rds) had medical insurance, but uncovered costs ran $5,000 on average. Medical expenses eat up modest savings accounts in a hurry. For borrowers who cited medical bills as a cause of default, the average bill was $15,000. More than 1 in 4 used home equity to try to pay off medical debt.

The paper suggests a number of policy options, including staying foreclosure for medical emergencies (not unlike what was attempted post-Hurricane Katrina in certain areas - not related to health issues). It also highlights emergency 'bridge' grants or loans like those provided in some states, HEMAP in Pennsylvania being a leading example. It also suggests health care and consumer health care coverage may be a risk factor lenders and policymakers might need to take more seriously when considering mortgage markets and special mortgage programs for high-risk consumers.

The authors might be able to use some econometric techniques to produce more robust findings, especially related to non-responses. But overall it is a solid effort and suggests more inquiry into this issue is warranted.

Mortgage Disclosures, Another Round

2008-11-14T19:18:00.000-08:00

HUD has announced a new RESPA (real estate settlement procedures act) regulation. RESPA reforms have been discussed for decades. HUD proposed various reforms to RESPA in the last 8 years each time beaten back by trade groups, other policy priorities or just plain old poor execution. The current change intends to strengthen the Good Faith Estimate (GFE) provided to mortgage loan applicants at or near the time of the first application for a loan. And then to beef up disclosures provided at the closing table. It initially even included a proposal to actually read a script to would-be borrowers about the terms of the loan.

Disclosure can work...if a policy goal is to have borrowers re-think their loan options and shop around or even exit the market. In theory more shopping around results in borrowers finding lower cost options and being better informed. Of course it might also just take up time and energy and gain the borrower little in lowered costs for their efforts. It is hard to say what the 'optimal' amount of shopping should be, although lots of pundits seem to like to make these assumptions lately.

The GFE has long been a problem. Lenders claim that it may be weeks or months from application to closing. It is impossible to say for sure what the interest rate and terms will be for a loan in the future. There is some validity to this. HUD now says the GFE must be within 10% of actual. That is probably a good step, but the GFE is vague and still probably not ideal for comparison shopping. Nor does is suggest/promote shopping. And the consumer really has no way to judge the relative cost of the loan offer compared to what else may be out there.

At the closing table the new RESPA rule requires 3 pages of disclosures about loan terms, prepayment and other penalties, and other conditions. There are several problems with disclosures at the loan closing. First, at this point the borrower has invested time and energy in the deal and basically just wants to sign the loan. Walking away is costly (in terms of opportunity costs at least). Second, there are a number of forms, contracts and disclosures required at closing, especially if the loan closing is simultaneous with a home purchase. Whether the form is written or read aloud, it probably would not have much effect on behavior.

It is interesting to note that the Federal Reserve also has disclosure authority under the Truth in Lending Act (TILA) as well as HOEPA (Home Owner Equity Protection Act). Apparently HUD and the Fed have been working separately on changes to TILA and RESPA changes. HOEPA only applies to high cost loans. My own research on aspects of HOEPA loans suggests a warning " YOU MAY LOSE YOUR HOME" provided at least 3 days before the closing, can be an effective mechanism if a goal is to encourage borrowers to walk away from a loan offer.

The problem borrowers have is judging what is a good deal. For a borrower with perfect credit, scanning the web or a local paper may provide a sense of the best APR available and then look for no fees or points (or the lowest). But what if you don't know if you have good credit? What if you know you have a 600 credit score? It is less clear what the going rate might be. Attempts to standardize pricing have been sporadic at best. One innovative experiment is MortgageGrader.com which offers the equivalent of a blue book guide for mortgages. Perhaps more lenders will follow this model as mortgage lenders consolidate and become more cautious about lending and fear being accused of taking advantage of confused borrowers.

So where does this leave HUD's RESPA reform? It is the right direction, for sure, but short of what consumers would ideally have in a legally mandated disclosure. At the very least the APR, fees and terms of the loan should be provided 3-5 business days before the closing and require a signature from the borrower acknowledging receipt and understanding. The disclosure might also make clear the borrower should shop around for the best terms and conditions, and ideally even suggest sources of information on current interest rates, such as a government website with current rates by credit score (which does not yet exist). Some time of warning about the risks of a loan, including foreclosure, also should be explicit. I suspect some new formats of disclosure may emerge too, such as web-based or video-based information.

