GLC supports Scottish pre-action legal requirement in eviction cases

GLC supports the Scottish Governent's proposal of a pre-action requirement (PAR) for eviction cases in the social rented sector; although the elephant in the room is why not extend this approach to private sector evictions too?

We believe this approach could significantly reduce the number of tenants evicted due to rent arrears in the social rented sector. A PAR has been suggested in a recent Scottish Government consulation paper. Such an approach would require all social landlords to deal with the problem of arrears effectively at an earlier stage. It would also help ensure that court action was only raised as a last resort.

GLC believes the Housing (Scotland) Act 2001 could be amended to ensure that compliance with a PAR prior to raising an eviction action was necessary in order to ensure that proceedings were competent in the same way that service of a valid notice of proceedings is required at present. Failure on a social landlord’s part to comply with the PAR would therefore be a defence to the action on competency grounds.

GLC believes it is important, from a public policy point of view that social tenants are afforded the same protection as homeowners. The introduction or a PAR would bring the protection of social rented tenants in line with the protection being introduced for homeowners in the Home Owner and Debtor Protection (Scotland) Act 2010.

However, GLC is concerned that the Scottish Government's approach could give rise to unintended consequences, unless appropriate safeguards were put in place.  For example, we are concerned that the PAR could be seen as evidence that it is reasonable to evict in terms of section 16 of the Housing (Scotland) Act 2001. GLC is concerned that social landlords could argue that as they have complied with the PAR, and that as their tenants still had arrears, it would be 'reasonable' to evict. We believe that it is important that full consideration is still given to the requirements of section 16.

Although we hope the introduction of a pre-action requirement will reduce the number of cases raised in court we think care must be taken to ensure that the result is not an automatic assumption that all the cases that end up in court must be ones where nothing can be done to assist the tenant and that eviction will be reasonable in these cases.

We also think it is important that landlords continue to work with the tenant to solve the problem of the arrears, even after court action is raised. Our experience is that once the case has been raised in court some landlords become focused on obtaining a decree and are not as willing to negotiate repayment arrangements with tenants. We are concerned that the pre-action requirement may be seen as landlords as all they are required to do to assist a tenant. Instead we believe it should be seen as a minimum level of assistance that must be given before an action can competently be raised. Landlords should still be encourage to engage with tenants and work towards preventing eviction even after court action has been raised.

GLC's full response, led by Lindsay Paterson, Solicitor, to the Scottish Government's consultation is available online here.

Scottish solicitors reject Government's '100% Tesco Law' model

Scottish solicitors have backed a compromise motion on Alternative Business Structures (ABS) by 1,550 to 1404 votes at their Annual General Meeting; with the compromise motion securing the highest number of votes in support of any ABS motion at the Law Society of Scotland's AGM on Thursday 27 May 2010.  The compromise motion would permit ownership of law firms by non-legal professionals to a maximum of 25% of the business.

The motion was proposed by GLC's Mike Dailly, seconded by Govanhill Law Centre's Lorraine Barrie, and backed by the Scottish Law Agents Society among others. ABS has been dubbed 'Tesco Law' because it would enable supermarkets, banks, corporate investors, fund managers - and potentially even organised criminals - to own and control 100% of a law firm as an 'external investor': the Scottish Government's Legal Services (Scotland) Bill, as introduced, makes provision for a 100% external ownership model of ABS. 

The Council of the Law Society of Scotland's motion called for a reduced version of the Scottish Government's own ABS model, with no more than 49% of a firm being owned by external investors. The Council's motion was narrowly passed by 21 votes: 1486 to 1465.  At the meeting of Council following the AGM, GLC's Mike Dailly argued that the Society's policy on ABS now had no moral mandate standing the AGM, and that the will of the legal profession was clearly divided, and incapable of being said to be in favour of 49% external ownership.  Council accepted that there was now no clear consensus on ABS.   The Society's official AGM report is here (opens as PDF).

Mike's main speech proposing the compromise motion is here; for arguments explaining why 100% external ownership of Scottish law firms could result in significant consumer detriment and be contrary to the public interest in Scotland see here (2010) and also see here (2008).

Why Suitabilty Tests and Fiduciary Duty May be Incompatible with ECOA

Starting out in the mortgage industry in 1998, I planned to make mortgage lending my career, so I was eager to learn as much as I could about my new profession. As part of my training, I took a lot of classes, and some of those classes involved training by the National Association of Mortgage Brokers on Fair Housing Laws and Equal Opportunity Credit Act laws. I was really surprised to learn that the standards for complying with these laws were quite a bit higher than I had understood.

For example, I thought that complying with the law meant treating everyone with respect, and working to get their loans processed, but I found out that according to the Equal Credit Opportunity Laws treating everybody fairly involved more than that. A broker offering a product had to make it available equally to everyone who qualified for it. A loan officer was not supposed to make credit decisions for a borrower. A loan officer was not supposed to refuse to take an application on any borrower or to process any borrower's application. We were told that we needed to at least send the application to a lender so that the lender could decline the loan regardless of how credit unworthy we believed the application to be. To refuse to do so could be construed as discriminating against the borrower. The loan originator had no right to decide whether the borrower could or should have a loan; that was the job of the credit underwriter.

Opponents of the industry have long held that certain products are unsuitable for certain types of people. For instance, one group of consumer advocates floated the idea that people over a certain age should not be allowed to apply for mortgage loans because they could be victims of predatory lending. Our Association responded that Equal Credit Opportunity Laws prohibited discrimination based on age and provided senior citizens with the same rights as people in other age groups to make their own decisions.

Today, as part of the new financial reform bill, we are seeing new standards for loan originators which have grown out of recommendations by consumer advocacy groups. These specifically include suitability tests for matching loan products to clients and fiduciary responsibility for loan originators to their clients.

The problem with this kind of a standard is that it creates a framework in which individuals can and must discriminate against borrowers. For example, under a suitability test, if a 75 year old wants to take out a thirty year equity loan against their home, should the loan originator refuse to process the loan because it is unsuitable for a person of that age? Last year, I received a phone call from a woman who was very frustrated because she had been trying to get a loan on her home at a major national bank. She had almost paid off a home equity loan on her home, and she wanted another one. Under Texas law she complied with the requirements for a home equity loan. She and her husband had retirement income of over $13,000 a month for life, and they had excellent credit. But the bank wanted to give them a reverse mortgage, which they did not want. And the bank had also asked her why she wanted the money, and when she told them that she wanted to redo her kitchen and give some money to her children, they told her that her children were taking advantage of her and she should not be giving them money.

Now, to the bank, a reverse mortgage seemed to be the most suitable product, since she was in her late sixties and her husband was in his early seventies, but as far as this borrower was concerned, their refusal to listen to her and respond to what she wanted was discriminatory. "I know my rights," she fumed as she recalled her experiences. "The bank cannot make me tell them why I want the money." I assured her that she would not have her privacy invaded. We processed the application, and she closed within 20 days.

But with a suitability standard, who decides whether a product is suitable for the borrower? Does the originator decide and refuse to process the application? Does the underwriter decide and decline the loan because it is not suitable for the borrower? Is there another final person who reviews it to decide whether the borrower has received the right product?

These are serious questions that could ultimately lead to serious law suits and legal problems as borrowers, originators and underwriters fight over who knows best about a person's financial planning and needs. And since suitability is really subjective, one company may feel, as in this case, that the older borrower belongs in a reverse mortgage while another company may feel that they belong in a home equity loan. Does a judge ultimately decide who is right?

What about the person who wants to be on a three year arm because they want a lower interest rate while their kids are in school, but the loan originator knows that a fixed rate is safer. Who is right? Who is going to make the decisions for which the borrower is literally going to be paying every month?

Sen Judd Gregg (R-NH) says in an article published May 24, 2010, "You'll basically have a consumer protection agency which decides to go out in the morning and say 'well everybody who's XYZ should have a loan, even though the local community bank says XYZ shouldn't have a loan, because if we give them a loan, we know they're not going to pay it back.' It's going to become an agency that defines lending on social justice purposes instead of safety and soundness purposes."

There is probably some truth to Gregg's statement, but I think that what we are going to see is a lot of willy-nilly decision making by a lot of different players rather than one set of guidelines equally applied to everyone. And when that happens, both equal credit and equal opportunity go out the window.

Free to Choose: Consumer Advocates Take on the Consumer

When ACORN's chief organizer, Bertha Lewis, speaking to a group of young people, told them that it takes courage to admit to being a socialist, no one in the mortgage community should have been surprised. We, after all, were used to dealing with ACORN and its constant complaints about the mortgage industry and the broker industry. Now ACORN is basically irrelevant--at least for this moment, but many other consumer advocacy groups have a powerful voice in Washington D.C. and they are setting policy which is affecting small business owners today and will affect all consumers of financial products in the near future after SB 3217 is reconciled with the House bill and then signed into law by the president (which is expected to happen by the fourth of July.)

