Mortgage Reform: Why Government Intelligence is Oxymoron

This post first appeared on Minyanville.

There's only one truly safe bet in the entire financial arena: Mortgages will cost more in 2009 than they did in 2008.

The inevitable regulatory overreaction will meaningfully constrict lending for the next decade, if not longer, driving up costs for anyone buying a home in the foreseeable future.

But some things never change: Homeowners on the lower rungs of the economic ladder will ultimately bear the greatest burden for our collective transgressions.

Yesterday, the Federal Reserve outlined a regulatory overhaul effective October 2009. Lenders have one year to bring underwriting standards and internal procedures into alignment with the new rules. While many of the new laws take much-needed steps to protect borrowers from predatory lending practices, one particular change is evident of the Fed’s desire to placate consumer groups rather than implement good policy.

12 months ago, a scant minority of the investment public had heard of lenders insidiously penalizing borrowers for paying their loans off early. Such "prepayment penalties" allow borrowers to obtain a lower interest rate, for which they agree to pay fees if they repay the loan in a specific period of time (usually 1-3 years).

For homeowners getting back on their feet or savvy investors looking for low carrying costs, such provisions can make or break a deal. These transactions spur economic activity, while vanilla mortgages offered to middle managers in the suburban jungle simply advance the status quo.

Prepayment penalties have since incurred the wrath of populists everywhere, who condemn them as just another way to con unsuspecting borrowers into complex, burdensome and extortionate loans.

It would be ignorant to deny that prepayment penalties, levied without proper disclosure or explanation, are a common tactic of unscrupulous lenders. But banning them outright is just bad policy. The more choices a borrower has, the better able he is to negotiate with a lender. When used properly, these types of small modifications can save thousands of dollars over the life of a loan.

The Fed’s new plan outlaws prepayment penalties if a loan’s rate adjusts within the first four years of the mortgage. With tighter underwriting requirements, many borrowers on the cusp can only qualify for a loan if the rate adjusts. For some, a prepayment penalty is the only way to make a loan affordable.

Keeping lending channels open to traditionally under-banked groups should be a hallmark of our new regulatory environment. The one we're moving toward, however, will block mortgage availability to those on the economic fringe, making the gap between the upper- and lower-classes even wider, intensifying the disparity between the haves and the have-nots.

If this sounds like rhetoric reminiscent of the boom years, pause for a moment to consider.

Subprime lending is not evil. Though it’s caused more harm than good in the last decade -- Countrywide (BAC), National City (NCC), IndyMac (IMB) and even Fannie Mae (FNM) and Freddie Mac (FRE) are but a few cases in point -- healthy, responsible alternative lending spurs economic development in lower-income neighborhoods. Such activities should be monitored by government agencies, but performed by the private sector.

Instead of removing choice from the mortgage process, regulators should strive for education, transparency and real-time enforcement of laws. A massive sting operation 3 years too late is just a publicity stunt.

What if prospective homeowners were required to pass a simple test to qualify for an exotic, complicated mortgage? For sophisticated investors, the test would be a cinch; it could effectively serve as a “license” to use creative lending to their advantage.

Typical borrowers looking to stretch their mortgage dollars a bit, on the other hand, would be required to learn what they’re getting themselves into before digging a hole from which they’ll never be able to climb out.

A focus on education -- what we here at Minvanville call financial literacy -- isn’t just a path to get us to the next quarter, or through the next fiscal year. Understanding the most important financial decision an individual makes -- the purchase of his or her home -- is the only way to prevent another mortgage crisis.

No amount of government intervention can replace empowerment through the lost art of education.