FRB: Federal Reserve Bank of San Francisco - June 16, 2006 - Transcript

Building Sustainable Homeownership:
Responsible Lending and Informed Consumer Choice

Federal Reserve Bank of San Francisco
101 Market Street, San Francisco, California 94105
June 16, 2006

Agenda | Transcript

Pages 1-25 | 26-50 | 51-75 | 76-100 | 101-125 | 126-150 | 151-175 | 176-200 | 201-225 | 226-250 | 251-254

Transcript	Line	Page
Yet as we look at -- if we look at a distribution	1	26
where we can get access to distributions of the	2	26
nontraditional product, particularly as they're sold into the	3	26
secondary market, we see in many cases -- I don't say that	4	26
we've seen every, but in a number of cases, we see that the	5	26
interest only or the low doc loans tend to correlate with	6	26
higher credit scores and either low or the lowest of the	7	26
loan-to-value ratios, which would suggest that there's a	8	26
significant element of consumer choice in that as opposed to	9	26
steering.	10	26
And yet, as I listened to you, it sounds as if you	11	26
are suggesting that the differences in price may work	12	26
exclusively disadvantageously to the less informed borrower.	13	26
Would you just clarify that?	14	26
MR. LEONARD: Well, I think both can be true	15	26
actually. I mean, I think it is, on the one hand, true that	16	26
more informed borrowers are making savvy decisions about	17	26
managing their own finances, selecting the products that are	18	26
best for them.	19	26
I think our concerns are really about the less	20	26
informed borrowers, folks who don't really understand the	21	26
complexities of the process, and particularly in the role of	22	26
brokers in selling these products, that the products may not	23	26
meet the best needs of the least informed borrowers, that	24	26
they may be least informed and least able to negotiate	25	26
products that might be available but that they are not aware	1	27
of, and that there are -- that these can be presented in ways	2	27
that appear to be advantageous to the borrowers but, in fact,	3	27
may not represent their best financial interests.	4	27
MR. OLSON: You -- I interrupted you as you were	5	27
about to make some suggestions. You talked about using the	6	27
unfair and deceptive authority. You talked about	7	27
suitability. You talked about changing of incentives to	8	27
brokers. Were there others that you -- other suggestions	9	27
you --	10	27
MR. LEONARD: No, those were the three primary ones.	11	27
MR. OLSON: Those were the three. I suspect we'll	12	27
have a chance to get back to those.	13	27
MR. LEONARD: Okay. Good.	14	27
MR. OLSON: I don't know if the FTC has held a	15	27
similar hearing. That's where we -- a lot of the activity	16	27
that takes place is an -- a lot of the mortgage activities	17	27
and institutions that are primarily regulated, not	18	27
exclusively but by the FTC.	19	27
Kevin --	20	27
MR. LEONARD: Just as a point of clarification, FTC	21	27
did host a forum in late May on these products.	22	27
MR. OLSON: They did. Okay. Good.	23	27
MR. LEONARD: They did, in Washington I believe.	24	27
MR. OLSON: Okay. Kevin, let's come back to one	25	27
point that you -- as you pointed out, we had some discussion	1	28
when I testified at -- on Monday on this issue about	2	28
expanding HMDA reporting. And let me state my concern. And	3	28
then I would be interested -- or our concern. And then would	4	28
be interested in your response.	5	28
I think as everybody here knows, HMDA -- the HMDA	6	28
reportable data is -- has been the location of the property,	7	28
the dollar amount of the loan, the date of the loan --	8	28
actually not the date of the loan. It includes income of the	9	28
borrower and now it is expanded also -- and the race of the	10	28
borrower. Now expanded to include loan pricing.	11	28
In research that we have done, the Fed has done, 90	12	28
percent of the mortgages issued are unique, which is to say	13	28
it's the only loan of that dollar amount made in that	14	28
geo-code area, probably a census tract, that year, by that	15	28
institution. So it would be relatively easy to through	16	28
cross-references with public records find out the name of the	17	28
person.	18	28
If we were to add other personal data to it, there	19	28
is an enormous privacy issue that is raised, number one.	20	28
Number two, credit scores are a purchase product and	21	28
increasingly financial institutions are using proprietary	22	28
credit scores. So there is an apples and oranges issue	23	28
there.	24	28
But I -- and then even so you -- in our experience,	25	28
in order to make a decision on whether or not a loan is being	1	29
made in equal terms, you need probably as many as 30 data	2	29
points. And you can get those only from a credit file. You	3	29
cannot get them from HMDA data. You cannot even get them	4	29
from a downloading typically of the front end system of a	5	29
mortgage originator.	6	29
So I know that you folks have thought this through,	7	29
the trade-off between what information you put in the public	8	29
domain and the important privacy implications.	9	29
MR. STEIN: Okay. Thank you for the question. And	10	29
if I may, I just wanted to add a bit to the prior question	11	29
just quickly.	12	29
This idea that we have savvy consumers that are	13	29
choosing these new products, just three things I'd say. One	14	29
is you may know the Consumer Federation of America did a	15	29
study recently where they called into question whether the	16	29
nontraditional products are really going to folks with higher	17	29
incomes and higher credit scores.	18	29
And secondly, we've seen such an explosion of these	19	29
products -- and I don't know if -- I mean, are we to assume	20	29
that we just have an exposition of more informed consumers	21	29
that are seeing the need for this product?	22	29
I think the product is being pushed more heavily,	23	29
and that I think is -- and to the third point, we're seeing	24	29
anecdotally a lot more evidence of people who have these loan	25	29
products and have no idea what they're getting. So we see a	1	30
lot of -- we see a big -- kind of a mess in this market.	2	30
On the point about HMDA, I appreciate the concerns	3	30