Today I want to look at a study completed by the Center for Responsible Lending entitled "Steered Wrong: Brokers, Borrower, and Subprime Loans," which was published in April of 2008 and can be found on the Center for Responsible Lending's website at responsiblelending.org. I found this 54 page study and its findings fascinating, and I think in light of everything that is happening around us today, the study is worth sharing.

The study, which is filled with official looking charts and graphs and numerous algebraic equations, puts the blame for the mortgage meltdown squarely on the shoulders of mortgage brokers. The Center for Responsible Lending wants us to know that it is not loose lending practices, or Community Re-Investment Acts, or scant oversight of Fannie Mae and Freddie Mac which caused the problems--it was mortgage brokers by themselves, plus nothing.

The study claims that brokers steered borrowers into subprime mortgages who could have qualified for prime mortgages, and in doing so cost them additional fees and higher interest rates which ultimately caused their homes to go into foreclosure. To support this theory, the report cites a study comparing loans of similar interest rates some of which were originated by brokers and others by retail originators. Now, without actually seeing the data and the files themselves, it would be impossible to make a precise comparison, but I can tell you with all certainty that there are reasons besides greed and heartlessness that borrowers used to go to into subprime loans. For example, two borrowers might both have a 660 credit score. One of the borrowers might have this score because he paid a few accounts thirty days late last year, but he now has 12 months of timely payments for all accounts on his credit report. Assuming that his income qualified him for the loan, he could probably get an automated underwriting approval for a prime loan. However, the other borrower might have a 660 credit score because he had a four year old medical collection for $10,000 which he could not afford to pay. This borrower would not qualify for a prime loan even though his other credit might be fine, because prime loans required that collections be paid at closing. (Even at the height of laxness, Fannie Mae and Freddie Mac never allowed unpaid collections over $5000.00.) So that borrower could either wait three more years for the collection to drop off his credit, or he could take a subprime mortgage at a higher interest rate and plan to refinance later. The study does not appear to consider any factors other than just the credit score, the debt to income ratio, whether the loan was considered full documentation, etc.

Nestled in among the charts and graphs are paragraphs editorializing about the role of the broker: "Brokers react to market incentives predictably; they seek to maximize both the number of loans they originate and their revenue per loan. However, since charging too much per loan could drive away potential customers, brokers must find the optimal balance between these two factors. We posit that brokers shift this balance according to their perception of a customer's credit profile." (page 4). "Homebuyers and homeowners have therefore trusted their brokers as mortgage professionals to help them choose a suitable loan. This misplaced trust has likely been a factor in the current foreclosure crisis." (page 5).

The report acknowledges that all states license mortgage brokers and that licensing requirements include criminal background checks, bonding, and educational experience requirements. But, this is not sufficient, according to the report, because "licensing statutes act primarily as enforcement mechanisms for substantive protections but do not actually establish protections themselves." The report fails to mention that retail originators--with whom it compares the brokers--were not required to be licensed at all until the SAFE ACT was implemented. But it asserts that retail originators are more likely to treat borrowers more fairly because of reputational risk and federal and state auditing requirements.

"Importantly, though their customers routinely rely on them as experts to help select lenders and loan products, mortgage brokers often assert that they are independent contractors and not agents of either borrowers or lenders." (page 6) Mortgage brokers asserted that because states like Texas had a form which borrowers were required to sign that said that we were independent agents and not agents of the borrowers or lenders. This form was mandatory in every file, and it was meant to clarify to the consumer the relationship between the broker and borrower. But a very large part of Center for Responsible Lending's hypothesis is that borrowers cannot and should not be trusted to read and understand forms.

The report states that "rational choice theory...assumes that people faced with choices will choose the best option based on their own set of preferences and constraints." However, the Center does not agree. "A 2007 study by Harvard University researchers finds that borrowers have a limited ability to analyze and compare multiple, complex mortgage products. The study finds that the complexity of mortgage pricing hampers both the borrowers' ability to assess risk and to comparison shop."(page 7)

This is reminiscent of the current Assistant Secretary of the Treasury's writings as quoted by Senator Richard Shelby, "Disclosures are geared towards influencing the intention of the borrower to change his behavior; however, even if the disclosure succeeds in changing the borrower's intentions, we know that there is often a large gap between intentions and actions...Product regulation would also reduce cognitive and emotional pressures related to potentially bad decision making by reducing the number of choices." Translation: Consumers can't be trusted to make the best decisions for themselves, no matter how much disclosure they have, so regulators and consumer advocacy must protect the consumer by limiting their choices. And since mortgage brokers represent a "one-stop shop" which offers many choices to borrowers, they are bad.

Now to the fascinating part. According to this study, borrowers in prime loans get a better deal with a mortgage broker than they do with a retail originator. "Finding Four: Prime borrowers who obtained loans from brokers generally experienced no additional costs compared to retail...Generally stronger credit borrowers with brokered loans that carried lower LTV ratios experienced savings compared to their similarly situated counterparts who received retail loans...Table 9 shows that in general, prime borrowers who obtained loans from brokers experienced no additional costs compared to those who received their loans from a retail lender." (page 25).

It gets better. "In six DTI/LTV combinations associated with borrowers with stronger credit profiles (credit scores greater than 720) retail loans are actually more expensive in the higher FICO scores...In fact the one year results displayed in Table 7 show that brokered loans carry lower interest costs to even more subsets of borrowers." (page 25) "Meanwhile, for a few subsets of prime borrowers, brokers seem to deliver some savings, though the magnitude of these savings is quite modest, ranging from $900-$1600 per $100,000 borrowed over the loan term." (page 31).

Wait a minute! Brokers are cheaper on prime loans? Considering that today in 2010 there is no subprime lending, and only prime loans are available, that makes the broker channel the cheapest option for consumers, or in the worst case at least no more expensive than retail options based on the Center's own study. If we are cheapest, doesn't that also make us the best? Why then is Barney Frank calling for death panels for non-depository lenders? And why are all of the recommendations from this report to be used in connection with subprime loans which no longer exist being implemented today as part of financial reform? Why is the word "mortgage broker" almost an obscenity?

Because we repesent choice and personal responsibility. Brokers offer choices, and in a world where borrowers are not trusted to read and understand disclosures and make their own choices, agents of choice must be done away with. The consumer is no longer free to choose and the business person is no longer free to offer choices, because people with choices will sometimes make the wrong ones. But they also have the opportunity to take risks, and to make choices that will move their lives forward.

The Bureau of Consumer Financial Protection's mandate is to give consumer advocacy groups such as ACORN, the Center for Responsible Lending, and myriad other groups who have signed onto Americans for Financial Reform a seat at the table when creating new rules that govern lending, disclosures and policies as it regulates brokers and banks. And since the Bureau's budget is entirely discretionary, they can fund whatever agencies and organizations they like, which means that we might even see a resurrected, fully funded ACORN back in the spotlight.

The Fairness Doctrine Part II

Yesterday's post received an anonymous comment which I thought brought up some very good points, so I wanted to address those in today's post. First, I think my intention in writing as I did was misunderstood. I was not intending to imply that I believe that the rules of underwriting or credit scoring should be tilted in favor of those who have had a rough time in life. I was merely pointing out that bad things happen to a lot of people.

Working in the mortgage industry for 12 years, I have met thousands of people and I have gotten to know them and hear their stories in a way that I would not have in any other profession. And I have met a lot of people who keep their financial lives in a perpetual mess because they choose to, but I have also met people who really have been dealt a bad hand. One reason that a consistent standard of underwriting guidelines which is evenly applied to everybody is critical is that we can't make lending decisions based on emotion, or personality, or likes or dislikes. We have to make decisions about lending based on a set of criteria which is the same for everyone.

The other point that the author made was that I did not define what I meant by fair. That actually set me to thinking, because I had not really thought about all of the nuances of the word's meaning. Growing up, I thought "fair" meant following the golden rule, "do unto others as you would have them do unto you." When I got into the mortgage business, I learned that there is a legal standard for fairness in lending as codified in the Equal Credit Opportunity Act and the Fair Housing Laws. On the wall in my offices, I have a poster printed by HUD which states that "It is illegal to discriminate against any person because of race, color, religion, sex, handicap, familial status, or national origin." This poster, which is required to be displayed in all mortgage lending offices, serves to remind the loan officer and the borrower that all people are entitled to be treated fairly. Tonight I did a quick on line search of definitions for the word "fair." The Encarta World English Dictionary defines "fair" as "reasonable or unbiased; not exhibiting any bias therefore reasonable or impartial; done according to the rules." I think I like that last definition best, "done according to the rules." There should be one set of rules for everyone--evenly applied to all.

