A Solution to the Mortgage Foreclosure Mess

The current mortgage foreclosure mess has the Adjustable Mortgage and Negative Amortization Loan as one of its primary culprits. An adjustable mortgage loan comes with a preliminary set of payments that revise, generally upwards, based on the current value of some widely recognized interest rate like Prime or Libor. In the face of falling housing prices (many times driving the value of the home below the principal balance) and rising mortgage payments, many homeowners are defaulting on their mortgage loans.

These defaults set off a chain reaction that cascades upward into the Mortgage Backed Security market and on to the balance sheets of some of the U.S.'s largest financial institutions. There are many causes for the foreclosures, but borrowers not understanding what they were getting into accounts for a major percentage of the foreclosures. The current crisis is well underway, but I want to propose a contractual improvement that could keep the Adjustable Mortgage Loan from being such a big problem in the future.

If the best finance minds in the country sat in on the average meeting between a mortgage broker and a prospective borrower, they would have a very difficult time advising the borrower on the probability that their mortgage payments (measured by some future interest rate) will be significantly higher or lower in the years to come. If these finance experts have difficulty with the rate issue, what is the chance that a hairdresser, an electrician, or a computer programmer (representative borrowers) will come to the correct conclusion on whether their personal finances can absorb the future payments implied by an interest rate, when even organizations with billions of dollars of finance professionals and computers can't predict that rate well. Some would say that an Adjustable Mortgage Loan contract is not a contract at all because the borrower has no real certainty of what their future payments will be, and hence can't commit to their future responsibilities.

The reader of this article may know how to compute the IRR implied by a mortgage loan and its payments, or know that the nominal interest rate is the sum of the real interest rate plus inflation, but for the average borrower, the mortgage decision comes down to a borrowed amount, the payments with some awareness of whether the loan is fixed or adjustable, and a rough understanding of the APR (Annual Percentage Rate) they are given.

The mechanism to increase contractual clarity for Adjustable Mortgage Loans is a Pre-Set Payment Schedule. A Pre-Set Payment Schedule means that the borrower must be shown all the payments over the life of their loan before they sign the loan documents. The payments don't have to be identical over the loan life, but the payment for any given future month must be shown to the borrower and fixed at the time of the loan (no basing the future payment on a fluctuating index rate). An example of a Pre-Set Payment Schedule would be $1400 a month for years 1 through 10, $1500 a month for years 11 through 20, and $1600 a month for years 21 through 30. All fixed rate loans of any term comply with the concept of a Pre-Set Payment schedule. Some people have argued that Adjustable Mortgage Loans should be outlawed. AMLs obviously have some value to borrowers and lenders because so many have been made. A Pre-Set Payment Schedule allows the flexibility of adjustable payments, and at the same time communicates to the borrower exactly what their obligations are.

The concept of APR was a means of improving the contractual quality of a mortgage by using one number to tell the borrower the true interest rate on the mortgage. The APR on most current Adjustable Mortgage Loans is worthless because the future payments are unknown. The use of a Pre-Set Payment Schedule increases contractual clarity and lowers information costs for the borrower. The lending institution with its superior resources for determining future inflation and interest rates sets the payment schedule subject to what the borrower will accept and what competitors are offering. The concept of Pre-Set Payment Schedules would allow for Negative Amortization loans, but it would be very obvious to the borrower that early payments that don't cover all the principal are being made up by much higher payments later in the life of the loan. Pre-Set Payment Schedules would not work well in a country experiencing unexpected inflation but that is the subject of another article.

It behooves any country to learn from its past mistakes and make sure that important contracts (we are now experiencing how important mortgage contracts are) are clear and transparent to all parties. I would argue that New Century (defunct), Lehman (defunct), Merrill Lynch (MER), purchased by B of A), Countrywide (purchased by B of A), Bank of America (BAC), Wells Fargo (WFC), Fannie Mae (FNM), Freddie Mac (FRE), J.P. Morgan (JPM), Morgan Stanley (MS), Goldman Sachs (GS), Thornburg (TMA) and all mortgage lending and MBS packaging institutions would benefit from a law requiring Pre-Set Payment Schedules. As a free market advocate I don't make the recommendations for new laws lightly, but in this case I feel Pre-Set Payment Schedules reduce information costs for the borrower, reduce foreclosures for the lenders, and would avoid some of our current societal disruptions in the future. A Pre-Set Payment Schedule could also be implemented in the U.S. by simply adding it as a requirement for loans packaged by Fannie Mae and Freddie Mac.

Disclosure: The author is long JPM and WFC.

Comments

[MFI-Miami:]

It think you are correct in your observation about APR as an attempt to clarify the actual mortgage obligation and then creating more confusion. In my 10 years of being a mortgage broker, the one issue that confused consumers the most was the APR calculation on the Truth-In-Lending statement. I constantly received the question, "I thought my interest was X% why does my APR statement say Y%?"

