Sunday, June 10, 2007

The Knowledge Gap in Mortgage Lending and Borrowing – What is the Fed to do?

The article in the Wall Street Journal illustrates something I have been watching for the better part of 3 decades. According to the Wall Street Journal article, Chairman Greenspan ignored a suggestion in 2000 to more closely scrutinize the sub-prime mortgage industry. One of the consequences of this action is that a large number of “exotic” mortgages (neg-ams, interest-only, ARMs, etc.) were obtained by borrowers that did not fully understand the ramifications (risks) of how they were financing the purchase of their home.

I am all for less regulation as opposed to more regulation. Further, I prefer all the different mortgage types in the market place, because mortgages are not one size fits all instruments. However, there is a considerable knowledge gap between the borrowers and the lenders concerning all the mortgage insruments. Every time this type of gap exists the least informed group has a good chance of ending up on the short end of the stick. Or if you prefer – when an inexperienced group with money (or good credit) deals with a group with a lot of experience, the experienced group ends up with all the money and the inexperienced group has had quite an experience.

The question is – how do you close this knowledge gap? Have the potential borrower take a 2-hour course on all the different mortgage types. How much can you learn about risk in 2 hours, when in fact risk is something that is learned over time with experience?

How about more disclosure from the lenders? What is going to keep this disclosure from being one more thing to check off on the process list. This of course makes the assumption that the person “selling” the mortgage knows what they are talking about.

There is no alternative except for the consumer to become more knowledgeable about borrowing. Watching this process for almost 30 years leads me to the conclusion that how closing this gap is accomplished is a mystery to me.

. . . . A former colleague says Mr. Greenspan blocked a proposal to increase scrutiny of subprime lenders under the Fed's broad authority. That added scrutiny might have helped curtail questionable lending practices now blamed for soaring defaults by mostly low-income borrowers. . . .

Edward Gramlich, who was Fed governor from 1997 to 2005, said he proposed to Mr. Greenspan in or around 2000, when predatory lending was a growing concern, that the Fed use its discretionary authority to send examiners into the offices of consumer-finance lenders that were units of Fed-regulated bank holding companies.

"I would have liked the Fed to be a leader" in cracking down on predatory lending, Mr. Gramlich, now a scholar at the Urban Institute, said in an interview this past week. Knowing it would be controversial with Mr. Greenspan, whose deregulatory philosophy is well known, Mr. Gramlich broached it to him personally rather than take it to the full board.

"He was opposed to it, so I didn't really pursue it," says Mr. Gramlich, a Democrat who was one of seven Fed governors.

Mr. Greenspan, in an interview, says he doesn't recall a specific discussion of the idea but confirmed his opposition to it.

There is "a very large number of small institutions, some on the margin of scrupulousness and very hard to detect when they are doing something wrong," says Mr. Greenspan, who retired in February last year. "For us to go in and audit how they act on their mortgage applications would have been a huge effort, and it's not clear to me we would have found anything that would have been worthwhile without undermining the desired availability of subprime credits."

Ben Bernanke, Mr. Greenspan's successor, told Congress in March that he has asked his staff for "a complete review of our powers and practices" in examining holding-company units. A Fed spokesman this past week said "that review is under way." The Fed Thursday will conduct a public meeting on steps it could take to strengthen laws governing subprime lending.

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