A Full-Court Press on Bad Loans, But Who Will Referee?

Consumer groups believe that lenders should not allow borrowers to take mortgages that aren't suitable for them. Lenders who do allow it should be held liable, they argue.

Whether mortgages were written for people who should not have gotten them is one of the questions at the base of the lending problems that have roiled financial markets recently.

The case for a mortgage suitability standard looks both simple and plausible, and it appears to have been making headway in Washington. A federal suitability rule has worked in the securities industry, the argument goes, so why wouldn't it work with home mortgages?

One major difference between the two markets is that the securities market has only one problem to which suitability is directed: preventing unsophisticated investors of limited means from being sold securities that are too risky for them. The home mortgage market, in contrast, has multiple problems for which suitability has been offered as a remedy.

Borrowers are often steered to the wrong mortgage, to a mortgage that is unaffordable, to a refinancing deal that provides them with no net benefit or to a high-price loan provider. It would be surprising if a suitability standard were the remedy for every problem.

In this article and others in the next few weeks, I will take a closer look at these problems and examine whether a suitability standard is an appropriate remedy. I will also look at whether there is another remedy that would work.

I begin with the problem of bad mortgage selection. This is the closest analogue to the securities market problem because bad mortgage selection in many cases means placing borrowers in mortgages that are too risky for them.

The following is an amalgam of many letters I have received recently from borrowers who took out option adjustable-rate mortgages in 2005 and 2006. These loans allow the borrower to pay what they choose each month, often adding the unpaid amount to their debt, a process called negative amortization.

"I took this loan because the monthly payment was much lower than any of the alternatives. The interest rate was only 1 percent because I qualified for a special program. I was led to believe that it would last for five years. I realize now that it didn't and that my loan balance has been going up every month. I am afraid that next year my payment is going to increase so much that I won't be able to afford it. How do I get out of this mess? Do I have recourse against the loan officer/broker who talked me into it?"

Option ARMs, as well as interest-only mortgages, which have some similar features, are marketed to borrowers who are attracted by the lower payments. In all too many cases, however, those borrowers don't understand why the payments are lower and are not prepared for the risks of higher payments in the future. The marketing, furthermore, is often based on deception.

Until recently, bad mortgage selection was a minor problem. That changed in 2005 and 2006, however, when the volume of option ARMs and interest-only loans exploded.

If lenders were held liable for making unsuitable mortgages, they would have to delegate operating responsibility to those who deal directly with borrowers: loan officers and mortgage brokers, whom I will lump together as "loan providers." But having loan providers judge suitability would be like having the coach of a contending team also serve as the referee.