However, the point that I wanted to make yesterday was that this is not the definition that consumer advocacy groups have of the word "fair". Their concept of fairness is based on something else entirely.

The first time I attended a legislative conference in Washington D.C. (early spring of 2001) I was very nervous because I was told that the year before activists from ACORN (the Association of Community Organizers for Reform Now) had stormed the conference and protested it saying that all mortgage lenders were a blight on mankind. Long before the rest of the nation was really aware of ACORN's existence, we in the mortgage community knew about them because they constantly fought to destroy mortgage brokers and mortgage lending as it existed in the US. On a google search of ACORN's website, under the Housing Tab, I found posted a list of initiatives which they believe need to be enacted to make lending "fair." Among these is a demand that tax credits for mortgage interest and property taxes be abolished for all but lower income families. We know what ACORN'S ideology is from statements that their Chief Organizer, Bertha Lewis, made in April while speaking to a group of young people, "First of all, let me just say any group that says, 'I'm young, I'm Democratic, and I'm a Socialist is all right with me."

Well, you may say, ACORN has been defunded so it really does not matter what they say. But there are a lot of other groups with the same mindset. A website calling itself Americans for Financial Reform lists links to dozens of organizations which are devoted to seeing financial reform happen. These include various organizations including the AFL-CIO, and AARP and a large number of consumer advocacy groups including the Center for Responsible Lending, which posts on its website a statement supporting Bureau of Consumer Financial Protection as outlined in Senate Bill 3217. The two page statement lists on the first page a breakdown explaining why the Bureau of Consumer Financial Protection will be a wonderful advocate for consumers, and in a box on the bottom of the page it lists some common misconceptions of Bureau. For instance, it says, the Bureau "Won't have unbridled rule-making power. Writes rules, but rules can be vetoed by a 2/3 vote of the newly created council of bank regulators." On the second page of this same document, which was presumably written by the same person or group of people, the document lists Essential Elements for CFPB Success: "Ability to make rules independently. The CFPB [Consumer Financial Protection Bureau] must have the authority to make rules that truly protect the marketplace. Interference by the OCC and banks or disproportionate veto power for regulatory council would compromise the bureau's efficacy. If the legislation authorizes any veto power, it should not allow unlimited discretion, but require any veto to be directly tied to concerns about systemic risk."

Tomorrow we will examine what the Center for Responsible Lending has to say about brokers.

GLC moves to Orkney Street Enterprise Centre

After over a decade on Burleigh Street, Govan Law Centre has relocated two of its offices to Govan's new Orkney Street Enterprise Centre (OSEC), 18-20 Orkney Street, Glasgow, G51 2BZ (view a location map here). All of our telephone, fax and minicom numbers remain unchanged, and any mail sent to our Burleigh Street address will be automatically re-directed.

Orkney Street was orginally Govan's Burgh Chambers in 1867, before serving as the local police and fire station, then as Govan's burgh court, jail with 36 cells and headquarters of Strathclyde Police 'G' Division.  The iconic listed building was redeveloped with a £3.5m budget, led by the Glasgow South West Regeneration Agency, and formally opened by Sir Alex Ferguson in February this year.

OSEC has full conference, business support facilities, and disability access. GLC can be found in Unit 4 and 6.  Unit 4 is a ultra modern open plan office on two levels, with unit 6 hosting our national Education Law Unit, and providing board room/meeting room facilities.  

Tommy McMahon, Chairman of GLC's Board of Trustees said:

"We're delighted with the law centre's relocation to Govan's Orkney Street Enterprise Centre. This development represents a major investment in our service and will enable us to deliver a more streamlined and effective service to our community and clients. Our larger premises also give us the capacity to develop a number of exciting new projects".

GLC 's Principal Solicitor, Mike Dailly said:

"Our new offices present fantastic opportunities to develop all of our services.  Because our partner agencies, including Money Matters Advice Centre are located in OSEC, the residents of Glasgow South West now have one of the best 'one-stop' shops in Scotland. A single visit to OSEC can provide citizens with free legal advice and representation, prevention of homelessness services, money and financial inclusion advice, help and support to get back to work or into further education, and access to social work services.  We aim to co-ordinate all of these services, so citizens in Glasgow South West will only need to make one appointment to receive a holistic, high quality service".

The Fairness Doctrine

For many years I traveled every spring to Washington DC to participate in a grassroots lobby with the National Association of Mortgage Brokers. Before our lobby day came, during which we went up to the Capitol and petitioned our lawmakers about the issues near and dear to us, we sat through a two day conference planned by the leaders of our association, who scheduled training sessions, speeches by various politicians and agency directors, and normally a panel of consumer advocacy attorneys. The panels with the consumer advocates were always the liveliest and most contentious events of the sessions, since the attorneys representing the consumer groups made no attempt to conceal their contempt for us as vile and vulgar capitalist pigs who made our livings by loaning money. (One attorney from such a group drew the wrath of everyone in the room when she cooed condescendingly to us, "I suppose that all of you people here consider yourselves to be professionals.")

On one such occasion we were sitting in a crowded room with a panel of consumer advocates, when one of the female attorneys who was giving us her perspective of how the U.S. credit system should operate made the suggestion, "Wouldn't it be great if everyone could have a 7% rate?" The men in the room (the male attendees way outnumbered the female attendees at conference and they were so loud that a woman could hardly get a word in) immediately shouted from all parts of the room that her suggestion was both impossible and ridiculous. Nonplussed, the attorney stood her ground and just kept raising the interest rate until finally she got to 15%. Wouldn't it be great if everybody could have a 15% interest rate? By now we were all stunned. And then she made her point, "It doesn't matter what the rate is, just as long as it is the same for everyone."

I read a comment recently about the now disgraced ACORN, that said incorrectly that ACORN believed that every person was entitled to a home. That actually is not true. ACORN, and the attorney in my story above, and many of other consumer advocates I met in Washington, did not really want or expect to see everyone in a home. But they were deeply opposed to the credit system in the United States which they perceived was discriminatory.

Enter the new Bureau of Consumer Financial Protection and the Office of Fair Lending and Equal Opportunity. The stated purpose of the Bureau of Consumer Financial Protection is to "implement, and where applicable, enforce Federal consumer law consistently for the purpose of ensuring that markets for consumer financial products and services are fair, transparent and competitive."

While this sounds great on the surface, we have to remember that the credit system in the United States is by its very nature unfair and discriminatory, and that is the reason it works. Now of course, we have Fair Housing and Equal Opportunity Laws which prohibit discrimination against a person on the basis of race, religion, national origin, family status, and sexual orientation and these laws are rightly in place to allow every race, creed, religion, etc. a potential place at the table as homeowners. But beyond these protected classes, the system is a risk based one which discriminates heavily in favor of certain behaviors and lifestyles and against others. Without this discrimination--this risk based analysis of a person's situation--we could not have the credit and mortgage system we have today.

For example, take credit scores. Credit scores were developed in the late 1990's as a means for assigning a numerical value to person's credit history. The credit score enabled automated underwriting systems and opened up credit access at low rates for many Americans by allowing the development of a risk based program of lending which permitted the lender to use a high credit score to compensate for other factors lacking in the file--such as very little downpayment or very little savings. The credit scoring system in the U.S. is unique to us. I attended a workshop given by the FTC while at our legislative conference one year, and they explained to us that most other countries do not have a means of reporting both good and bad credit. For instance at the time that I attended this workshop(which was about 7 years ago) Australia did not have a system for reporting positive credit. The Australian system reported only negative credit, so if you had a credit report in Australia, and you charged off one item, but paid the rest of your credit perfectly, the credit report would show only the negative item and ignore all of the accounts you paid on time. Only the U.S. had a credit system which reflected all of the accounts which you had paid on time, the accounts which were not paid on time, how many open accounts you had, how much total debt was reporting, and used all of this information to formulate a score to determine your credit worthiness.

This system has allowed for a huge growth in access to credit at great terms and low rates, but it is completely discriminatory. A person with a low score is going to receive less favorable terms than a person with a high score. Ironically, since the federal government took Fannie Mae and Freddie Mac into conservatorship, Fannie and Freddie have changed their interest rate offerings to make them score based. A few years ago, if you got an approval through Fannie Mae, you got the same interest rate as any other person who also had the approval, regardless of your score. Today, a person with a 620 credit score will receive a much higher interest rate than a person with a 750 score on a thirty year fixed rate mortgage because of price adjustments for individuals with lower scores. To me, that seems unfair because I remember the system that was in place until very recently. I have talked to many deeply disappointed borrowers who cannot get a 4.875% interest rate on a thirty year mortgage because even though their credit profile is good, their score is too low. Only those with a 740 and above receive the best rates.

