Preventing the Next Mortgage Crisis

They say that prevention is the best medicine. In keeping with that theme, and my earlier article on solutions to the current problem, here are some ideas on how to prevent another mortgage crisis from occurring in the future.

1. Part of the problem we’re facing now is that many exotic mortgages were originated at levels where the borrower could only afford the teaser payment; if banks are going to continue to originate such mortgages the need to modify their lending standards appropriately. Exotic Mortgages should be originated at a level where the person can afford to pay the reset payment using no more than 28% of their grossly monthly income, perhaps as high as 35% for high-income borrowers with very high credit ratings.
2. Part of the documentation for any mortgage should note the reset payment +/- 200 basis points in order to indicate the impact of rate cuts and increases, borrowers should be required to sign a document indicating that they’re aware of what their reset payment will be.
3. Back to common sense lending standards: a requirement of down payments for all buyers outside of those with very high incomes and high credit cards, and setting a mortgage payment limit of 28-31% of one’s gross monthly income.
4. Stronger documentation around the 30-yr cost of the home, i.e. based on my experiences lenders don’t really make you aware of the fact that you’re not spending $300k for a home, you’re spending $300k in principle and nearly $300k in interest (even with the tax deduction).
5. Stronger documentation and required signed disclosures if a borrower elects to use a high-cost/subprime mortgage to buy their home, especially with respect to how the high interest rate often eviscerates any benefits from appreciation. Granted this will probably discourage many from buying homes with subprime loans, but it’s not a stretch to say that no one should use a subprime loan unless they can refinance to prime in a relatively short period of time.
6. There needs to be greater investments around homeowner financial education so that they have a better understanding of what they’re getting into. For instance the average person buys a home for X sells it for say 1.25x and counts the 0.25x as their profit, in truth they should be subtracting their interest expense from the 0.25x and adjusting it for their pre-ownership rental costs. It’s a relatively simple calculation yet few homeowners are aware of it, providing this sort of education to people would result in potential homeowners who are much less likely to make bad decisions.
7. Borrowers shouldn’t be blindly told to just buy a house for the taxation advantages; instead lenders should provide documentation with an estimate of how much of an advantage they’re to receive. Considering how much information a mortgage lender collects, it shouldn’t be too difficult to provide this estimate. Borrowers should be aware that in many cases the standard deduction nullifies over 80-90% if not all of any tax advantage they would receive from buying.

I’m sure the banking industry (and the NAR) would balk at many of these requirements claiming they would stifle homeownership and appreciation; however I would argue that our society shouldn’t artificially inflate a market by encouraging people above their means on their homes. More importantly home owners should seek to follow the guidelines above as they will keep them financially safe and in their homes, which should be their primary objective. Lenders and realtors may not like my ideas but at the end of the day, no one is going to go into foreclosure by making a conservative home purchase decision.

Comments

[ValuationGuy]

you made some excellent points but one additional suggestion needs to be an over-haul of the appraisal practice; for too long lenders have pressured appraisers into making the number - we need a true independent system for collateral valuations. While the recent announcements by OFHEO are a good starting point, my concern is that appraisal management companies work not with local and experienced appraisers but rather the lowest cost provider. A mortgage is based on the borrowers ability to repay the debt and the value of the underlying collateral - the use of Automated Valuation Models and the reliance on those appraisers who are willing to make the lenders required value appear legitimate has played a big part in this crisis and needs to be addressed.