The Fed and HUD, and maybe FTC as well, are likely to keep trying to make consumer disclosures better in the next year. There is not a great deal of research in this arena - at least not recent research. Let's hope policymakers are able to come up with sensible solutions in any case.

State Foreclosure Laws and Default Counseling

2008-11-02T20:14:00.000-08:00

With rising levels of home mortgage foreclosure filings, policymakers are increasingly exploring how public programs and processes can be designed to prevent families from losing their homes.

In a recent paper with Chris Herbert and Ken Lam of Abt Associates, we explore the extent to which consumers may benefit from three types of state foreclosure polices: (1) judicial foreclosure proceedings, (2) rights of redemption, and (3) statewide foreclosure prevention initiatives. We also test how voluntary efforts of lenders to promote third party default counseling may also benefit consumers, as well as how these efforts may be more powerful in states with each state policy.

We used data on 32,000 borrowers in default from one national lender during the 15 month period of January 2007 through March 2008.

In general judicial proceedings, rights of redemption and state foreclosure interventions have little effect on the cure rate or foreclosure avoidance in the period we examined. Although we found weak effects of state policies in general, the direction was inconclusive. Loans in states with judicial proceedings may benefit consumers by allowing more opportunities for borrower-lender contact, but may also be associated with worsening loan outcomes such as foreclosure filings. No state policy was associated with either an increase or a decrease in borrowers losing their homes to foreclosure.

Lender voluntary offers of telephone-based default counseling are associated with about a 12% reduction in days delinquent. This is a promising finding suggesting promoting consumers to call a hotline might actually help consumers (we created a control group using a group of borrowers not offered counseling --so technically we can report on the offer of counseling not the actual receipt of it).

The more interesting finding is that when offers of counseling are implemented in states with foreclosure prevention policies or programs, borrower-lender contact rates are about 12% higher and rates of foreclosure filings 30% lower than when implemented in states without such policies.

The implications of these findings suggest state policy efforts at preventing foreclosure may be enhanced by coordination with financial institutions and counseling providers. So states with high foreclosure rates which offer media campaigns, refinance pools, grants and other initiatives combined with lender offers of default counseling may prove most successful.

The paper will be presented at a couple of conferences in the coming weeks, and likely improved with the comments of discussants. In the meantime a draft version is online.

Foreclosures and Consumer Perceptions

2008-11-02T19:50:00.000-08:00

In March 328 owners and renters in greater Chicago answered a set of questions about their willingness to invest in housing. In August 349 renters in greater San Francisco did the same. For each respondent we collected a zip code, allowing a matching of the 'neighborhood' foreclosure rate to the respondent. The result? No surprise, foreclosures weaken consumers' enthusiasm for buying or maintaining a home.

We asked "How many people who buy a home this year will lose it in a foreclosure?". The mean answer was between 35 and 38 in both cities--quite a bit higher than reality (the most pessimistic estimate is 20/100 could lose their home). In both areas each percentage point increase in foreclosure rates (say from 2% to 3%) results in consumers perceiving about a 6/100 increase in the risk of foreclosure. This is controlling for age, income, race, language and other factors. It also includes fixed effects to account for any unobserved characteristics of the zip code.

Among owners in Chicago (owners were not included in the San Fran sample), an increase in foreclosure rates was associated with a 5% decrease in willingness to invest in a $5,000 home repair or improvement. In San Francisco each percentage point boost in foreclosure rates was associated with a 10% drop in agreement with the idea that owning a home is better than renting in general. Renters also show about an 8% reduction in willingness to buy a home in 6 or 12 months for each point rise in foreclosure rates (although not in 36 months).

The general finding is that owners in high foreclosure areas, even controlling for the other factors you might expect to influence opinions, are report a lower level of willingness to maintain their homes. Meanwhile renters in higher foreclosure areas have a reduced willingness to buy a home at least in the short (under 2 years) run. This has the potential to create a negative feedback loop where high foreclosure areas have lower levels of investment in housing, which undermine home values and could result in more foreclosures on the margin.

