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The Fed and Foreclosure

posted by Angie Littwin

Imagine if instead of the warnings on cigarette packages, tobacco companies were required to insert a small pamphlet containing facts and figures about smoking.  It would be written in plain English, but the information could still be primarily technical.  It would encourage purchasers to ask themselves questions like, “Is smoking the right choice for you?”

That is what the Federal Reserve has done in its recent update to its Consumer Handbook on Adjustable-Rate Mortgages.  The new handbook includes many welcome warnings about the risks of ARMs.  It cautions consumers that their mortgage payments may increase dramatically, that most brokers are not required to find them the best deal, that interest-rate caps do not provide complete protection from rate increases, that pre-payment penalties can prevent them from refinancing or selling their homes, and that minimum payment plans can result in consumers owing more money than they originally borrowed.

But simply providing the right information is not enough.  The handbook needs to warn consumers that taking out adjustable-rate mortgages they cannot afford could lead to them losing their homes. (Not once does the handbook mention the f-word, foreclosure.)  And it needs to drive that message home in such a way that consumers will grasp the message on a psychological level.  It needs to do the equivalent of the thetruth.com ad I saw on TV this weekend where a “singing cowboy” "sings" “you don’t always die from tobacco” through a hole in his throat.

I am aware that there are big differences between cigarettes and adjustable-rate mortgages, the most obvious being that, no matter how egregious your terms, a home mortgage probably won’t kill you.  Also, the chain of causation between risky mortgage products and foreclosures is more controversial than the health effects of tobacco.  And ARMs can work for some people, whereas few people outside of Thank You for Smoking’s Nick Naylor would argue that cigarettes offer substantial benefits.  Most importantly, the Fed does not consider discouraging ARMs to be part of its job, the way the Surgeon General’s office does with tobacco.  But it should move in that direction, at least for some home buyers.

Last March, the Federal Reserve’s own economists published a report which found that over one-third of people with ARMs did not know how much their rate could increase and that 41 percent did not know the highest rate they could face.  The study also determined that the people with less education and lower incomes were the least likely to understand their mortgage terms.  Meanwhile, the national rate of ARMS and interest-only mortgages continues to rise – it is now past 25% of mortgages. (See my post on September 21, 2006.) And the foreclosure rate has risen with it.  At the end of 2006, a foreclosure-tracking service found that foreclosures had increased 68 percent from November 2005 to November 2006.

The Federal Reserve should be in the business of discouraging that 35-41 percent of people from purchasing homes with adjustable-rate mortgages, or at least of educating them about the newer mortgage products so that they understand the risks on a psychological, as well as an intellectual, level.  (It’s not clear that the Fed succeeds on an intellectual level either.  Unsophisticated ARM consumers are not going to become any more sophisticated by reading paragraphs like, “Let's say that your ARM starts out with a 6% rate and the loan has a 6% lifetime cap--that is, the rate can never exceed 12%. Suppose the index rate increases 1% in each of the next 9 years. With a 6% overall cap, your payment would never exceed $1,998.84--compared with the $2,409.11 that it would have reached in the tenth year without a cap.”)  It certainly should be in the business of working to halt the rising foreclosure rate.  Instead of beginning its “Consumer Cautions” section with the attention grabber “Discounted interest rates,” it could start with something like, “WARNING:  This mortgage could increase your risk of losing your home.”

Thanks to Lauren Willis for the tip.


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Its crazy how high the inventory is right now.

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