Paul Wylie’s Blog

Much attention has been directed toward blaming the players in the real estate meltdown. Mortgage brokers are blamed for providing borrowers who, in reality, were unqualified to repay many of the loans. The government is blamed both for failing to regulate the industry and for interfering with the industry in a “half pregnant” manner. The lenders are blamed for predatory lending. The rating agencies have come under scrutiny for providing an investment grade on almost any loan originated. And homeowners are blamed for jumping in way too fast and getting way over their heads in debt.

Yet real estate agents have categorically escaped scrutiny.

The time for blame has come and gone. Today’s crisis now begs all players—including real estate agents—to stop pointing their fingers at others and start pointing their thumbs at themselves, asking: What can we do to help cure the crisis or, at a minimum, prevent a similar reoccurrence as the worm turns ?

As the legal fiduciary of the buyer, real estate agents can help their clients by adopting a “clients for life,” relationship-based, best-practices model. Rather than treating home buying as a transaction experience, real estate agents can counsel buyers and sellers about market trends. Had realtors sat down their clients in recent years and explained that the drastic upswing in home prices was a statistical anomaly based on historic metrics in relationship to median income, rental rates, and interest rates, the agents likely would have lost several sales. However, by maintaining a commitment to full disclosure, they would have turned many one-time clients into clients for life. And they might have prevented more than a few folks from making life-altering mistakes.

A commitment to financial literacy must come from all players across the board, especially those of us who have knowledge, access to relevant data, and a duty to inform. This collaborative alignment of interests will do more to cure the financial meltdown than any bailout package or regulation could hope to do.

Thank you,

Paul Wylie

Please visit http://www.paulwylie.com

In the wake of the mortgage meltdown, many pundits are calling for more regulation of the lending industry. But a better approach would be based on economist Adam Smith’s concept of the Invisible Hand. In his 1776 magnum opus, The Wealth of Nations, Smith described the ability of a free market to correct for seemingly disastrous situations with little government intervention. In other words, the market will correct itself when left unfettered.

While painful, the recent housing crisis could provide an important lesson: an unregulated market allows individuals and companies to learn from their mistakes and apply a deeper and more disciplined approach to financial matters. Instead of creating an entitlement system whereby homeownership is granted to everyone simply for participating, we could use the lessons from the mortgage meltdown to reestablish a strong system of meritocracy, which is the only way to sustain a high quality of life in the face of increasingly competitive global markets.

Some media outlets and the general public are pointing to the mortgage meltdown as evidence of the free market’s pitfalls, saying that more regulatory measures are necessary to prevent future bubbles. But regulations are at least in part responsible for the meltdown.

Let’s take a look at two examples:

1. Not content to let the market sort itself after the dot-com catastrophe, the Feds made it cheaper and cheaper to borrow money in hopes that they could stave off the worst of the bubble burst. The easier and cheaper it was for banks to borrow money from the government (the federal funds rate was as low as 1 percent), the easier and cheaper it was for lenders to loan money. The easier and cheaper it was to borrow, the more buyers appeared in the market. More dollars competing for the same homes equaled asset inflation.

2. Augmenting matters, the government implemented and facilitated programs to make it easier for low-income borrowers and people with poor credit scores to buy homes. Considering very high homeownership part of its responsibility, the government created initiatives that allowed almost anyone to own a home without having to work as hard as previous generations to purchase it. Banks were (and still are) subject to the Community Reinvestment Act, which requires banks to extend credit to underserved populations. This initiative purports to make homeownership affordable to low-income populations. In other words, it forces banks to make loans available to people who cannot always afford them.

Making matters more confusing, the long-arm of the government extends to touch Fannie Mae and Freddie Mac, government-sponsored entities that are vital to market liquidity and the homeownership process. These hybrid entities are both public and private, which means they must compete in a capitalist system while still adhering to governmental bureaucracy. So when Congress ordered Fannie Mae and Freddie Mac to provide loans to previously underserved borrowers, they had no choice but to extend trillions of dollars of loans to people who would have not qualified otherwise.

The government even went so far as to guarantee some of the loans, which meant lenders faced less risk and were increasingly willing to lend money to otherwise-unqualified borrowers. Because the buyers were often exempted from down payment requirements, they faced little risk and were willing to finance increasingly expensive homes. Again, more dollars competing for the same inventory of homes translated into asset inflation.

