Will Proposed Reforms in Lending Work?

New Yorker Cartoon Satirizing Wall Street’s Opaque Securitization Chain

Over the last few weeks, considerable reforms have been proposed in the world of mortgage financing.  The most salient has been Iowa Attorney General Tom Miller’s proposal that would, among other things, require banks to terminate foreclosure proceedings while borrowers are actively pursuing a modification.  While Miller’s ideas seem both necessary and commonsensical on the surface, they have run into criticism from all ends of the political and economic spectrum.  The critics, from various vantage points, ultimately posit the same inquiry: will the reforms work?

On one hand, critics from the left argue that the reforms do not go far enough. In a staff editorial a few days back, the New York Times vigorously puts forth this contention, expressing concern that the terms of the reform will provide the banks leeway to avoid the kinds of strong penalties they deserve.  In particular, the Times cites the fact that the proposal does not proffer a way to implement reforms.  Moreover, Miller and his fellow attorneys generals have discussed the possibility of a settlement over the banks illegal practices, like the infamous robo-signing scams and systemic predatory lending—which may function as a prosecutorial shield.

The Times’ also cites a review of the proposal by their staff writer, Gretchen Morgenson.  In addition to outlining the overhaul’s lack of sufficient legal remedies for borrowers, Morgenson also points out what in her estimation appears to be yet another substantive flaw:

the terms severely disappoint in their treatment of second liens, a major sticking point in many loan modifications. The proposal would treat first and subsequent mortgages equally, turning upside down centuries-old law requiring creditors at the head of the line to be paid before i.o.u.’s signed later.

Treating holders of first and second liens alike is a boon to the banks, since so many second mortgages are owned by the nation’s largest institutions; many of the firsts are held by investors in mortgage-backed securities. The banks want the first mortgages to take the hit, leaving the seconds intact. Or at least for them both to share the pain equally.

To some degree, the document presented by Mr. Miller raises more questions than it answers.

As news of the proposal’s substance continues to rapidly unravel, a few thoughts come to mind.  While the proposal is a much needed step in the right direction, it does not seem to address the institutional nature of predatory lending.  We now know that the aggressive marketing of bad loans to uninformed consumers morphed into a systemic problem largely as a result of a perverse incentive structure.  As we’ve outlined in many previous posts, main street banks often possessed an incentive to dole out non-prime loans because of a pervasive securitization chain that linked borrowers, lenders, investment banks, and investors.

While consumer protection reforms are needed, no doubt, attorneys general would fundamentally benefit from a regulatory infrastructure at the federal level that addresses the securities market.  The Frank-Dodd Bill is a start, but as John Cassidy recently pointed out in his much talked about New Yorker article a few months back, asset-backed securities have become the heart of the financial industry, implicating average Joes and Wall Street investors alike.  Without financial regulation that adequately integrates consumer protection measures, Miller and the rest of the state’s attorneys will not gain the legal leverage they need to stymie the broken lending processes that have afflicted far too many of their constituents and thus may be forced to make concessions.

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