Financial firms are strongly resisting any attempts to impose greater regulation on their activities, according to various media accounts. By taking this position, the finance industry gives the impression that its members do not live on Planet Earth. Despite the allegiance of most Americans to a free market economy, the vast majority believes that unregulated behavior in the mortgage business was extremely harmful to the nation and should not continue.
In an atmosphere where the greed of mortgage brokers — and conduit lenders in particular — went unregulated, many were emboldened to exploit unsophisticated and unqualified borrowers. At the height of the economic boom, brokers frequently pressed residential borrowers who were eligible for prime mortgage loans to take out subprime loans that came attached with higher interest rates, which improved the brokers' profits.
In other cases, brokers accepted borrowers' estimated incomes without documentation, made interest-only loans, or used “teaser” initial rates only to be followed by large increases in monthly payments that weren't clearly disclosed to borrowers. Brokers also made loans with no down payments and pressured rating agencies to provide high-quality ratings to securitized issues of subprime loans.
Eradicating bad practices
In response to such reckless behavior, federal regulators should adopt some version of the following regulations on all lenders or brokers, not just on those charging above average interest rates:
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Any person or firm making or brokering residential mortgage loans should be required to register with some federal or state authority. Specific requirements for registration should be simple, but include professional insurance.
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All residential mortgage lenders and brokers must be required to document income estimates and provide valid documentation in the closing papers.
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Residential borrowers must not be allowed to spend more than some maximum fraction of total income servicing mortgage and other debts.
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Every residential borrower must be fully informed about the course of future monthly payments over the next five or more years and acknowledge that in writing. All fees to be paid by the borrower to the mortgage company and broker involved over the life of the loan should also be spelled out in writing.
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If the residential borrower qualifies for a loan with prime rather than subprime rates, that should be documented in writing and made clear to all parties. If the borrower is induced to accept a loan at a rate that is higher than the minimum applicable rate, the borrower should have the right to switch to the lower-rate mortgage at any time without penalty and receive a refund from the lender of any “excess payments” already made.
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Every residential borrower must have a down payment of at least 3% of the purchase price, and cannot acquire that 3% as part of the home purchase loan.
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Investment banking firms engaged in large-scale lending should be required to maintain an adequate amount of financial reserves. If the Fed is going to bail out such firms, as it has been doing, these lenders should satisfy this requirement.
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All parties engaged in residential or commercial lending should be required to compute the degree of leverage with borrowed funds, which should be less than some maximum level to be established in consultation with the industry.
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Rating agencies should be required to receive payment from the users of those ratings, or from other sources not requesting the ratings for their own issuance of securities.
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Issuers of securities backed by a wide array of residential, commercial loans or other instruments should be required to provide transparent documentation of the different types of loans included in each issue, and the overall share of each type of loan within the entire issue.
Brace for a fight
There's no doubt that the finance industry will continue to vehemently resist attempts at more regulation. Its members will claim that added regulation would impede efficient operation of free markets. Yet if there has ever been a clear demonstration of the seriously adverse impact of the almost totally free operation of private markets, recent events provide compelling evidence.
The huge run-up and decline in housing prices, massive defaults and foreclosures, and a paralyzing credit crunch, convince me that greed has run amok. Despite Treasury Secretary Henry Paulson's declaration that we don't need more regulation, the American public deserves better oversight of the finance industry by the federal government than it has gotten in the past decade.
Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at [email protected].