These government interventions contributed to a cyclical craze whereby prices inflated drastically, which meant more borrowers entered the market, which drove prices even higher.

This wild asset inflation led to an additional problem: speculation. With housing prices rising rapidly, investors wanted to enter the action, contributing their own dollars to the competition and further driving up prices.

With prices rising so quickly, lenders perceived little risk: if the buyer ultimately cannot afford his mortgage, he can just sell it for a profit, thought the lender. Lenders made increasingly risky loans. Buyers, too, perceived little risk, and they applied for loans that far exceeded their budgets.

This is how the bubble was created. And when it burst, it was a giant explosion: not only did asset inflation skyrocket so severely that even the most brash lenders and buyers were no longer willing to get involved, but at the same time, all those people who could not afford their loans stopped making payments, putting their homes on the market, only to discover their homes were priced too high to sell.

Had the government applied true laissez-faire capitalist ideals, the Invisible Hand would have created a system of checks and balances. Afraid of losing money by lending to unqualified borrowers, lenders would have created strict guidelines to prevent low-income borrowers and people with poor credit histories from obtaining loans they could not or would not pay back. And borrowers, required to make down payments, would have been cautious about their investments.

Some people want government to create more regulation in an attempt to solve the very problem to which it contributed. But the best role for the government is to police and enforce existing laws, not to create unnecessary and addition layers of regulation. We seem to have forgotten this: while the government adds more and more costly regulations, the FBI is under-resourced to investigate real estate and mortgage fraud that is still growing and unfolding before their eyes!

Subsequent programs to regulate lenders and bail out borrowers will only succeed in keeping affordable housing out of the reach of potential homebuyers. In the meantime, many deserving borrowers will continue to suffer through this crisis. Other borrowers will simply walk away from their obligations, leaving banks and lenders with little or no recourse.

The “meltdown” is not an example of the free market’s failure. It is the Invisible Hand’s way of restoring balance in the wake of unnecessary government regulation. And if the government lets the Invisible Hand handle the process, prices will fall to a level that the market determines is affordable, and lenders will start to see property values stabilize or rise. Eager to protect their principal and learn from their mistakes, they will make more rational lending decisions, such as requiring a down payment to ensure that borrowers can actually afford the mortgages they take on.

And the government can focus on its job: enforcing the existing laws to protect borrowers and businesses from fraud and other criminal behavior.

Paul Wylie

Please visit http://www.paulwylie.com

A colleague of mine recently received this email:

My wife and I are thinking about doing a “buy and bail.” We can’t justify paying a $440,000 mortgage when our house is now worth only $240,000. We have found some homes in our neighborhood selling for $200,000, and we’d like to walk away from our current home and get into something more affordable. We aren’t worried about our credit (our credit reports are both spotless).  Forget all the moral issues: what are the ramifications to this?

These are the ramifications:

1. First and foremost, the moral issues cannot be put aside. A fully capable couple merely feels inconvenienced to honor its legal and moral obligations. The couple doesn’t feel like paying. Unlike a predatory lending situation in which the couple did not understand what it was signing, this couple is engaging in predatory borrowing.

This couple has a “heads-I-win-tails-you-lose” mentality. The couple seems to have signed its loan documents with this in mind: If our investment is good in the first few years, we will pay our obligations, but if not, we will walk away.

What if people who bought stock using their credit cards were required to pay their bill only if the stocks went up in the first few years? Obviously, this would be unacceptable. The credit card company is merely acting as a facilitator between the borrower (stock buyer) and seller (stock). Why should it suffer losses because of the borrower’s investment choices?

Yet when it comes to home loans, this attitude has become socially and politically acceptable, as though banks that fully disclosed their terms on government-mandated forms were at fault when, in fact, they were merely acting as facilitators.

2. When borrowers do not honor their commitment, taxpayers pay part of the borrowers’ bill. In an effort to keep operating at a profit and serving their customers, lenders are forced to recover their losses somewhere or close their doors. In this case, as in most cases, the losses affect hardworking and honest taxpayers in the form of higher interest rates and fees.

3. Because of people like this, Freddie Mac, Fannie Mae, and private mortgage companies have tightened the requirements for borrowers who want subsequent mortgages for homes in the neighborhood in which they currently live. To be approved for a subsequent mortgage in the same neighborhood, a borrower needs a larger downpayment and at least 25 percent equity in the first old home. As well, the borrower has to qualify for the second home without using any rental income on either home. This means fewer transitions, which further depress values for deserving people.