The current policy debates about rescuing lenders versus borrowers, and the allocation of subsidies to buy/renovate/demolish foreclosed properties should heed these results. Foreclosures do not happen in isolation and the ripple effects of an additional foreclosure on a neighborhood should not be underestimated.

Foreclosure Patterns

2008-10-30T15:38:00.000-07:00

Below is a map of foreclosure patterns per household. The extent of the problem is clear in places in red -like FL and CA.

Why does this matter if you are not being foreclosed on? Because it shakes confidence in the entire housing market. Surveys I ran in CA and IL show that neighborhoods with higher foreclosure rates have scared consumers. Even controlling for income, education, race and other factors, including neighborhood factors, renters in high foreclosure areas are more cautions about buying a home and see the risk of foreclosure as being higher. Homeowners are less likely to take on a home improvement or repair. The collateral damage can be significant.

I will post more on this issue in the coming days, but this map (pulled from foreclosurepulse.com) tells quite a story...

Subprime Myths

2008-10-05T18:30:00.000-07:00

The consumer implications of the current mortgage crisis offer rich material for commentary. Nevertheless I feel compelled to comment first on some of the 'facts' that are often thrown about this ‘subprime mortgage crisis.’

1) The problem is too many poor people became first-time homeowners. And 'poor' means lower-income and minority families. It is true homeownership rates hit record highs in the last decade. It is also true much of the growth in ownership came from younger households - Gen Y and Gen X. Much of what happened was pure demographics, however. Demographers in the 90s predicted a boom in homebuying even before it started. Gen X has a tendency to do things later (get education, settle down, have a family, etc) and Gen Y to do things faster. Right there you have the makings of a boom (plus Gen Y is quite large a birth cohort). These groups also tend to be lower-income by virtue of being younger and have a larger percentage of non-white members with higher birth rates than average. The result: more minority homebuyers. The market catered to these buyers with low-downpayment loans. Then, as house prices shot up, offered multiple varieties of home equity loans to provide extra cash to these households to make consumer purchases or pay off credit cards. When house prices dropped, these same households lack the deeper pockets of older age cohorts and also greater job instability. It is true these households entering the market put upward pressure on house prices at the entry level and this cascaded on up the housing value pyramid. But these buyers are not speculators nor more risky in terms of non-payment of loans.

2) Government policies like the Community Reinvestment Act (CRA) caused the speculative bubble and created subprime loans. This one seems to be getting a lot of play. Let's be clear about what CRA is. It was created in the 1970s because banks took deposits from large groups of people who they would never make loans to. And from areas where they would not make loans ('redlining' certain areas as unqualified for a loan). CRA is all-in-all a pretty weak provision. A lot of bankers and economists hate CRA because it forces banks to make certain loans. But in reality a poor CRA rating creates a slight case of bad PR and may slow down a bank's ability to take over another bank, or be taken over, but that's about all. Importantly, CRA is only applied to depositories. Nearly all subprime lenders were not depositories, but went right to capital markets. So the growth of subprime was all OUTSIDE of the scope of CRA. One could argue that because banks largely ignored borrowers with poor credit, subprime filled that vacuum. Had CRA encouraged more innovations, more careful loans by CRA-covered banks might have been offered and made to those borrowers who ended up in subprime loans.

3) Fannie Mae and Freddie Mac fueled the subprime market into excess. This is another popular line in the OpEd pages. Fannie and Freddie (the GSEs) are huge political targets. Republicans have always argued against their public-private structure, while Democrats benefited from the GSE’s largess. The GSEs are complicated and there is logic to their existence, but their implicit guarantee structure was clearly flawed. These entities were established to create a mortgage market, but within a set of guidelines. GSEs buy whole loans from banks and then split out the cash flow to investors who buy into a security (MBS). GSE guidelines focused on 80% loan to value ratio loans- so borrowers had a fat downpayment or mortgage insurance. And GSEs also had high credit standards. So they did not make subprime loans. One of the flaws of the GSE model is they could borrow at very low rates - close to Treasury rates - and then lend at higher rates. So the GSEs would not just buy and package loans, they would also buy their own securities as well as other MBS on the market. By law they could not take on much risk - so they bought the AAA-rated top level tranches. This meant they got paid first even if there were more defaults in the pool of loans underlying the MBS than expected. Lots of investors bought these top-tiers of MBS on subprime loans - insurance companies, pension funds and foreign governments. In general these top tiers of these MBS issues are still paying as expected...an often overlooked fact. But the value of these securities has plummeted since no investor wants them. Much like the homebuyer who owes more on their home than it can be sold in the market, the GSEs were sitting on investments worth far less than their book value. The whole mortgage market was around $12 billion. Subprime about $1 billion. The GSEs were about involved in abut 20% of the overall mortgage market and bought the AAA pieces of between 25% and 40% of all subprime MBS. So they did provide capital to the subprime market, and at a higher rate than they provided to the overall market (this varies by year however). Between the I-Banks, commercial banks and sovereign funds, subprime MBS would have grown during the housing bubble, even without the GSEs. The GSEs fueled the fire, but hardly caused subprime lenders to take on more risks...remember someone else bought the riskier lower-tranches of MBS for the GSEs to buy the top rated tranches.