The system discriminates in other ways. It favors the salaried over the self-employed. It favors those who save money over those who spend everything they get their hands on. It favors the frugal who work to keep their debt down over those who are maxed out on their credit cards. To the consumer advocates in Washington, this is unfair because everyone should have the same rate, no matter how high that rate has to be. The only way to accomplish this is to either charge everyone a 15% rate, or to use tax dollars to subsidize a 7% rate for those who do not qualify for it. In the first solution, all homeowners are paying to make everything equitable and in the second solution, all taxpayers are paying to make everything equitable. But the government has effectively removed any personal incentive to correct whatever situations exist that cause this individual to be a poor credit risk.

Trying to make the credit system in this country fair is like trying to make life fair--it is just not workable. Experience teaches that most of us do not really want our situation to be fair; we want it to be advantageous. For instance, we may believe that life has been unfair to us if we compare ourselves to our brother who was accepted into Harvard, became a successful neurosurgeon and now has a booming private practice and a summer home in Italy. But we will seldom complain that life is unfair when comparing our situation to that of our sister who dropped out of school at sixteen and now works nights at a convenience store. In the first example, we may spend our lives grumbling that "Fred always got all the breaks," but in the second example we will congratulate ourselves that we were more responsible than Sally. If someone told us that they would magically make our position equal to that of our sibling, we would be busy picking out the curtains for our new summer home if we could be made equal to Fred, but we would protest loudly if we were to suddenly be made equal to Sally.

Our credit system rewards good behaviors, responsible choices, and in some cases good fortune. The system will be kind to the twenty-eight year old woman with the 770 credit score who has never really worked a full day in her life, but holds a great position with her father's company who pays her an excellent salary which he direct deposits into her bank account. Nobody stands behind her as she closes on her $300,000 house with gift money from her parents as a downpayment and says, "Don't give her that loan. Yes she qualifies for it, but only because of her parents and the breaks she had in life."

Likewise, the credit system does not see the life story of the small business owner who never took a vacation or a sick day, paid all of his taxes and was kind to his neighbors, but lost his business during the recession and has seen his house go into foreclosure. The credit system will not differentiate between his plight and that of the compulsive gambler who was foreclosed on because he took the last three months of mortgage payments to place a bet on a "sure thing" at the race track. The system is impersonal, mercilous, and unfair.

However, our system also has built into it a reset button that allows our mistakes to fall off of our credit reports automatically after seven years. The person who has suffered through tragedy through no fault of his own and the chronically irresponsible person who has refused to honor any of his contracts are both afforded this same privilege. This small dispensation of grace means that for each of us, no matter who we are, what we have done, or what has been done to us, we have the ability to make a fresh start if we are willing to change. Come to think of it, that is not fair either, but it is certainly advantageous.

Don't Forget to Bring Home the Bacon

Where would modern government and Congress be without a little pork fat padding the end of every bill? That is the case with SB 3217, where the last nine pages of the 1566 bill create a whole new entitlement.

Now that the Senate bill has moved over back to committee to be reconciled with the House version, plenty of entities and industry insiders are weighing in on the provisions of the new soon to be law. But this final provision is buried so far at the back that it may go almost unnoticed even as we are paying for it.

Entitled Title XII, Improving Access to Mainstream Financial Institutions Act of 2010, the stated purpose of this Title is to, "encourage initiatives for financial products and services that are appropriate and accessible for millions of Americans who are not fully incorporated into the financial mainstream."

Put simply, the purpose of the title is to create incentives for the portion of our culture which does not maintain bank accounts and routinely uses pay day lenders as their money source.

The Act authorizes the Secretary of the Treasury to establish "a multi year program of grants, cooperative agreements, financial agency agreements, and similar contracts or undertakings to promote initiatives designed to:"

1. Enable low to moderate income individuals to establish one or more accounts in federally insured depository institutions that are appropriate to meet the financial needs of such individuals.

2. To improve access to the provision of accounts, on reasonable terms, for low to moderate income individuals.

Further, the Secretary of the Treasury is authorized to establish multi-year programs through grants, contracts, or financial agency agreements, with banks and depository institutions to provide low cost, small loans up to $2500.00 which will be less expensive for consumers than payday loans.

As part of participation in this program, the lending institutions who take part shall offer financial education courses including counseling services, educational courses and wealth building programs to each consumer receiving this type of loan. The cost for this education will be covered through federal grants.

Since payday loans are notoriously high risk and a series of small balance loans which defaulted could wreak havoc on a bank's balance sheet, the Act also creates grants to establish a loan loss reserve fund to offset the costs of the small dollar loan program. This fund may not be used to make loans to consumers, but it may be used to recapture part or all of a defaulted loan under the small dollar loan program.

There will also be grants provided to be used for technology, staff support and other cots associated with this program.

The requirements for these loans is that they shall not exceed $2,500.00, must be repaid in installments, must have no pre-payment penalty, and must be reported as a tradeline by the institution to at least one of the consumer credit reporting agencies.

The Act does not fix a dollar amount on the cost of this program. Rather it says that "such sums as are necessary to administer and fund the programs and projects authorized by this title" are authorized to be appropriated to the Treasury Secretary beginning in fiscal year 2010.

I am not saying that payday loans are the ideal financial instrument, but is it really the responsibility of the Federal Government (aka the American Taxpayer) to provide low interest loans to consumers who have made lifestyle choices that preclude more traditional forms of credit and banking? The same bill that dictates that consumer choices need to be limited in mortgage loans and that creates a huge bureaucracy to supervise how responsible people obtain credit is going to spend as much as is deemed necessary to provide perhaps less responsible people with loans they would not qualify for in a free market.
If that's not pork, I don't know what is.

Who Will Watch the Watchers?

Last night the Senate voted to pass SB 3217, which is being touted as the largest financial overhaul since the Great Depression. The bill now returns to the House to be reconciled with its Financial Reform Bill. The final bill is supposed to be signed by the President before the Fourth of July.

The bill creates a new Bureau of Consumer Financial Protection which has unprecedented authority and power and whose director is appointed by the President. Yesterday we examined the makeup of the Bureau; today we are going to take a look at its power and authority.

The Bureau of Consumer Financial Protection, as we saw yesterday, will have transferred to it all of the consumer financial protection powers of a number of various agencies of the government which allow it to regulate all depository and non-depository financial institutions (for a list see yesterday's post.) Within 1 year after the creation of the Bureau, the Bureau is to issue a rule defining a class of "covered person" who will be regulated.

The Bureau shall "require reports and conduct examinations on a periodic basis" of covered persons for the purposes of "assessing compliance with the requirements of Federal consumer law; obtaining information about the activities and compliance systems or procedures of such a person, and detecting and assessing risks to consumers and to markets for consumer financial products and services." The Bureau's examinations will be based on the Bureau's determination of risks that are posed by certain products; it will take into account geographical areas of the country, how much money the entity being investigated has, the volume of financial transactions the entity is doing, the potential risks to consumers posed by financial products and services, the extent to which they are regulated by the states and other agencies, and any other information which the Bureau decides is relevant.

The Bureau has exclusive rulemaking authority and enforcement authority of its rules. For example, the Bureau can make rules regarding registration requirements for covered persons, and is required to publicly disclose the registration of covered persons to help consumers identify persons and entities regulated by the Bureau. The Bureau can require that covered persons generate, keep and maintain records to help the Bureau assess and detect risks to consumers.

The Bureau can create rules to ensure that covered persons are "able to perform their obligations to consumers." These rules can include requiring background checks for principals, officers, directors or key personnel and requiring bonding or setting financial requirements.

One of the Bureau's first mandates under the bill is to conduct a study of and report back to Congress regarding the use of arbitration agreements governing future disputes between providers of financial services and consumers. Mandatory arbitration is routinely used in the mortgage industry to keep down costs associated with law suits, but the Bureau has been given authority to prohibit or set limitations or conditions on the use of arbitration agreements.

The Bureau has the power to make rules regarding disclosures for any consumer financial product or service. The bill specifically states that one of the first acts of the Bureau is to look at creating a new disclosure combining the good faith estimate and the truth in lending. The Act does not acknowledge that the current good faith estimate, which was just implemented January 1, 2010 at great cost to the entire mortgage industry, was the result of 8 years of study by HUD.

The Bureau can make rules regarding what types of financial products may offered and how they may be sold. The bill makes it "unlawful to advertise, market, offer, or sell a consumer financial product not in conformity with this title or the rules issued by the Bureau." It is also illegal to enforce or attempt to enforce any agreement with a consumer or to impose any charge on a consumer as part of a financial product or service that is not prescribed by the rules issued by the Bureau. All financial activity outside of the scope of the Bureau is illegal, so if you are a person who routinely uses the private money guy down the street to get your financing, be warned.

