Wednesday, January 20, 2010

Would a Consumer Financial Protection Agency end this?

One result of the recent financial crisis is a call for increased consumer protection.  I'm interested in this idea and, in general, wish that people were more numerate.  There are many things I want to say about consumer protection, but I'm having trouble organizing my thoughts.  So I wanted to post a single example and try to generate some discussion about whether/how the proposed consumer protection mechanisms would affect it.

About 3 years ago, I was considering buying a house and went through the process of getting pre-approved for a mortgage.  I was, obviously, given a (mortgage) dollar amount that I qualified for.  What I didn't expect, though, was that I was given a variety of schedules illustrating the various debt structures and their respective payoff features.  That is, I was given excel files for:

  • An 80% 5-1 ARM with 10% down and a 10% 2nd mortgage
  • An 80% 5-1 ARM with 5% down and a 15% 2nd mortgage
  • An 80% 5-1 ARM with 0% down and a 20% 2nd mortgage
  • An 80% interest only 5-1 ARM with 10% down and a 10% 2nd mortgage
I suspect that not all of these would be available to me right now.  But the one I'm most interested in is this one:
  • 90% pay option ARM
Here's a snapshot of the Excel file.  (Click to enlarge)

(There's some type of misprint, because all the other files were based on $400k purchase price.  So I think the LTV should be 80% rather than 90%.  But put that aside for now.)

I think this is exactly the type of mortgage that caused so much trouble.  It's a negative amortization loan - if you make the minimum payment each month, your mortgage balance will increase over time.  Unless you are in the odd position of having very little money now and know that you will have substantially increasing money in the future, this is almost certainly a bad idea.  But look at how this document (advertisement?) compares the monthly payments to other mortgage options (Step 3) saying "LOOK, THIS OPTION IS BETTER THAN THE OTHER MORTGAGES YOU COULD GET.  YOUR MONTHLY PAYMENT WILL BE LOWER."  It helpfully does this with a nice green arrow.

In case the prospective borrowers find something fishy about this, Step 5 provides the monthly maximum payment.  It reassures the borrower that, even if the rate increases to the maximum, the Year 5 payment is still lower than the other options.  "THIS IS THE MAXIMUM MONTHLY PAYMENT YOU'LL MAKE, LOOK AT THE SAVINGS.  ALSO CONSIDER THAT MOST PEOPLE DON'T EVEN LIVE IN THEIR HOUSES FOR MORE THAN 5-7 YEARS."

So what's missing?  Step 6, the one that would say, "YOU ARE TOTALLY FUCKED AFTER YEAR 5."

My thoughts on this are similar to something I just read on Bronte Capital.   It involves another business model that, I would argue, is aimed at convincing people to make poor financial decisions:  the Rent-To-Own model.  As the post says:
The business model is disarmingly simple.  You have shops with 200-300 stock keeping units (running the shop is not the business).  They sell things on a very simple mark-up basis.  The advertised price of the thing (a TV, a couch) in the shop is 100 percent mark-up on the invoice price.  However the real price is 48 monthly (or more realistically 208 weekly) instalments based on recovering 400 percent of the invoice price.  If the TV wholesales for $1000 then the monthly instalments add to $4000.
My question is this:
Regarding this particular Pay Option mortgage, what would the consumer financial protection agency do?  The terms seem to be fairly well laid out and, presumably, are truthful.  It's a legal product that would possibly be useful to at least some (very small) part of the population.  Yet, just as the author of the Bronte Capital post, I am offended by this mortgage.  It doesn't feel right.  I've got a good financial background, so I understand the repercussions of this mortgage, but many people wouldn't.

But, for the life of me, I can't figure out on what grounds I should want to eliminate this type of mortgage.  I suppose you could make the argument that they shouldn't be able to nudge me in the direction of a dangerous financial product by using pretty illustrations, but at that point we're treating the lenders like cigarette makers who aren't allowed to direct advertising to minors.  (Bye, Joe Camel!)

Even if many people can't make sophisticated financial decisions consistently, we shouldn't protect them (literally) the same way that we protect children from cigarette advertising, right?

If this type of product would be covered by a financial protection agency, how would it work?

And if it wouldn't be covered by a financial protection agency, are we perhaps missing the forest for the trees?

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