4) The Clinton/Bush Administration pushed too many people into buying homes. Nearly every president since Hoover has promoted homeownership. It is the 'American Dream' after all. Clinton and Bush had homeownership goals, but these goals were very close to what demographers predicted would happen anyway. On net these programs amounted to some homebuyer education (averaging $30-50 million per year, which is not much at a national scale) and some special programs serving a few thousand families annually. All of this was more PR than substance. And amounted to little especially relative to the massive $60-80 billion in tax breaks offered to homeowners annually.

Foreclosures today are mostly (a) people who have refinanced and taken out cash (b) people who bought at the peak of the housing bubble (c) speculators--mostly in California, Florida, Arizona and Nevada. In all cases they are in troubled because we had a housing bubble and they owe more than their home is worth. My guess from data I have from one major lender is true speculators, meaning people buying property to rent or flip, account for less than 10% of foreclosures. Peak bubble buyers who took out purchase loans worth more than the house was ever worth are less than a quarter. The remainder are people who used their equity to pay off other debt and now owe more than the house is worth. Think of the mortgage like the coral reef - it collects the toxins in household consumption behavior. All the credit card and other debt winds up there.

So who's fault is the current mess? Lenders offered easy credit, thanks in part to over-reliance on technology for underwriting loans. Wall Street thought MBS carried little risk and plowed cheap money into the market. The GSEs were certainly sloppy in their management and accounting for the risk and value of investments in MBS. But at the street, mortgage brokers, real estate agents, appraisers and buyers and sellers all bought into the notion that house prices could only go up and never would go down everywhere at once. They were wrong. Prices are likely to go down 25-30% from their peak, if not more. Even classic 20% downpayment loans are in trouble. This is not just a subprime problem anymore.

The Subprime Solution

2008-09-24T20:35:00.000-07:00

I just picked up Robert Shiller's Subprime Solution. It is a quick read and I highly recommend it. Despite its title, I am not sure the book presents a perfect prescription for policymakers today. Shiller obviously wrote the book before the fatal issues with the GSE's, AIG and I-banks emerged. His main proposal is to re-establish the Home Owner's Loan Corporation to buy up distressed assets...an idea that has been tossed around for at least a year. But there is a lot to like about this book.

First, Shiller provides a nice background on the run up in house prices. In general research has been focused on asset bubbles for quite some time. He wrote Irrational Exuberance on the tech stock bubble (also a recommended read). Subprime Solution echoes many of the ideas of that book - that markets and economists tend to forget that psychology matters. People get caught up in a frenzy and start to believe prices can only go up (or if prices go down, it won't happen all at once or as much as what can and does happen). It is a compelling and easy to read description of the evidence. Too often we read the popular press blame the foreclosure crisis on the Fed keeping interest rates low, or, my personal favorite, Community Reinvestment Act lending (never mind almost all subprime lenders were not covered by CRA). He offers a simple explanation of a speculative bubble that fueled homeowners, bankers, Wall Street, ratings agencies and even policymakers. I think this is mostly right and not well understood.

