Thank you

I wanted to thank the editors of Credit Slips for giving me the opportunity to air my opinions this week. I'm a regular reader of this blog and it's an honor to be a contributor as well.

Ethan

Why a Foreclosure Compensation Fund Is a Bad Idea

The Washington Post yesterday wrote : 

"State attorneys general and the country's biggest lenders are negotiating to create a nationwide fund to compensate borrowers who can prove they lost their home in an improper foreclosure"

The fund is being compared to the BP oil spill and other general compensation funds.

A general compensation fund is reasonable if a large, non-specific damage has occurred. In such a case, one needs some intermediary to figure out who was damaged and by how much. In the foreclosure example, we don't have generalized damage; each bank in question had the ability (and the responsibility) to evaluate each document. 

A compensation fund would validate the idea that foreclosures are necessarily an error-ridden and imprecise process; that is, that robo-signers are the way of the world. 

Do we really want to put the burden of proof on borrowers? If the note holder can't figure out ownership, how could we expect a homeowner to do it? See huffpost on this.

Anything short of holding the banks fully responsible for current legal requirements is yet another subsidy.

Principles Aren't Always Enough; Rules Are Needed Too.

In my last posting, I discussed the tradeoffs of regulation on the consumer side, and the extent to which disclosure would be sufficient to resolve consumer protection issues.

Here, I pose a simple problem to illustrate why principles based regulation would be inadequate.

New Consumer Regulation: Education and Disclosure Is Not Enough

Elizabeth Warren’s appointment as special advisor to the president was widely hailed as an achievement for consumer advocates. Professor Warren has long been a strong advocate of the middle class and famously compared financial products to flaming toasters.

The creation of a new agency brings new possibilities and new risks for consumer advocates. Most importantly will be the agency’s approach to regulation. In a two-part posting, I will comment on two key aspects of the new agency’s direction. The first revolves around understanding of consumer behavior and the second around firm behavior.

Part 1:

A core component of the CFPB mission is based around the idea that banks provided risky products to consumers that didn’t understand them. There is abundant evidence that consumers didn’t understand the products they bought; however, it’s far from clear that this is a sufficient role for the CFPB. I’ll argue here that in addition to disclosures, education and information, we need explicit regulation of the products as well.

Effectively, this boils down to a simple question: if banks want to offer a risky product (a flaming toaster) to consumers that fully understand its dangers, should the bank be permitted to offer it?

Modern Redlining in Historical Context

A paper that I wrote while an employee of the Federal Reserve System a couple years back documents the presence of ‘redlining’ in the issue of credit cards. Credit Slips picked it up here (link).

(To ensure there are no misunderstandings, this paper did not and does not represent the views of the Federal Reserve Bank of Boston or the Federal Reserve System; in fact, both entities did their utmost to prevent its release) ... continue…

To be more specific: I find that credit issuers use the racial composition of a neighborhood in determining how much credit to give to individuals that live in it. I use the term ‘redlining’ with historical reference: this idea is that particular areas have been identified as high risk. What I find is that the ‘high risk’ areas are highly correlated with the presence of minorities.

I’ll be clear, I cannot definitely prove that lenders use race—I’m an economist, not a lawyer! Regardless, I’ll present the point that the practice is still redlining even if lenders never use race, but use location-based information that is correlated with race.

They Really Did Know the Loans Were Bad…

A firm which few know of – Clayton holdings—will likely soon be at the center of a wide variety of lawsuits and individual complaints. Clayton’s job was to validate the innards of mortgage backed securities (MBS) when made available for sale. The typical setup would have an issuer of a MBS call Clayton and ask them to take a 10 percent sample of the loans, and evaluate whether the loans met the portfolio criteria (had documents been filed, credit scores as reported, etc.). If the loans were incorrect, they could either be taken from the pool and replaced with a good one, an exception made, or a substitute placed into the sample and evaluated instead.

Clayton holdings staff testified last month that 255,802 mortgages out of 911,000 evaluated did not meet portfolio screening criteria. The bank underwriters waived more than 100,000 of them (>39%); that is, even though the mortgages failed the criteria, the banks included them in the MBS pools anyway.

So much for the idea that the issuers didn’t know the loans were bad…

Am I Paying for My House or the Brooklyn Bridge?

The foreclosure mess has raised new tough questions. We once again seem back to distributional issues. If a foreclosure is in question for a homeowner that has not been paying and a bank that has no good proof of its ownership, what should happen to the house?

1. The bank should get it because a homeowner that fails to pay should forfeit his/her collateral. Morally, why should this deadbeat get an asset for free? Particularly if the whole thing was stirred up by a lawyer. (See the WSJ article on this).

2. We should work through the mess in the courts to determine the validity of the individual case. No one should lose their home based on falsified documents. Careful determination ownership is important.

I have a new suggestion:

3. Any payments that the homeowner made to the bank, the one with no evidence of ownership, should be placed into a third party escrow account.