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Wednesday, September 05, 2007

The mortgage crisis: what to do, what not to do

Searchlight Crusade has an important post on the mortgage crisis, and USA Today's short-sighted suggestions to fix it. It seems the editorial writers at USA Today lack even the most basic understanding of economics. Their suggestions of allowing judges to freely change mortgages, to give the bank hundreds of thousands of dollars of losses by fiat, really should have been rejected by some editor's smell test.

The situation we're in now all comes down to saying "Putting your financial well-being on a risky mortgage that only pays off if housing prices increase considerably over the next two or three years is foolish." It's just like saying "Investing in an unproven tech stock at an inflated price is foolish."

But consider many people, me included, would have said the same thing about housing back in 2004, and tech stocks back in 1998. And people investing in both would have seen their investment pay off, big time.

Now, I have some common-sense suggestions that, while not helping people who foolishly entered mortgages they couldn't later afford, would help people understand the risks they voluntarily undertake.

1. Illustrations

Let's start by adopting a requirement seen in insurance. An insurance product called universal life insurance was created in the 1970's and 1980's, when it was both technologically feasible and a marketable product. Universal life insurance has unbundled the product's mortality, expense, and interest components, and when interest rates were high, the product looked quite impressive, even reaching a point where you wouldn't have to pay premiums because the interest on the policy's cash value exceeded the costs. Unfortunately, that required double digit interest rates to continue. Now, insurance products like these require illustrations, showing the product's cash value under current assumptions, and the worst-cast scenario showing the less-favorable guaranteed assumptions.

It's not a perfect analogue, but you could show any mortgage product's payment schedule, principal/interest split, and outstanding debt by month under current assumptions, assuming ten-year average mortgage rates, assuming twenty-year average mortgage rates, and under an arbitrary higher interest rate. Let homeowners see the jump in payments with an interest-only mortgage, or see how much payments will rise if mortgage rates go to 10%.

2. Plain English documents

You can describe mortgages in plain English, and make that description the first thing people sign.

3. Audio records during the signing

We have the technology to record mortgage brokers or bankers explaining the mortgage, and homeowners acknowledging they understand what they're signing. I'm sure a fair number of the people now complaining about how they were misled once said, "Hey, I'll just refinance this $450,000 mortgage in two years, when my house is worth $600,000, and lock in a fixed rate then. What could possibly go wrong?"

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