Second, Shiller offers a wide ranging set of longer-term priorities. While this section reads as a bit of a grab bag, there are some great nuggets here. What I am most struck by is his emphasis on consumers. He discusses improvements to the 'information infrastructure' which will help prevent future problems. Number one is "comprehensive financial advice," especially for lower-income consumers. This might include subsidized fee-only financial planning (an idea EARN is working on in San Francisco, along with a handful of other nonprofits in other areas) or even new technologies. He also talks about using learnings from behavioral finance, such as relying more on default options in mortgage product promotion, and continuously adjustable mortgage contracts which in effect modify themselves as housing or economic conditions change over time. He also provides a critique of too low FDIC and SPIC deposit insurance coverage. All in all a nice collection of ideas.

Shiller concludes by plugging ideas he has worked on for a decade or more, including home equity insurance (he even notes his experiment in Syracuse NY run with Neighborhood Reinvestment Corporation) and options markets consumers can use to hedge drops in real estate prices.

Shiller's general theme in Subprime Solution is the Great Depression spurred the creation of bold social experiments - many of which still exist and play a vital role in the economy - like FHA and FDIC deposit insurance. He thinks today's crisis should result in a similar response. Time will tell if he is correct, but kudos for writing such a timely and accessible summary of policy options today, and for keeping consumer behavior at the center of the debate.

A New Structure for Financial Insitutions, and Regulators?

2008-09-22T07:39:00.000-07:00

Today we hear news many old line investment banks are reorganizing as commercial banks or bank holding companies. No long ago (like a year) commercial banks were considered too old school for modern capital markets. Now being regulated as a bank means ready access to the historically little-used Federal Reserve's cash drawer. Given the sense among investors that investment banks lack liquidity or ready access to capital, just having the option to tap the Fed's money may be viewed as a plus.

This just highlights our fractured regulatory system. In 1999 decades old restrictions on blending banking, insurance and investing functions were repealed. Yet the regulatory system remained a mix of mortgage lending compliance, capital ratios for depositories, lighter oversight of some holding companies and then the SEC for Wall Street. It seems the market might actually appreciate one set of rules which serve to reduce overall financial institution risk taking and also make information more transparent across firms. Commonly applied asset ratios means the former investment bank will need to have more cash and liquid assets and will not longer be able to place huge bets by borrowing or swapping liabilities.

During the S&L crisis of the 1980s (which rolled into the 1990s) there were some changes in the structure and functions of the bank regulators --to review this includes: the OTS (part of Treasury focused on thrifts or S&Ls), OCC ('national' banks), FDIC (state chartered but also broader functions related to deposit insurance), the Fed or 'FRB' (holding companies and commercial banks), HUD (a grab bag of institions doing mortgage lending including many former subprime institutions) and NCUA (credit unions).

In the last year the Federal Reserve has been clarified as the super-regulator. In general the regulatory agencies seem to be getting along (except maybe the SEC ). But as policymakers mull their chocies this week it is time to re-examine a more modern system of regulation with one agency outside of the executive branch to work with Treasury as needed.

In the process the community/public/consumer affairs function hopefully can be strenthened. Likewise the commitment to fair lending and community reinvestment can be affirmed. The UK's Financial Services Authority used to be a model to look towards, but the breakdown related to Northern Rock last year might suggest even the FSA model did not go far enough (the FSA lacked the Fed's market mechanism--that stayed with central bank).

In the 1990s financial instututions would shop around altering their charter or aquisitions to find a regulatory agency they felt best met their needs. In hindsight a standardize higher regulatory bar would have been a better approach. One could imagine the FDIC as the insurance agency, as well as expert in taking over failing banks. The FDIC could assess safety and soundness risk and be ready to jump in when firm-level instability looked immenient. The Fed could then take the OCC, OTS and NCUA under its wing, taking on safety and soundness as well as consumer affairs and fair lending.

Most likely there will be resistence to changes and agencies won't willingly give up power. With mega-bank instutitions like Bank of America, Citi, JPMorgan/Chase, and now Goldman and Morgan Stanley under the Fed's purview, the odds are more in favor of the Fed being the achitect of the regulatory structure going forward. Regardless, let's hope the new structure includes a robust consumer perspective in addition to making investors feel more secure about putting money into institutions.

Fannie and Freddie: Implications for Consumer Policy?

2008-09-14T11:54:00.000-07:00

The news from Wall Street just keeps coming. I have been drafting thoughts on current events and then constantly revising them as more information comes out. It looks like AIG will have access to an infusion of public capital, but at a cost to shareholders and management, much like Fannie Mae and Freddie Mac. But the issues are very different.

