By Jack Guttentag
Saturday, November 10, 2007

Editor's note: This column is a version of an article that has appeared previously on Jack Guttentag's Web site and elsewhere. The issue it addresses has been revived in legislation now under consideration in the House of Representatives.

Q: I understand that in pending federal legislation aimed at predatory lending, lenders would be prohibited from refinancing a mortgage unless there is a "tangible net benefit" to the borrower. Is this a good rule?

A: The tangible-net-benefit rule applied to loans being refinanced would make lenders responsible for something over which they have little or no control.

All or almost all refinanced mortgages provide benefits; otherwise borrowers wouldn't take them. A borrower who closes a refinance only to find that there is no benefit has three days to rescind. Even predatory lenders, who are the focus of the proposed legislation, provide a benefit to the refinancing borrower.

The problem is that in exchange for the benefit, the predator extracts a pound of flesh. That's why the proposed legislation requires a "net" benefit, meaning that the benefit outweighs the cost. However, there is no way a lender can determine this. Whether the benefit outweighs the cost in any particular case depends heavily on what is in the borrower's head.

This will become clear from looking at the four main reasons why borrowers refinance: reduce costs, raise cash, reduce monthly payments and reduce interest rate risk.

Cost-reduction refinance: A cost-reduction refinance is one in which the new interest rate or mortgage insurance premium is lower than the existing one. In most cases, however, the borrower incurs costs upfront. If there is to be a "net benefit," therefore, the future savings must outweigh the upfront costs.

But future savings depend, among other things, on how long the borrower expects to have the mortgage. This critical piece of information, if it is anywhere, is in the borrower's head.

Cash-out refinance: Some of the worst market abuses arise in "cash-out" refinances, where the motive is to raise cash. Suppose that in raising $5,000 this way, John Doe has to accept a 7 percent loan as replacement for his current 6 percent loan and $5,000 in refinance costs that are tacked on to his loan balance. The tangible benefit of $5,000 in cash is clear, but is it a net benefit?

There is no objective way for the lender to answer the question. The price seems high, but maybe the borrower needs the $5,000 to pay for life-saving medicine for his children. Again, the answer is in the head of the borrower.

It could be argued that whether there is a net benefit should depend on the borrower's options. If the borrower could raise the $5,000 elsewhere at a much lower cost, the finding should be that there is no net benefit. It is neither feasible nor fair, however, to make lenders responsible for assessing their customers' options.

Payment-reduction refinance: Some borrowers are willing to pay a stiff price, in the form of wealth reduction in the future, to reduce their monthly payments now. Frequently, this involves converting a fixed-rate loan to an adjustable-rate loan carrying a lower rate, often with an interest-only option, for a limited period. Costs are usually tacked on to the balance.

Whether there is a net benefit depends in part on how critical it is to the borrower to lower the payment. Perhaps the alternative to a payment reduction is default. Only the borrower knows.

Risk-reduction refinance: When interest rates are expected to rise, many holders of adjustable-rate mortgages consider converting them to fixed-rate mortgages. The borrowers making the switch are willing to pay a higher rate now in exchange for future rate certainty. On this issue, lenders are in no position to substitute their judgment for that of the borrower.

In sum, no matter why borrowers refinance, the question of whether they receive a net benefit should be for borrowers alone to answer. Lenders do not have the information needed to second-guess them.

However, borrowers often make their decisions on the basis of incomplete and even misleading information from lenders. Instead of requiring lenders to assume responsibility for borrowers' decisions, let's make them responsible for providing borrowers with the information they need to make their own decisions.

The formulation of disclosure rules has long been viewed as a proper responsibility of government, because this is the only way to assure uniformity of disclosures across the market. But the federal government has proven that it is not up to this task. The existing mandatory disclosure rules are obsolete and shamefully inadequate. Every attempt to fix them gets bogged down in politics. It is time to try making lenders responsible for disclosures.

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://www.mtgprofessor.com.

Copyright 2007 Jack Guttentag

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