In an ARM mortgage, there is no way to calculate what the new payment will be after the recast. I do like your idea of using a pre-set payment schedule on ARM loans. However, if the American consumer doesn't become more business savvy soon, the only products available will be fixed programs.

2008 Sep 22 09:45 AM

[Thomas J. G...:]

MFI-MIami: I went you your website. You really are involved in this stuff in a big way. I didn't know there was such a thing as forensic mortgage auditing. In terms of the article, as long as people were looking for solutions, I thought I would propose something I thought made sense. ... Flash

2008 Sep 22 03:44 PM

[Smalltownba...:]

The concept of pre-set payment schedules has already been tried and is failing miserably, it is called the option ARM. There is no problem with ARM loans. The problem is with disclosure. In 1993 when you applied for an adjustable rate loan you signed a disclosure which clearly identified the worst case scenario payment adjustments in a straightforward way and presented a 10 year history of the index. When you applied you had to qualify at the Start Rate plus 2% to the rate and as a result many people abandoned the ARM for the fixed rate loan at the time of disclosure.

Today we present them with a disclosure which describes the interest rate caps, the concept of index + margin and the adjustment periods plus a Truth-in-Lending Disclosure that reflects only the fully indexed rate based on current index levels. Unsofisticated borrowers look at a "Truth in Lending" (should read misdirection in lending) disclosure which tells them their payment will go down when the fixed period on their loan expires and they look no further. They sign on the dotted line for a mortgage they really do not understand at all.

All ARM applicants should be presented with and required to sign a "Truth in Lending" Disclosure that presents not only the fully indexed rate but also a 20 year history of the index, and a worst case scenario on the loan they are applying for. ARM loans for more than 80% of purchase price should require a Face-to-Face application with these disclosures provided at application, not mailed 3 days later. With today's technology there is no reason to require a borrower to wait for the disclosure.

The ARM is a viable product. I have a fixed rate now but from 1996 until Summer of 2008 I owned 4 homes and they were all purchased with variable rate products.

Pre-set payment schedules are an abomination and are not only a bad suggestion, they should not even be allowed.

2008 Sep 23 09:08 AM

[Smalltownba...:]

Oopps. Make that unsophisticated borrowers and bad spellers like me.

2008 Sep 23 09:10 AM

[Dionyz:]

This whole mess goes back more than 10 years, when the democracts were harranguing the banks to give loans to people with low incomes (read - people who have no business owning a house).

Over time the banks came up with all the creative products to make it look like these poor people had the means to buy houses.

The result every one knows.

Since this mess was caused by the democratic legislators, the bail out shoul be coming from these legislators personal accounts and not the american tax payers.

Also, the american tax payer should learn their lesson well and throw these liberal bums out of the office.

2008 Sep 23 10:26 AM

[Thomas J. G...:]

tcornelison,
I would give you that an alternative to the Pre Set idea would be to present the borrower with the "worst case" scenario that the lender is proposing. Most AML have limits on the payment increases, although the limits allow for substantial increases in the payments. If these were shown to people ahead of time it might have some affect. I came to the conclusion that information costs for the average mortgage borrower are too high. We need something to simplify. Pre-Set simplifies but it does prevent decreases in payments later on if the index tied to the mortgage drops.
Dionyz,
I agree with you but I think we are going to get the opposite. I also worry that mark to market accounting associated with Sarbannes Oxley may be another government intervention that caused a huge problem but is not well understood by the average voter. I think I'm reading that with the accounting rules in affect in the early 90's, Bear Stearns would still be an independent company with billionaire executives. The Paulson solution makes it look like only the big bwana government can fix the mess the free enterprise investment bankers caused. I hope I'm wrong about this helping the parties of big government.

2008 Sep 23 12:24 PM

[Responsibility:]

To encourage people to be responsible, we should have tax penalty and special points for future loans on load defaulters and tax incentive to people who keep their mortgages, to those who take on new mortgages, and to those who increase their mortgages, similar to tax on big cars and incentives for small/hybrid cars. Please spread this if you agree so that the politicians will do something.

2008 Sep 23 02:30 PM

[edtheincome...:]

I have option ARM too, it helped me buy a house in the best area and the best schools. I received clear and full disclosure (Wells Fargo) and had the means to fully pay off if necessary (loan is 10X assets). It actually adjusted LOWER in July to 4.25% Those borrowers who didn't understand (NO excuse, you signed a contract) or never really had the means are the ones at fault for this crisis! They should be penalized like Responsibility says.

2008 Sep 23 07:13 PM

[Thomas J. G...:]

edtheincomeinvestor
I'm glad your arm has worked out so well. I believe in "NO excuse, you signed a contract" too. But it seems like certain politico's are willing to implement socialism on the entire country as a means of dealing with this housing crisis. So I was trying to suggest ideas that helped prevent the problem in the future short of "The government will run all the banks and loan all the mortgage money", which I believe would be a step backward. ... Flash

2008 Sep 24 10:17 PM