Fannie and Freddie - the government sponsored enterprises (GSEs) - were created as a public-private enterprises. They have historically played a key role in buying whole mortgages from banks, allowing banks to make more mortgage loans. This secondary market function was an innovation and has helped the banking system overall.

The public part of the GSE mission has been widely debated for years. Investors always believed there was an implicit government backing for Fannie and Freddie. Investors behaved like GSE securities were 'almost' like Treasury securities. This gave the GSEs access to lower cost capital and ultimately allowed for lower interest rates on mortgages. How much lower? There have been several studies. The most objective study (arguably) is from the Fed (in the Alan Greenspan era) and suggests about 25 basis points lower interest rates on conforming mortgages. That is one-quarter of 1 percentage point of interest. Not that much for a consumer to notice, really, but it is something from the view of capital markets.

The other function of the GSEs that is less discussed is as a 'backstop' in the capital markets for mortgages available to the middle class. A few years ago many argued banks had direct access to Wall Street and the GSE function was outdated. But as we have just seen, investor capital moves globally in seconds. As confidence in mortgages and financial institutions weakens, investors pull out rapidly. For some lenders there would be no more capital to make another mortgage loan without access to a stablized secondary market. A consumer who is in need of cash to pay for an unexpected expense might not be able to take out a home equity loan. Someone moving might not be able to sell their home because no cash buyers exist. It gets ugly fast.

There has been widespread criticism of how the GSEs have been treated. This summer's announcement that Treasury has the power to take over the GSEs, but no one at Treasury thought they would need to use it had a destabilizing effect. Investors were not comfortable with being in limbo- "maybe the government will take over and maybe that means shareholders are wiped out." In a market with extremely low tolerance for uncertainty, investors ran from Fannie and Freddie. As these firms had losses on the lending side they needed capital, but no investor was willing to go there. In the end Treasury had no choice. Fannie and Freddie shares still exist, but are worth just pennies.

So now what? With all the news about Lehman and AIG, we have not heard much on Fannie and Freddie the last few days. Key staff are heading for the exits, and that is troubling. But the GSE market function is still working. Mortgage rates are somewhat stable. Local lenders can still operate.

How will the GSEs look in the future? We don't know how Treasury will proceed. The clean-up alone will take a while. One view is to spilt them up into 5-6 smaller secondary market firms to buy loans. The Federal Home Loan Banks played a bit of this game a few years back. It is not clear more smaller firms helps overall, and there will always be returns to scale such that consolidation could make economic sense. Firms could specialize by type of loan or region, but that presents problems in terms of concentrated risk.

Regardless of the institutional structure, the public-private GSE structure needs review. The government guarantee needs to be priced and made into legal contracts. The affordable housing function of the GSEs should continue at least as long as the GSEs have some federal support and probably longer. If banks are required to make lending balance deposits under the Community Reinvestment Act, then there must be a vibrant secondary market to support this function. It is hard to imagine a completely private mortgage secondary market. In fact the 3rd GSE - Ginnie Mae - is essentially a department of HUD and facilitates the secondary market for mortgages insured by FHA/VA mortgage insurance. This is going to be complex to sort out.

Unfortunatelty election year politics are caught up in all of this. Most policymakers don't have a full understanding of the issues involved. Career staff at Treasury and HUD, as well as the Fed, will have their hands full for quite some time. Consumer advocates need to be as well informed as possible and make sure lending markets are stable and capital keeps flowing especially for the market segments least well served by the financial market--working families in older urban areas and rural markets--as well as immigrants and minorities with no connections to the financial sector. These consumers are going to continue to be first-time homebuyers, especially as home prices come back down to more affordable levels.

A recent survey I helped run in California and Illinois shows moderate income renters are as interested in buying a home as ever. They see prices coming down and want to own a home. But they also see the risks, and want to be well-educated how to buy a home and find a mortgage loan (in fact they tend to substantially over-estimate the risks of foreclosure--we'll save that for another post). The majority have doubts any lender will offer them a loan. Reading the current press and watching the media, no wonder.

Financial Literacy is a Failure?

