Saturday, October 02, 2010

The William Cohan fallacy

William Cohan the other day complained that Elizabeth Warren fallaciously claimed borrowers did not know what they were getting themselves into when they took out exotic loans. Cohan suggests instead that the vast majority of borrowers knew what they were signing up for when they took out exotic mortgages.

This was certainly the case for some borrowers (particularly speculators), but I am not sure "vast majority" is correct. Understanding the intricacies of, say, a pay-option ARM requires a degree of mathematical sophistication that I would guess is beyond the capabilities of many borrowers. My former GW colleague Vanessa Perry has found that many borrowers do not understand anything about credit beyond their next monthly payment. In the case of pay-option ARMS, this payment was often low relative to income and stayed low for some time, so a potential borrower/homebuyer could be "advised" by a mortgage broker lender and/or real estate broker that an expensive house was indeed "affordable."

Should such borrowers have known better? I don't know. I do know that even though I really wanted to dunk a basketball, it was never going to happen, because I am short and can't jump. Similarly, no matter how much they try, there will be potential borrowers with generally good life skills who will never be able to understand an amortization schedule, and who are susceptible to a good sales pitch. To suggest such people are "responsible" for their plight is akin to suggesting that I am "responsible" for never being able to dunk a basketball.

Might Elizabeth Warren's idea of sufficient consumer protection go too far? Sure. But the events of the past eight years or so strongly suggest to me that consumer protection was insufficient.


Rhonda said...

Plenty of mortgage bankers originated "pay option ARMs" too... WaMU's pick-a-payment was around for a quite a while before this product imploded. World Savings and other banks offered this product via their retail channels too.

Bank and wholesale lenders would have their reps call on mortgage brokers and correspondent lenders to push this product. There was little to no care if the consumer understood how the option arm worked.

I recently had a conversation with a very savvy borrower who's trying to refinance out of an option ARM (I did not originate it)...he told me that although he intended to make more than the minimum payment, there was always something else to spend that money on or a reason not he believed his home would continue to appreciate.

I am glad to see that you included real estate agents in your post... not only would they push products like this to their buyers, it was not uncommon during the subprime era to have an agent ask "can't they do stated income?" if they wanted to sell their buyer a more expensive home than what they qualified for.

I'm glad the subprime days are behind us and it will be interesting to see what the future holds for the mortgage industry.

richardrad said...

Of course borrowers should have known better. Exotic loans should not have been offered in such large numbers. Many lenders took leave of their senses. But the blame for the mortgage mess does not rest solely with the banking industry, Fanny, Freddie or Congress. Borrowers are also to blame for what has happened. Taking out a mortgage is the biggest financial decision most of us will ever make. Refusing to spend the time to understand the basic terms is both lazy and foolish. To disagree I think is to argue that we should all live in a nanny state where we are protected from making taking responsibility for ourselves. - Richard

Steve Layman said...

I enjoy your blog and have from time to time posted some of your stuff on my blog.

But.........surely you don't really mean this:

"To suggest such people are 'responsible' for their plight is akin to suggesting that I am 'responsible' for never being able to dunk a basketball."

About six years ago, I signed a non-recourse mortgage with a "yield maintenance" clause in it. The calculation in the document was complicated. I sort of ignored it, assuming it was just a pre-payment penalty. The mortgage broker didn't think it was a big deal. Wow. It was a pre-payment penalty on steriods. It kept us from being able to profitably sell the property at the peak of the recent froth, so we still own it.

I signed the mortgage. I could have asked our attorney to reveiw it, or I could have asked the mortgage broker for some written examples of "yield maintenance".

Doing neither, I am responsible. Signing the mortgage, taking the money, I must accept the consequences. To suggest that "potential borrowers with generally good life skills" not accept responsibility for their actions seems like setting out on a sure path to having some wise government functionary make all our decisions for us.

Just seems to me that acceptance of personal responsibility is requiste for a free society.


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