How is this enforced? Well, remember that the Bureau has supervisory authority over the entire lending community, including the authority to conduct routine examinations and investigations. In case of an investigation of a possible infraction, the Bureau can demand that all "tangible things" pertaining to an investigation be turned over to the Bureau. Each question or reporting requirement which is part of a Bureau investigation must be answered in writing under oath. If the Bureau investigator takes oral testimony, this is also under oath and must be recorded by a stenographer. After the testimony has been transcribed, it must be turned over to a "Custodian" of the Bureau.

A person being required to answer questions of an investigator may have an attorney present during questioning, and the attorney may object to the questioning and a person being questioned may plead the fifth amendment to a specific question; however, the investigator may petition the U.S. District Court to require the person being investigated to answer the question--even questions on which he has invoked the fifth amendment.

After the testimony is transcribed, the person answering the questions is required to sign it. If he refuses to sign it, the investigator signs it with a notation that the witness refused to sign, but that the transcription is a true and correct record of the testimony.

If the investigation determines that a rule has been violated, the Bureau can issue a cease and desist order. A covered person can appeal a cease and desist order, but unless the court specifically issues a stay, the order must be complied with pending appeal.

If the investigation finds that the financial records of the company being investigated are incomplete or inaccurate "so that the Bureau is unable to determine the financial condition of that person" the Bureau can issue a cease desist order or issue an order requiring the covered person to get their financial records up to date in a "complete and accurate state." If the investigator/examiner suspects that the records may not match those filed with the IRS, he is required to send his report to IRS commissioner that an audit needs to be done. (This is not just in case of an investigation of possible misconduct, but it is also mandated during the course of a routine examination.)

The penalties are harsh for violating the Bureau's rules. Penalties include: Rescission of contracts, refund of moneys, restitution, public notification of penalities imposed on violators, and other penalties. "Any person who violates through any act or ommission, any provision of the Federal consumer financial law" shall be penalized based on a Tier system as follows: Tier I not to exceed $5000.00 for each day during which the violation or failure to pay continues; Tier II not to exceed $25,000 for each day of violation or failure to pay and for Tier III fines not to exceed $1,000,000 per day for each violation.

Finally, the Bureau investigators can refer the examination of a covered person to the Attorney General of the United States for criminal prosecution if the investigator feels that such action is warranted.

Who will watch the watchers themselves? Congress and the Senate are creating a mammoth agency with the power to force citizens to give sworn statements to the federal government, to create and regulate financial products, and to decide what we can borrow, what we can pay, and effectively what we as citizens can have and own. To me, that's horrifying.

Big Brother is Watching III

Yesterday the Senate voted not to end debate on SB 3217, which means that interested Americans still have time to call and email their candidates and weigh in on the Financial Reform Bill. We are going to devote today and tomorrow to the specific details of a key provision of this bill: the creation of the Bureau of Consumer Financial Protection. I believe that this will come to be one of the most important, and intrusive, agencies established in the history of the United States. Since SB 3217 gives this agency almost unchecked power over the lending industry and the American Consumer, I think it is wise to look at who they will be and what they will do.

First of all, what exactly is the bureau? Under the provisions of the bill, the Bureau of Consumer Financial Protection will be established within the Federal Reserve System, and it shall "regulate the offering and provision of consumer financial products or services under Federal Consumer financial laws." The Bureau will have a director who will be appointed by the President of the United States and confirmed by the Senate who will serve a five year term. There will also be a Deputy Director appointed by the Director.

Although the Bureau is established within the Federal Reserve, the bill states that "no rule or order of the Bureau shall be subject to approval or review by the Board of Governors [of the Federal Reserve]. The Board of Governors may not delay or prevent the issuance of any rule or order of of the Bureau." Further, the Agency does not answer to any other agency or official in the government as stated on page 1211 (4): No officer or agency of the United States shall have any authority to require the Director or any other officer of the Bureau to submit legislative recommendations, or testimony, or comments on legislation, to any officer or agency of the United States for approval, comments, or review prior to the submission of such recommendations, testimony or comments to Congress," as long as the Director includes a statement that his views and recommendations are his own and not those of the President or the Board of Governors of the Federal Reserve.

The bureau is to be established no earlier than 180 days and no later than 18 months after the bill is enacted into law. If for any reason, all of the provisions cannot be enacted within this time frame, the Secretary of the Treasury may designate a later date with Congressional permission if he explains in writing why the original date is not feasible, why the extension is necessary, and what steps he is taking to make sure that implementation of this act will happen during the extension period.

The new Bureau of Consumer Financial Protection will then take on all of the consumer financial protection functions of the following agencies:
the Board of Governors of the Federal Reserve, the Comptroller of the Currency, and the Office of Thrift Supervision (as an aside, SB 3217 in section 341 halts the office of Thrift Supervision and the Office of the Comptroller of the Currency from issuing any new Federal Savings Association Charters effective the date of the enactment of this bill.) The Bureau also assumes all of the consumer financial protection powers and duties of the FDIC, the Federal Trade Commission, (although the FTC is still allowed to regulate a few select industries), the National Credit Union Administration, and the Department of Housing and Urban Development (HUD). Specifically, the bill takes oversight for enforcing the Real Estate Settlement Procedures Act (RESPA) and the Secure and Fair Enforcement Act (the national licensure for loan originators known by the acronym SAFE) and turns oversight and enforcement of these two Acts over to the new Bureau.

The statute also creates The Office of Fair Lending and Equal Opportunity, which will have whatever powers and duties are assigned to them by the Director of the Bureau. The Office will oversee and enforce Federal laws to ensure, fair, equitable and non discriminatory access to credit, coordinate fair lending and fair housing efforts with the Bureau and other agencies.

The bill gives the Director the Bureau of Consumer Financial Protection a seat as Vice Chairman of the Financial Literacy and Education Commission.

As part of this bill, a separate fund will be established in the Federal Reserve Board, called the "Consumer Financial Protection Fund". All amounts transferred to the Bureau will be deposited into this fund. Any funds that are not deemed necessary for operation of the Bureau can invested by the Board of Governors of the Federal Reserve. The statute creates a separate civil penalty fund for deposits gleaned from Civil Penalties (as as we will see tomorrow, they plan on having plenty of money to invest).

Whom can they regulate? Any organization in the credit business. The current amendments specifically exclude businesses such as dentists, jewelers and the businesses that extend credit as part of selling a good or service that is not credit related. For example, furniture stores would not be covered as the bill is currently written because they offer credit only to enable them to sell the sofa sectional. The bill excludes real estate agents and brokers, manufactured and modular home retailers, and persons covered by state insurance regulators. It also gives the Director of the Bureau power to exempt any class of persons, or service providers, or consumer financial products or services, from any provision of the bill or any rule issued under the bill as the Bureau sees fit.

In addition to all banking entities and credit unions and the few savings institutions that remain, all non depository lending institutions are covered. This includes, anyone who "offers or provides origination, brokerage, or servicing of loans secured by real estate for personal, family or household purposes, or loan modification or foreclosure relief services...or is a larger participant of a market for other consumer financial products or services."

Within 1 year of the enactment of this statute, the Director is to present a list of "covered persons" whom the Bureau will regulate. The Bureau also the power to regulate service providers to any covered persons.

What do they do? The statute gives the Bureau exclusive rule making authority and exclusive enforcement authority over the entities they regulate. Tomorrow, we will look at that in detail.

Big Brother is Watching Part II

One of my favorite movies is The Lost City starring Andy Garcia, which tells the story of the Castro revolution in Cuba through the eyes of a very successful, but non political, nightclub owner in Havana. At a key point in the movie, after the revolution has taken place, the head of the Musicians' Union goes to Garcia's character's nightclub while his staff is rehearsing for the upcoming show. (The nightclub features Xavier Cugat-type dinner shows every evening.) The head of the union informs Garcia's character that saxophones are no longer permitted in the orchestra because saxophones were invented by a Belgian and Belgium represents Western Imperialism as evidenced by their activities in the Congo.

I love the scene because it is a great depiction of what happens when the government starts micromanaging our lives. A prejudice against an ideology can lead to the banishment of a musical instrument.

Unfortunately, we may not be too far away from this kind of micro management in the United States if the government does not start scaling back. The new Bureau of Consumer Financial Protection as it exists in Senate Bill 3217, gives unprecedented powers to one agency of the federal government to control not only the financial landscape of the United States but to dictate what we as individuals can borrow and how we as Americans will be allowed to manage our finances.

I want to begin with a quotation taken from Richard Shelby's (R-TX) website on May 6, 2010, since after reading much of the bill, I believe that his summary of key points does do this issue justice.

Shelby states:

Under the Dodd bill, the Consumer Financial Protection Bureau would issue rules without considering their impact on the safety and soundness of financial institutions. ...Unfortunately, the Dodd bill would create a massive new bureaucracy with unprecedented powers to regulate small businesses and consumers. The Consumer Financial Protection Bureau could dictate exactly what forms businesses must use, who they can provide services to, and how they can sell their products. Control over American businesses would shift from entreprenuers to bureaucrats in Washington.