2008-08-29T11:09:00.000-07:00

In recent weeks the writings of law professor Lauren Willis have become much more widely distributed, in part thanks to a short piece in Money magazine. (see: http://money.cnn.com/2008/08/25/pf/teaching_money.moneymag/index.htm)

Professor Willis has at least 2 law review articles suggesting in essence that the financial market is too complex for the average consumer and only prescriptive legislation regulating consumer financial products will prevent consumers from taking on higher risk or cost products than necessary.

One 2006 Maryland Law Review article is titled: Against Financial Literacy Education. Those who toil on consumer education topics might find the titles alone a little alarming. The articles are worth a read and certainly are serving to provoke discussion.

A few points are worth remembering.

First, regulation and education are complements, not substitutes. Policymakers can, and in fact do, regulate the terms of some products while also supporting consumer education.

Second, from a legal scholar's point of view regulation provides an absolute and highly standardized way to present a solution to a social problem. Economists tend to a bit more skeptical--if there is consumer demand the market will develop a work around almost before the ink is dry on a new law. The markets evolve so fast product regulation is more like a game of whack-a-mole.

Third, Professor Willis is correct much of the data on financial education and disclosure shows non-significant effects, and when findings are significant, plagued by selection bias--that is the consumers most likely to get information are the most motivated and successful even in the absence of education or disclosure. But this points more to failures in research methods and design than in public policy. As a society we do seem to believe education has value; there is not reason to think education only works in certain domains. Moreover, some research is carefully done and shows financial literacy education and disclosures are effective at statistically significant levels. There is not enough research in the field (so says the researcher) on financial education and disclosures, and far too little research on how to deliver information to consumers or when the ideal times to do so might be.

Consumer decisions in financial markets are more complicated than in the past: for example defined pensions are now more likely to be consumer-directed retirement accounts and fixed rate mortgages now come in multiple adjustable rate flavors. Consumers have the capacity to navigate this marketplace without resorting to high cost advisers. Before throwing out the concept of consumer education maybe policymakers need to take a fresh look at what is being attempted and how it can be improved.

Back to school

2008-08-28T07:07:00.001-07:00

The thousands of new college students descending on campuses nationally are a keen reminder of how consumers can quickly become mired in credit card debt. College freshman are the target of credit card marketers for several reasons. This is a key time when consumer sign up for cards--many for their first card. Students are also typically cash strapped, thus likely to run a balance and pay interest.

College campuses have a range of policies--some actively work with companies and gain revenue from the marketing of credit cards. Others restrict access to campus property or regulate if card offers are tied to gifts or incentives.

For many students a credit card is a useful tool. Students tend to have expenses related to getting set up to learn (computer books etc) and as such going into debt to invest in future educational gains might make sense. Late night pizzas...not so much. Surveys sponsored by student lender Nellie Mae show more than 3 out of 4 undergraduates have at least one card. Those with cards on average owe more than $2,150. Most get their card their freshman year and many accumulate more than one card.

My own research shows few students look at mandated card disclosures unless directed. They are easily misled to think the introductory teaser APR is the actual APR. Almost none will look at details such as a default rate which might be three times the normal APR if the student defaults on any loan of any kind.

Thankfully most student credit cards have low balance limits. Some students may need these kinds of offers--and to make a few mistakes--to learn some hard financial lessons.

Campuses that limit offers to certain areas might be on the right path. Certainly students seeking a card can find one, but impulse applications at the bookstore might not be as prudent. Limiting free T-shirts, iPods or other features makes sense too--these may become a distraction from the actual terms and conditions of the card.

But most of all students need to learn, after all, and there is more most campuses can do. Simple brochures and email messages are a good start, as are workshops or seminars on financial topics. One small survey I conducted with undergraduates at Cornell University, where many students came from affluent backgrounds, showed more than two-thirds of students would attend a workshop on credit and financial management if it was offered at a convenient time and place.

Parents, or course, play a key role. My surveys show 87% of undergraduates say they learned about financial management from their parents. The number two source: the internet, at 40%. About one-third of the students I surveyed expect their parents to pay their bills for them and another third pay their own bills but have asked their parents for help in the past.