4. This sort of behavior not only hurts the economy, but it also hurts the country’s psychology by promulgating a society in which integrity and honor are options of convenience and neither expected nor required.

5. The borrowers’ children, who watch their parents walk away from their responsibilities, will never learn financial responsibility or integrity.

6. Fortunately, there is some justice in this. Though the couple might think its spotless credit will be affected only minimally, it might want to think again Aside from a bankruptcy, a foreclosure is the single worst thing that can happen to a person’s credit score. Husband and wife might have spotless credit now, but after a buy and bail, their credit scores will be much lower than necessary to receive the best interest rates on subsequent loans or credit cards. If they plan on buying anything with credit in the next seven years, their payments will be higher due to the foreclosure. According to a report by William Hillestad, founder of Everyday Wealth, a weak credit score costs an average of $287,000 over a lifetime. And Philip X. Tirone, author of 7 Steps to a 720 Credit Score, says a poor credit score can cost a person $212,040 in extra interest payments over the life of a 30-year, fixed-rate loan.

Paul Wylie

Please visit http://www.paulwylie.com

Much emphasis has been placed on the responsibility of lenders and the government to regulate the mortgage industry, but consumer advocate groups, mortgage industry regulators, and the government have not focused on the individual’s responsibility to be financially literate.

And yet, financial literacy trumps regulation any day of the week. (If regulation could effectively control the markets, communism would have prevailed over democracy.) Imagine how different our market would be if companies, municipalities, lenders, and borrowers were more knowledgeable and aware of financial matters before signing on the dotted line. Regardless of whether they were rich or poor, borrowers would have made informed decisions about the loan products they were using, and this would have gone a long way toward minimizing the real estate crisis.

Instead, regulators and borrowers alike seem to think a set of disclosures alone is enough to constitute an informed decision. Case in point: the newly proposed HUD RESPA Reform mandates lengthy generic disclosure scripts to be read by the closing agent during closing. This is not only too little and too late, but it also places responsibility on the wrong party.

Financial literacy is not the simple transfer of knowledge via disclosures. Rather, financial literacy is marked by an individual’s ability to make appropriate decisions when managing finances. Financial literacy is an individual’s commitment to be informed, aware, and responsible of the possible risks of a transaction, as well as a commitment to own the costs of the risk just as a borrower would own the proceeds of the risk.

Though financial literacy is primarily an individual’s responsibility, it can be promulgated by the government. I applaud the steps the federal government has recently taken in this area—educational materials produced by the federal government are readily available for free online, in print, or on a CD. But this alone is not enough to create a community of financially literate borrowers. Let’s start with an aggressive federal campaign in our public schools. Just like JFK started the Official U.S. Physical Fitness Program, so could our government encourage an attitude of financial literacy in today’s students (and tomorrow’s borrowers).

And finally, let’s use this housing crisis as a catalyst for shifting awareness. No one knows a borrower’s financial situation better than the borrower. As such, it is incumbent on the borrower to embrace financial literacy as a necessary component of making an informed decision before accepting a loan.

-Paul Wylie

Please visit http://www.paulwylie.com

Mortgage product “suitability” is a topic that has surfaced often over the last year as more and more borrowers have become delinquent and are defaulting at high levels. Delinquencies and defaults are higher on “non-traditional loan products”. “Non-traditional “ can mean any loan product other than a fixed 30 year or 15 year fully amortized loan with full documentation and a down payment provided by the borrower. Currently some states and certain federal regulations currently impose partial responsibility on lenders’ shoulders.

I believe all loan products are potentially good loan products in the right hands much like a chainsaw is a good tool in trained hands and potentially very destructive in a child’s hands. “Non-traditional loans” have risk and potential reward. The question remains who best can determine “suitability”. The borrower, the lender, or the government?

In the world of investments, in particular with riskier investments, the federal government has established income and/or net worth that the investor certifies prior to being allowed to make certain high risk investments. This process defines a high risk investment, qualified investors, and requires the investor to certify their qualifications. This simply standardizes what a high risk investment is and who can make it. The same could be done for residential loans.

Thank you,
Paul Wylie

Please checkout http://www.paulwylie.com