Perhaps the most troubling aspect of their approach is that it assumes that consumers need benevolent bureaucrats to make decisions for them. In order to make that happen, the Dodd bill authorizes the new Consumer Agency to collect any information it desires.

Small businesses across this country fear the massive and potentially very intrusive new bureaucracy created under the rubric of consumer protection. They have every right to be afraid.

This massive new government bureaucracy has the power to place individuals under oath and demand information about their personal financial affairs. The new bureaucracy is also required to report to the IRS any information it gets that it believes may be evidence of tax evasion.

Why does their new bureaucracy need these incredible powers? Because their bill envisions the Bureau analyzing and monitoring American's behavior and then issuing regulations to stop them from doing things the bureaucrats deem 'irrational' or inappropriate. ...

One of the strongest proponents for the new consumer bureaucracy has been the Treasury's Assistant Secretary for Financial Institutions...Allow me to read into the record a couple of quotes from a paper entitled, "Behaviorally Informed Financial Services Regulation' co-authored by the Assistant Secretary Barr in October of 2008.

The Secretary writes, 'Because people are fallible and easily misled, transparency does not always pay off'...He writes that 'regulatory choice ought to be analyzed according to the market's stance towards human fallibility. Product regulation would also reduce cognitive and emotional pressures relating to potentially bad decision making by reducing the number of choices...Disclosures are geared towards influencing the intention of the borrower to change his behavior; however, even if the disclosure succeeds in changing the borrower's intentions, we know that there is often a large gap between intention and action...'

The Dodd bill fails to take any reasonable steps to hold the Bureau accountable. The Bureau receives all of its funding from the Federal Reserve, beyond both Congressional and executive oversight. The Bureau has complete discretion on how it spends its budget...

For the full text of Shelby's remarks log on to shelby.senate.gov and search for financial reform remarks on May 6, 2010.

Tomorrow's post will examine the make up and authority of new bureau of Consumer Financial Protection taken directly from SB 3217 as it appears in amendment 3739.

Big Brother is Watching

I love reading government bills. I really do, because as I slog through thousands of pages of gibberish, I get a real sense of where we are headed as a country. For instance, take amendment 3739 to Senate Bill 3217. The amendment--which is presented as a replacement for the bill, offered by Harry Reid (D NV) on April 29, 2010, defines its intentions in the first paragraph, "To promote financial stability of the United States by improving accountability and transparency in the financial system, to end 'too big to fail,' and to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes." It is the "other purposes" that really shine through in this 1566 page piece of bloated legislation.

In its first three hundred pages, SB 3217 (as presented in the amendment) creates at least 4 new regulatory authorities. We have the Office of National Insurance which will work with state regulators to oversee all lines of insurance in the United States except health insurance--which is specifically excluded. This office will "receive and collect data and information on and from the insurance industry and insurers, enter into information sharing agreements, analyze and disseminate data and information, and issue reports regarding all lines of insurance except health insurance."

We have the Financial Stability Oversight Council which will be established effective the date of the enactment of the new financial services bill. The Council will be comprised of the Secretary of the Treasury, who will be the chairperson, the Fed Reserve Chair, the Comptroller of the Currency, the Chairperson of FDIC, the Chairperson of the Commodities Future Trading Commission, the director of the Bureau of Consumer Financial Protection, which the bill also creates, the Chair of the SEC, and one other member appointed by the President. The board members will serve six year terms.

We also have the Office of Financial Research, which will conduct research on insured depository institutions (banks) and insurance companies. Section 155 establishes the financial research fund which is to be a separate fund within the United States Treasury. All monies coming into the Office of Financial Research shall be deposited into the fund. Amounts over the amount that the Director of the Office of Financial Research believes are necessary to run the agency may be invested with the consent of the Secretary of the Treasury. Interestingly, the bill states that "Funds obtained by, transferred to, or credited to the Financial Research Fund shall not be construed to be Government funds or appropriated monies." Where is all of this money going to come from? For the first two years, the Board of Governors of the Federal Reserve is to allocate enough monies to cover the office's expenses, but beginning two years after the law goes into effect, the Treasury Secretary is going to establish a schedule of fees for bank holding companies and non bank financial companies. It is interesting that the government is planning its financial portfolio for an agency that does not yet exist at a time when so many Americans can't even find a job.

Moving on, SB 3217, as amended, creates an Orderly Liquidation Authority Panel. The Orderly Liquidation Authority Panel consists of 3 judges from the United States Bankruptcy Court in Delaware. These are appointed by the Chief Judge of the U.S. Bankruptcy Court in Delaware, who is supposed to take into consideration the financial expertise of each judge in making his appointments.

The Orderly Liquidation Authority Panel is designed to speed up the process of getting rid of lenders who could be a danger to society. Here's how it works: the Secretary of the Treasury determines that a financial company is in default or in danger of default. The Treasury Secretary then petitions the Panel for an order authorizing the Secretary to appoint the FDIC as the receiver. The petition is to be strictly confidential--in fact the penalty for disclosing a petition or pending court proceedings is up to a $250,000 fine or 5 years in prison or both. The company in jeopardy is to be notified, and they have the right to oppose the petition. The Panel is to review the Secretary's petition and supporting evidence, which is supposed to be "substantial", that the financial company is in default or in danger of default. Within 24 hours, the Panel is to make a decision about whether to take the company into receivership. The Panel's decision is final, although it can be appealed through the Court of Appeals and within 30 days of their ruling can be appealed to the Supreme Court of the United States if they choose to hear the case. However, SB 3217 states specifically that the Supreme Court is limited in their ruling as to whether the Secretary's determination that the covered financial company is in default was supported by substantial evidence.

The bill states that no stay or injunction pending appeal is possible. If the Panel's finding is that the financial institution must be turned over to the FDIC, there is no recourse.

If the Panel finds that the Secretary of the Treasury did not provide substantial evidence that the financial institution is in danger of default, within 24 hours they are to provide him with a written statement of each reason that it was not supported and allow him to immediately amend his petition and refile.

Creating an enormous bureaucracy and giving Tim Geithner and whoever his successors may be life and death power over financial institutions may be part of the "other purposes" as defined in the first paragraph of the bill, but it certainly is not part of a system which fosters respect for free enterprise and private ownership of business.

Killing Small Business Part II

Last week we discussed how the Merkley amendment kills small business by mandating caps on originator compensation. Today, I want to look at another aspect of the amendment to Senate bill 3217--the part that mandates that all loans must be underwritten to consider the borrower's ability to repay the loan.

Like so many other things that are codified into law, this sounds great on the surface. After all, we all know about the infamous "liar loans" that allowed waitresses with $10.00 an hour incomes to purchase $500,000 houses. So mandating that borrowers need to prove their incomes and be underwritten according to their incomes is actually necessary to prevent another housing meltdown. Right?

Not necessarily. To really understand what mandating that loans be underwritten based on income means, it is important to understand first that this is a moving target. Several years ago, underwriting to full income through Fannie Mae and Freddie Mac meant, for a salaried employee, one paystub and the most recent W2 from the previous year. For a self- employed person with great credit, it could mean the most recent year's tax returns. Many of the low documentation and no documentation programs were credit score driven and designed to help individuals who had the income but could not pass the underwriting litmus test. Today, underwriting standards have tilted dramatically against the small business owner and the self-employed or commissioned individual, making it harder for these people to qualify to purchase or refinance a home.

Let's look at a few examples:

Borrower # 1 has owned his own business for three years. He has exceptional credit (over 750), but when the recession started in 2007, he was one of the first to lose his job, so he took his savings and invested in setting up a business. Year # 1 he lost money. Year #2 (2008 filing period) he broke even but still got to carry forward some losses from the previous year on his income taxes. Year #3, 2009, he made a healthy profit and now six months into 2010, he is realizing a good income. His credit is strong, and he still has some savings. Now, he wants to take advantage of the lower interest rates and falling prices and purchase a new home. His neighbor Fred's sister in law is moving back to town and she needs a place to rent, so he has agreed to rent his existing home to her for 1250.00 a month. Since his escrowed house payment (principal, interest, taxes and insurance) is $1000.00 a month he will have the payment completely covered. Even though guidelines allow the underwriter to use only 75% of the rental income against the escrowed payment, he still has it covered.

Will borrower # 1 qualify? Probably not. Under current guidelines, the underwriter will have to average his income from 2009 and 2008 as reflected on his tax returns. Although he had a good year in 2009, in 2008 he broke even and he had a loss that carried forward from 2007. That will probably be enough to negate his profit in 2009. The income he is currently making won't make any difference--he will have to file his 2010 taxes in order to come up with a better average.