Parents with college students might consider having a regular conversation about credit card debt and budgeting with their kids. When they apply for a card ask questions about the APR and ask them what they think that means. Ask them to tell you about other fees--such as for using the card at an ATM to get a cash advance. All this will focus attention on costly features and details. And let them know your expectations about their spending. Even if you are willing to bail them out in an emergency, be sure they understand you are not a co-signer and the card is their responsibility. Since the majority of students use credit cards for convenience a low balance should be just fine for most students (often $500-1,000, or the cost of an unexpected plane ticket or emergency car repair). Beware that the card issuer may offer increased balance limits over time. Parents can discourage students from taking larger limits and make sure the student knows a larger limit just means larger bills.

With the proper tools, information and support, most students will do just fine with their first foray into the credit market. But parents and university administrators need to pay attention too.

Highlights of Student Credit Card Survey
Cornell University, Spring 2008 (n=182)

Use of Disclosures:

40% incorrectly identified the APR as the 'teaser' balance transfer rate
32% incorrectly identified APR as not changing or varying
40% incorrectly identified late payment fees
33% did not understand 'default rate' changes with late payments on other credit cards

Use of Cards:

55% used cards for convenience and always paid off the balance
15% carried a balance of $1,000 or more
20% paid a late payment fee in last 12 months
35% report using their card more when they feel stressed
75% report it is "very easy" or "easy" to get a credit card
10% reported ever being denied for a credit card
25% report getting credit card offers in the mail at least weekly
Most popular marketing features: rewards or bonuses for making charges
Least popular marketing features: free t-shirts or discounts for signing up

Attitudes:

69% report being "very likely" or "likely" to attend a seminar on personal financial management offered on campus at a convenient time
36% report "next to my student loan my credit card debt is nothing"

New Forms of Credit Disclosures?

2008-08-23T07:42:00.000-07:00

Economist Richard Thaler and law professor Cass Sunstein ran an article in the Wall Street Journal suggesting policy makers re-look at consumer disclosures for credit products (and even cell phones). The authors mostly promoted themes from their new book "Nudge: Improving Decisions about Health, Wealth and Happiness." But in general they have a good point -- too often disclosures and consumer information strategies are dismissed. Would better disclosures have avoided the current subprime mortgage default problem? Surely not. But at least at the margin some consumers would have had more information.

I have some research in process showing that states requiring a signed "YOU MAY LOSE YOUR HOME" statement on disclosure forms for very high cost loans reduces the probability a consumer will go through with a loan offer from a lender. The effect is not large, but not zero either.

Thaler and Sunstein wrote "the Fed can substantially improve its proposal by requiring credit issuers to disclose relevant information electronically in a standardized, machine-readable format. In one simple stroke, new disclosure requirements would dramatically improve the current situation."

The key to their solution is that 3rd party providers will create a market to supply consumers with easy to read reports and recommended actions--much like investment tracking firms like Morningstar do in the mutual fund market.

They argue "electronic disclosure will merely supplement the current written disclosure requirements...the electronic disclosure we are advocating would make it much easier for nonprofit groups to help the poor make better choices because they could have all the information they need right on a computer."

Would it work? It is hard to say for certain, but at least this suggests technology can enhance paper and pen information disclosures. Before deciding consumer disclosures are a failure, policy makers ought to explore how disclosures--many of which are regulated by a hodgepodge of agencies and using forms dating back to the 70s--can be modernized and refined to better impact consumer behavior.

I agree with Thaler and Sunstein when they wrote"Some politicians have clamored for banning some types of mortgages, especially in the subprime market, but low-income or high-risk borrowers are often the ones that can particularly benefit from financial innovation." Product bans such as they fear are probably unlikely to happen, and in fact the private market has shut down most risky lending on its own. It seems likely these products will return, however. It may take a few years but $1000 downpayments, low credit scores and high debt to income ratios will be common again in the mortgage market before long. In the meantime, exploring better ways to communicate the terms, costs and risks of products to consumers should be a high priority. The Federal Reserve Board and FTC have some research efforts under way on the wording of disclosures, but more testing of innovations such as Thaler and Sunstein discuss has merit.

See the full op-ed at:

http://online.wsj.com/services/article/S B121858695060335079-search.html

Welcome

2008-08-15T06:51:00.001-07:00

I am new to blogging but decided with all of the current events in consumer finance policy I should take a crack at posting interesting research, policy debates, articles and other information as it comes up. Thanks for looking!