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A Full-Court Press on Bad Loans, But Who Will Referee?
Loan providers have a personal financial interest in the outcome. Their business is selling loans. Judging that a loan is not suitable for a borrower would cost them money.
What has made the suitability standard workable in the securities industry is that the short-term interest of brokers in selling unsuitable securities is usually overruled by their long-term interest in maintaining a roster of satisfied clients. While transaction-oriented operators looking for the fast buck exist, they are on the periphery of the industry.
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In the home mortgage market, in contrast, client-oriented loan providers are the minority group. The majority sell loans.
But determining mortgage suitability by a referee wouldn't work even if the referee were not involved in the outcome. Determining the suitability of an investment or a mortgage requires balancing the objectives of the client against the risk of the instrument. In the case of investments, this is relatively easy because the client's objective can almost always be framed in terms of rate of return.
The objectives of mortgage borrowers, in contrast, are diverse, complex and often not known by the loan provider. Here are five objectives that have been reported to me by borrowers who have selected option ARMs and interest-only loans:
? Reduce cash outflow to invest the excess in securities.
? Reduce cash outflow to pay down a second mortgage.
? Pay principal when convenient.
? Buy more house.
? Reduce payment to avoid default.
I sometimes get involved in an exchange with borrowers about whether their objectives are worth the risk, and sometimes I express my opinion to them quite forcefully. I would not want the legal right to overrule them, however, because I am not that smart.
Next: An alternative to a suitability standard was recently proposed by an interagency group of federal regulators.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,http:/
? 2007, Jack Guttentag
Distributed by Inman News Features
