Should Banks Be Protected from "Predatory" Consumers?

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It’s being said that Washington should create a Financial Product Safety Commission (FPSC) because consumers need to be protected from predatory lenders as well as themselves.  Some advocates of an FPSC regard households as the easy prey of lenders looking to slip exorbitant fees and unfair terms into mortgages and other financial contracts.  Others believe many consumers are unable to make prudent decisions, as some households take on more debt than is sustainable, or select specific products that are not suitable for their income or age profile. 

There’s no denying that some mortgage borrowers were misled into agreeing to exotic adjustable mortgage terms they didn’t understand.  Likewise, there are many households than ran up credit card debt balances due to unclear finance terms and misleading balance transfer offers.  Yet, the more researchers learn about the excesses of the financial bubble period, the less evidence – on a comparative basis – there is to support the assumption that consumers were myopic or uninformed.  In many cases, the evidence suggests that consumers knew precisely what they were doing, and were exploiting a dysfunctional credit allocation system – one in which the myopic, uninformed behavior was more prevalent among lenders than borrowers. 

A 2009 research paper looked into a sample of mortgage foreclosures in Southern California from 2005 through 2007.  Far from ratifying the presumption that information asymmetries allowed financial firms to take advantage of consumers through the marketing of products they did not understand, the researchers found that mortgage borrowers were the ones exploiting the system.  As housing prices in Southern California rose, borrowers extracted their equity by taking on additional mortgage debt, either through home equity loans or by refinancing their original mortgage with a new, higher balance.  For example, if house prices rose 20%, a household that originally bought a house for $300,000 with a $270,000 mortgage (90% loan-to-value ratio, or LTV) could maintain the same leverage by refinancing into a $324,000 mortgage and receiving $54,000 in cash (excluding transaction costs).  If house prices later fell by 32% – as the Case-Shiller index estimates has been the case nationally since June 2006 – the house would be worth only $245,000, which would be about $80,000 less than the outstanding mortgage balance.  Since mortgages are non-recourse loans, the homeowners could walk away from the mortgage and the lender would have no claim against them (and that $54,000 in cash) beyond assuming the property in a foreclosure proceeding.

Data from Southern California show that from 2002 to 2006, foreclosed property owners invested $262 million in aggregate down payments but had mortgage debt at the foreclosure date of over $2.256 billion.  After accounting for initial mortgage terms, this means that home equity loans and mortgage refinancing allowed these foreclosed property owners to extract nearly $2 billion in cash from their properties.  This translates to an annualized gain of 40% on their initial investment.  At the same time, total lender losses on these mortgages are estimated to be nearly $1 billion, which works out to an average loss rate exceeding 40%.  While lenders were far from blameless in these losses, it’s also clear that borrowers engaged in their own form of “predatory” behavior.  

A 2007 Federal Reserve working paper coauthored by Chairman Alan Greenspan found a similar trend throughout the nation.  Drawing on regional data, the paper estimated that “home equity withdrawal” through refinancing and home equity loans exceeded $1 trillion in 2005 and 2006.  Much, if not all, of the collateral used to secure these loans was illusory, as home prices in many areas have returned to 2004 levels.  The International Monetary Fund’s Financial Stability Report, released in early October, estimates that $419 billion of the $1.025 trillion in total U.S. banking system losses will come from residential mortgages, much of it from second liens and refinancing that took place in the 2005-2007 period. 

Instances of confusion among consumers are not hard to find.  But systematic study of actual foreclosures demonstrates that many consumers were consciously gaming the mortgage market as home prices rose.  Some of them clearly “lost,” and are now paying the price.  But even bigger losses were incurred by the equity investors of financial institutions that funded these mortgage loans, as well as the taxpayers who had to bail out those institutions.  Instead of latching on to popular, media-driven narratives of consumer predation, policymakers would be better served focusing on the fee-based lending myopia, lack of market discipline, and corporate governance problems that led so many institutions to fund so many of these problematic loans.