But let's suppose that our borrower made so much money in 2009 that even with averaging the two years together he still has enough income to qualify. Unless he has thirty percent equity in the house he is currently living in he will not be able to use the rent money from his new tenant to qualify--even if the new tenant is prepared to give him a check for the first month's rent before closing. (Some programs also require evidence of two year's experience as a landlord.) In this case, he has to qualify with the full payment on the existing house he owns now and the full payment on the new house he wants to purchase. The 30% equity rule was established about 18 months ago to prevent underwater borrowers who could not refinance from purchasing a new home at a lower interest rate and better terms and then letting the previous one go into foreclosure. But in practice, it can prevent qualified borrowers from being able to buy a home. Since the 30% equity must be established by an appraisal ordered through an appraisal management company by the lender, even if the borrower perceives that he has the equity in the house, that equity can be eaten up by something as arbitrary as a recent low-ball sale of a similar property on the same street. And the borrower, who has already paid for two appraisals, has no recourse unless he wants to start over with a different lender, pay for two more appraisals, and hope for a different outcome. So borrower # 1, who was willing to take a chance during a recession, work hard and build a new business, probably will not get his loan.

Borrower # 2 is a salaried employee, but his wife is commissioned. Together they have decent credit and not a lot of debt. She has always worked for the same company but recently she moved to a different deparment where she has greater earning potential and she went from salaried plus commissioned to purely commissioned. She is currently earning about twice as much as she did last year. They also want to take advantage of the current low rates and buy a house. Will they qualify? Maybe but maybe not. Even though the wife has worked for the same company, she is now strictly commissioned. Her commissions would have to be averaged for two years, and even though she is making much more now than she was making with her salary, the underwriter would not take the previous salary into account--just the commissions. So unless the salaried spouse's income is strong enough to carry the deal, Borrower #2 may not qualify either.

Borrower # 3 is a career federal agent. He has 15 years on his job. His credit is excellent (over 750) and he has job stability and an annual income of just over six figures. Five years ago he got a divorce, and the court awarded his ex-wife child support, which he pays on time. Early last year, he re-married. His new wife has a bankruptcy and a foreclosure resulting from her previous divorce. She owns a deli, which with her child support from her ex was barely enough to keep her alive until she married our borrower. In 2009, they filed a joint tax return and since she is a sole proprietor with a struggling business, she filed a loss on the joint return.

To me, this is the most unfair example of all. Before the new underwriting guidelines went into effect, if you had one borrower with strong credit and stable income and a spouse with terrible credit and no income, you put the spouse with the good credit and the good income on the loan. Texas is a homestead state, so the spouse who did not qualify signed onto the deed of trust as a non-purchasing spouse and had ownership interest in the property, but neither their income nor their credit was considered for a conforming conventional loan.

The current guidelines change that. Even though borrower 3 receives all of his income from his salaried job with Uncle Sam, his new wife's losses from her business must be subtracted from his income even though she is not on the loan. And if he currently owns a home, he must be able to prove that he has 30% equity in the house, or he will have to qualify with that payment also and prove that he has 6 months of principal, interest, taxes and insurance put aside so that he can make the payment on the current home. Further, a 401K or other retirement account no longer qualifies for reserves, because in order to use that money we must have proof that he has actually withdrawn the funds. So even though all three of our borrowers might have put away some money in investments, we don't get to consider that money unless they have cashed out the investment and deposited it into the bank.

The Merkley amendment may sound as though it prevents another financial meltdown, but in reality, all of these new rules overlook the fact that people are individuals with individual challenges and problems. Rather than preventing problems, amendments like this one merely keep qualified, responsible borrowers from buying houses, and slow down the recovery.

Killing Small Business

The past few days have seen the passage of two important amendments to Senate Bill 3217, the Restoring American Financial Security Act, which is currently being debated in the Senate. Both amendments have implications as they relate to small business and the availability of credit for mortgage lending.

The first amendment, the Landrieu (D LA)/Isakson (R GA) amendment, directs financial regulators to create a "qualified" category of mortgage loans which will not be subject to the 5% risk retention requirement of the bill. This is critically important because without the ability to sell mortgage loans into the secondary market, it is not possible to maintain liquidity to originate new mortgages. In simple terms, selling the loans allows the lender to free up cash to make new loans.

The second amendment is not such good news. Jeff Merkley (D OR) sponsored an amendment which was introduced after hours on Tuesday and voted through on Wednesday morning (a maneuver which was obviously intended to stymie industry lobbying efforts.) This amendment effectively caps loan originator compensation at 3% to include all lender fees and up to 1% of the insurance charged by State and Federal Entities (for example the FHA premium to which we devoted our last two posts). This is also significant, because the federal government, rather than competition and free market conditions, are regulating the compensation of individuals who work in lending. No longer will it be legal for loan originators to receive compensation based on the interest rate of the loan, unless the consumer is charged no other fees whatsoever except for third party fees such as appraisal and title insurance.

The loan does allow bonus and incentive payments to loan originators who produce volume loans.

Interestingly the wording of the amendment specifically states that nothing in the bill shall limit the compensation that the lender can make when they sell the closed loan on the secondary market. This compensation is also based on the interest rate. This is one sure and quick way for banks to shore up their reserves. The spread on interest is a function of the market, and for virtually any interest rate there is some cost or some gain. So a law which makes it illegal to share the gain with the originator allows the bank to keep the money which it can apply directly to its bottom line.

This idea of limiting compensation may sound good to many people who have heard horror stories of greedy lenders who devoured helpless victims' equity from their home loans, but in reality it is just another federal intrusion into the market place. As an active originator for the last twelve years, I can speak to the fact that competition is a better tool for getting consumers into good loans than government supervision. A good example is what has been going on this past year and a half. With interest rates at historic lows ranging from 4.5% to 5.25% on thirty year fixed rate loans, borrowers have watched the market carefully. They have looked at the internet and watched the news, so when the rates go down in a day, they hear about it. Before the new RESPA reforms went into effect, we were able to offer no origination fee loans because we got paid on the spread of the money. (We cannot do that under the new rules because all lender fees including any lender compensation through the rate must be included in the origination fee). Competition kept the costs and the interest rates reasonable for most borrowers, because they were able to shop for a lower rate. And competition forced originators to keep the interest rates they offered and the fees they charged in line with the local market. After all, who is going to take a 5.125% interest rate if all of their friends got a 4.75% and they find out they could qualify for a 4.75% as well. And while the government bemoans loan originators who overcharged, the truth is that originators who overcharged too much lost the transaction and didn't get paid at all.

Small businesses are not charitable organizations. They have high overhead, employee expenses etc. With recent rulings determining that all loan originators must be W2'd by their employers and stating that loan originators are legally entitled to overtime pay, it is increasingly difficult for the small business owner to compete. Merkley's newest amendment basically means that an originator will be able to make about 1% on a loan, if he is lucky, after he pays the lender fees and the title escrow fee, the attorney's fees and up to 1% of any federally mandated insurance. By the time he splits his portion with his employer, he will barely have the money to pay his own mortgage. All of which spells fewer people working in the industry, fewer choices for consumers, and ultimately higher prices as a multi-trillion dollar industry becomes concentrated into fewer and fewer hands.

Senate Bill 3217 is expected to pass next week, and then the House bill 4317 and the Senate version will have to be reconciled. The House version does not contain the qualified loan exemption to risk retention, so it is going to be very interesting to see how this shakes out in the end. In the meantime, those of us who heard Barney Frank's warning that he would have death panels for non-depository lenders are getting our blindfolds ready to face the firing squad.

Call for Scottish register to create an inclusive and accessible pool of pro bono legal talent

Pro bono work offers a "huge width of potential" to help those excluded from legal services, the Lord Advocate said today. Elish Angiolini QC gave the keynote address at a conference hosted by her in the Scottish Government offices, entitled "For the Public Good: The Future of Pro Bono Legal Services in Scotland". 

The Lord Advocate told the conference that Scottish lawyers "have a long tradition of working to ensure that people are treated fairly and have their rights respected. The unfortunate reality, however, is that there are many people who cannot afford legal advice when they need it".

Speaking at the conference, Govan Law Centre's Principal Solicitor, Mike Dailly, made a call for a national, free, online pro bono Scottish ''register' to collate who was free to volunteer, the skills set they had, and which organisations had vacancies, and what skills they were looking for.  GLC believes that no one body should have a monopoly on co-ordinating or delivering pro bono work. Scotland needs an inclusive system whereby any advice agency, firm or local charity could tap into a pool of legal talent (which should include retired lawyers, practitioners and law students). GLC believes the Law Society of Scotland is best placed to provide this online, free, co-ordinating service in the public interest.

