Tuesday, December 4, 2007

Predatory Lending Laws- a HORRIBLE idea

After months of deliberating over what, if anything, to do about the large number of defaults in the subprime industry and the lax lending and borrowing standards that led to them--the House has passed its answer: The Mortgage Reform and Anti-Predatory Lending Act of 2007. But while this bill purports to foster a well-functioning mortgage-market in which borrowers get affordable loans, it attempts to do so by making life impossible for lenders.

The bill tells lenders they may not engage in the undefined practice of "predatory lending"--examples of which include vague offenses such as offering loans that are not "solely in the best interest of the consumer" or offering loans that a borrower does not have a "reasonable ability to repay."

Since the bill offers no clear standard of a "reasonable ability to repay" or the "best interest of the consumer," if it is passed, lenders could be held liable for any loan a borrower fails to pay off. All an irresponsible borrower or unscrupulous lawyer needs to do is convince a jury in hindsight that the lender should have known better--and he can cash in at the lender's expense. To compound the injustice, the new law would apply, not only to those who initiate loans that fail, but to any financial institution that buys and pools loans made by others (a practice that makes possible better risk management and lower mortgage rates).

If you were a mortgage lender facing this sword of Damocles for any loan that goes bad, what would you do? Exactly what mortgage lenders will do if this legislation passes: jack up rates to account for the high risk of lawsuits--and likely avoid lending to higher-risk candidates altogether. Is this going to protect the lower-income home-buyers that "predatory lending" opponents claim to treasure? Is this going to yield a well-functioning mortgage market?

This bill is so bad that even many of the congressmen who voted for it acknowledge that it has problems. But, in the words of Rep. Spencer Bachus, R-Ala., they believe "we need not let the perfect get in the way of the good"--"the good" here being some kind of government crackdown on mortgage lenders to prevent the lending and borrowing practices that have caused lenders to lose billions and borrowers to lose their homes.

But no government crackdown is needed to promote borrowing and lending that allows lenders to make a profit and borrowers to keep their homes. If the market is left free to function, participants learn from their mistakes and adjust. By the nature of the mortgage market, it is both in lenders' long-term interest and borrowers' long-term interest for loans to be paid off. That's how lenders profit and borrowers keep their homes.

When bad loans are made, both borrowers and lenders are punished--and must correct course. Observe that Wall Street financial firms and direct lenders who engaged in lax lending are suffering huge losses (such as Merrill Lynch's $8 billion loss) and internal upheaval--and have changed their practices accordingly. The number of subprime, adjustable-rate mortgages has declined by 50% this year. As for the middlemen who tried to make (and often succeeded in doing so) a quick buck on dubious loans, their reputations are sullied and their business has dried up.


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