GLC also renewed our call for a proper Scottish public legal education strategy to empower citizens with self-help remedies; and tackle scam artists, which include all too many claims management companies (currently wholly unregulated in Scotland).  A key priority for GLC was the need to focus on public interest casework in Scotland: to undertake legal work and research that could change the legal landscape, and improve the lives of the Scottish public, particulary those on low and modest incomes and those subject to discrimination.

GLC congratulated the Lord Advocate for taking the lead in Scotland on the development on pro bono legal services.  The contribution from GLC's Mike Dailly is available online here.

David Stevens, FHA Commissioner, Responds

Yesterday's post was about HR 5072 sponsored by Maxine Waters, (D CA), which is entitled "FHA Reform of ACT of 2010".

A few hours after I posted this blog, I received the following email from FHA Commissioner David Stevens:
"There is a huge factual error in this. The current premium is 2.25% up front and .55% annually. Under the legislation, FHA will have the authority to raise the annual higher but as stated the fees will be changed as follows: the upfront will drop from 2.25% to 1% and the annual will go from .55% to .90%.

The trade off is easier for the market by lowering the upfront it impacts initial equity less and the trade off is the increase to the annual.

The blog below has missed the actual proposal as I testified to in committee and as Ms. Waters would state as well."

After receiving Mr. Stevens' email, I re-read the text of HR 5072. The text of the bill as it reads states that the annual premium is being increased from a maximum of .55% to a maximum of 1.55% so I emailed him back promising to make note of his comments in today's post and asking him for clarification on this point. He responded "The 1.55% is simply to get room for the many years to come without ever having to go back to Congress."

The text of the Congressional bill does not reduce the up front MI--it says nothing about this whatsoever. So I did some additional research.
The testimony that Stevens refers to in his above email is written testimony which he provided to Congress on March 11 which can be viewed by going to hud.gov and then clicking pressroom tab. In this testimony he states, "The increased presence of FHA and others in the housing market, including Fannie Mae and Freddie Mac, has helped support liquidity in the purchase market, helping us ride through difficult times until private capital returns to its natural levels." How increased? We noted yesterday that FHA had 2% market share in 2005. In Fiscal year 2008, according to Steven's testimony, FHA insured over 1.1 million single family loans, and this number was about three times what they had insured in 2007. In 2009, FHA insured about 2,000,000 homes. So the growth has been huge, which has caused a decrease in FHA's Congressionally mandated reserves.

In 2008, as part of the Housing and Economic Recovery Act, Congress authorized FHA to raise the upfront MI to a maximum of 3%. In January of 2010, FHA issued a mortgagee letter which increased the upfront MI to 2.25% and this went into effect with loans with FHA case numbers issued after April 5. As part of his testimony, Stevens presented Congress with the proposed FY 2011 budget, and the budget which has been proposed does call for lowering the upfront MI to 1% for fiscal year 2011 and raising the annual MI, which is paid as a monthly fee by the borrower, to .90%. The testimony contains a chart to show how this would affect the borrower's payment. For a purchase price of $176,000, under the current MI structure, the loan amount would be $169,840.00, the loan amount with current upfront MI at 2.25% would be $173,661, the principal and interest would be $986.00, the estimated PITI (principal, interest, taxes and insurance) would be $1360.00 and the PITI plus FHA premium would be $1434.00. (All of the loan examples on the chart assume a 5.5% interest rate.)

The new plan proposed for the 2011 budget shows that for the same sale of $176,000, with a loan amount of $169,840.00, the loan amount with the upfront MIP at 1% would be $171,538.40, the principal and interest would be $974.00, the PITI would be $1348. and the PITI plus the FHA annual premium would be $1475.00, which is an increase of $41.00.

Remember that these changes are not written into the law. They are proposed budgetary changes which are in the new budget for 2011 which has been submitted to Congress. These changes would undoubtedly be implemented by a new mortgagee letter (a mortgagee letter is the means by which FHA announces and implements policy changes). The Housing and Economic Recovery Act, combined with HR 5072 gives FHA the authority to raise the up front MI as high as 3% and the annual MI as high as 1.55% if they choose to exercise those options in the future.

Stevens asserts in his testimony that one reason for the proposed changes is to bring FHA's pricing more in line with private mortgage insurance companies and "enable robust competition."

At the end of the day, robust competition is the only thing that is going to keep prices down and get the real estate market back on track. At a time when about 50% of new home purchases are FHA or government loans, there is just too much strain on a system that was never designed to be the primary lender for all Americans.

Justice for Scotland candidates elected; please grant a proxy vote in favour of SLAS

John McGovern, solicitor-advocate and President of the GBA, Walter Semple, solicitor and GLC's Principal Solcitor, Mike Dailly have all been elected to the Council of the Law Society of Scotland in the Sheriff Court District of Glasgow and Strathkelvin.  Together with past GBA President, David O'Hagan, solicitor, they represent a strong contigent against the external ownership and control of law firms in Scotland, and the need for progressive Law Society reform.  The full results are available here.

GLC's Mike Dailly said: "I would like to thank all of the Glasgow solicitors who voted for me.  I will work with my colleagues to deliver progressive reform in the interest of the Scottish public and their independent solicitors and law firms. If any Glasgow solicitor wishes to raise any law society or justice related issue with me you can e-mail me on councilmrd @ gmail.com (with 'council' in the subject line) and I will do my best to try and help".

"Together we have already changed the Law Society's policy on 100% external ownership.  Together we can go further. There is a growing consensus for a compromise position of capping non-solicitor ownership at 25%, but requiring those non-solicitor professionals to be working within the firm, and providing a service incidental to the work of the firm.  This would mean Scottish law firms remained independent, Scottish, law firms. If you want to support this reasonable compromise position please grant a proxy in favour of the Scottish Law Agents Society.  A proxy form can be downloaded here (opens as PDF)".

The papers for the forthcoming AGM of the Law Society of Scotland are available online here.

Every Loan a Government Loan Part II

In an earlier post this week, we talked about the explosive growth of FHA loans. Five years ago, FHA had about 2% of the market. The reason--it simply was not competitive. FHA was expensive for the brokers and required a down payment for the consumer whereas other products on the market did not. Also FHA upfront premiums and monthly premiums did not compete well with free market products like My Community Mortgage and Emerging Markets programs which required no down payment and had lower cost mortgage insurance than other conventional loans. At one point, it looked as though FHA was about to join the dinosaur and the dodo bird on the extinct species list.

What a difference five years makes. Recent statistics published in the Scotman's Guide (a trade publication for industry professionals) indicate that FHA and government loans comprise 50% of new purchase loans. The reason--today FHA and other government loans are basically the only game in town when it comes to low down payment financing. FHA still allows a 3.5% down payment (which is up from 3% in the past), while most conventional loans require 5-10% down payment, and 20% is better. So a government product that could not compete with free market products five years ago now has no competition.

FHA reminds us that they have insured approximately 37,000,000 loans since the program was established in 1934. For a program that is 76 years old and has seen one of the biggest real estate booms in history, that number should be larger. And even David Stevens, the FHA commissioner, admits that the FHA program was not designed to handle the volume it is handling today and that free market solutions are needed so that FHA can go back to normal levels of lending. The volume of loans going through is simply a strain on the reserves--which are Congressionally mandated. But in lieu of free market solutions, FHA is raising prices.

In January, FHA raised the Up front Premium for borrowers from 1.75% to 2.25%. For a borrower buying a $200,000 house, the financed MI premium went from $3500.00 to $4500.00. Since this figure is spread out over the life of the loan, consumers don't feel it so much, but they are still footing the bill for restoring the financial health of FHA. Now, with Maxine Water's (D CA) new bill, HR 5072, the FHA Reform Act of 2010, consumers are looking at another increase, and this one they will feel more directly. HR 5072 raises the monthly MI premium from .55% to 1.55%--almost three times what it is today. And since the monthly MI is paid, well, monthly, consumers are going to feel this much more directly in their wallets.

Let's look at an example. For the $200,000 loan that we just mentioned, the current MI premium is $91.66 per month. If the increase is approved, the premium will be $258.00 per month. That is a $166.00 increase in the consumer's payment. To put it into perspective, for a $200,000 loan with a 5.25% interest rate fixed for thirty years, the consumer's principal and interest payment would be $1104.41. Under the current MI percentage, the payment with MI would be $1196.07. The payment with the new percentage would be $1362.41. These payments do not include taxes and insurance, which would be required escrows for FHA. In addition to costing the consumer more, this large an increase can actually prevent some consumers from qualifying for a loan.

This is just simply a case of what happens when competition disappears. When consumers have only one option, prices go up. To get prices down, we need competition. David Stevens has asked NAR, the National Association of Realtors, to have all of their members lobby on behalf of HR 5072. I believe that rather than lobbying for higher premiums to help FHA increase its reserves, NAR and all consumers need to be lobbying for reduced regulations and incentives for private market solutions so that more loan options can be introduced into the market. This will take the strain off of FHA and the consumer.