about privacy. And I guess I would say just generally that	4	30
it's interesting and a bit frustrating because the Fed has	5	30
been good about requiring more data to be included, and while	6	30
we keep getting more and more data, in a way what we hear	7	30
from the industry is that the data is somehow less and less	8	30
meaningful, which is -- which doesn't make sense.	9	30
If we have a HMDA statute and a reporting	10	30
requirement and the idea is to help us identify	11	30
discrimination, then we should make sure that the HMDA	12	30
regulations and reporting requirements get us to that paint.	13	30
If there are -- and I think the folks at the Fed are	14	30
probably a lot smarter about this than I would be. But if	15	30
there is no way to require -- to require more data and	16	30
maintain the privacy of consumers, perhaps there's a way to	17	30
require the data to be reported and to have -- and not	18	30
necessarily have all of it be made public.	19	30
MR. OLSON: That's exactly -- that's exactly what	20	30
happens now. And that's exactly what we examined for. And	21	30
so -- but what the -- the difference is it happens in the	22	30
examination process but not in the information that's	23	30
publicly available.	24	30
MR. STEIN: Well, I note that in the analysis that	25	30
was put out with the release of the 2004 HMDA data, maybe	1	31
there's some analogy that the researchers did look at the	2	31
what we think of as the other CRC data, which is that private	3	31
database. And we had some questions about the validity of	4	31
doing that, to look at a private database to try to overlay	5	31
some of the additional information that's not available	6	31
through HMDA.	7	31
And perhaps if there was public reporting -- if	8	31
there was a reporting requirement that applied to all	9	31
financial institutions where the government was the receiver	10	31
of the information and we could have government researchers	11	31
looking at that, at that information, that would I think be a	12	31
better -- a better way to go than what we saw in 2004.	13	31
MR. OLSON: Rick, the -- talk about these	14	31
experiences -- these issues again. And the next two are both	15	31
lenders and it will be very interesting. How -- you folks as	16	31
lenders are clearly aware of these issues. The way -- the	17	31
additional complexity puts an extra burden on a responsible	18	31
lender.	19	31
Let's get the fundamental issue on the table.	20	31
There's some bad actors out there. There's no question about	21	31
that. We didn't invite any of them to speak here.	22	31
MR. LIEBER: They probably wouldn't have shown up.	23	31
MR. OLSON: But there are.	24	31
So in your case, you look at that information	25	31
asymmetry if you will. And it starts either -- it starts	1	32
either when you're working with -- through brokers if you're	2	32
doing so or when people come in the door and then -- and then	3	32
let's -- at some point let's compare your sale, for example,	4	32
to what we're hearing about the -- you must be picking up	5	32
anecdotally what's happening with the push marketers who are	6	32
operating in quite a different way. So would be interested	7	32
in hearing your perspective.	8	32
MR. LIEBER: Well, one of the key things that I	9	32
think works to the benefit of IndyMac for the consumer is	10	32
that we only have one origination process that handles both	11	32
non-prime, prime, and our alternative products. So that a	12	32
loan that comes to us goes through actually our automated	13	32
engine and the engine determines the best product and all	14	32
products available to that consumer. So I think that's a	15	32
major benefit for us.	16	32
MR. OLSON: Say that again because I think that	17	32
that's -- it sounds like you're -- that you are -- that your	18	32
process automatically or in an automated fashion generates	19	32
that analysis.	20	32
MR. LIEBER: Correct.	21	32
MR. OLSON: So describe the -- describe it again.	22	32
MR. LIEBER: Sure. It's an automated engine. And	23	32
whoever our customer is, whether that would be a consumer	24	32
directly or a mortgage banker or broker, will submit the loan	25	32
request. We'll actually pull the credit report and, based on	1	33
that information, give the borrower the best product and the	2	33
best pricing available.	3	33
Or stated another way, you can't say, "Hey, I want a	4	33
non-prime price because I think, as the broker, I will get	5	33
more money as a result of that." So if a borrower has prime	6	33
characteristics, they will get a prime loan through our	7	33
system. And I think that's a key advantage that we've got in	8	33
our methodology.	9	33
And we certainly are in the mortgage business for	10	33
the long-term, as is World and other major players, and we	11	33
don't want to make loans to borrowers that they won't have	12	33
the -- that won't serve their best interests. But I agree	13	33
with you there are some bad actors in the industry that are	14	33
causing problems for everybody.	15	33
MR. OLSON: Bruce, you -- World is known as a	16	33
portfolio lender.	17	33
MR. FULLER: Right.	18	33
MR. OLSON: Not -- are you exclusively still a --	19	33
MR. FULLER: Yeah, 99 percent.	20	33
MR. OLSON: Okay. And for those -- what that means	21	33
in broader terms is that when you -- when you make a loan,	22	33
you take full responsibility for it for as long as that loan	23	33
is in your portfolio.	24	33
MR. FULLER: Right.	25	33
MR. OLSON: So you also said that you have been	1	34
doing option ARMs, if I understand, since 1981?	2	34
MR. FULLER: Right.	3	34
MR. OLSON: One of the -- one of the criteria that	4	34
we use -- that the regulators use to evaluate credit risk	5	34
exposure is we ask them to test it through the cycle. What	6	34
that would mean would be through a cycle, typically an	7	34
economic downturn through the full cycle and through an	8	34
interest rate cycle.	9	34
FULLER: Right.	10	34
MR. OLSON: Well, you -- since 1981 you have been	11	34
through several --	12	34
MR. FULLER: Right.	13	34
MR. OLSON: -- cycles. So could you describe what	14	34
your experience is through interest rate upturns over that	15	34
period of time, recognizing, I'm sure, that you are dealing	16	34
with much smaller numbers in prior cycles.	17	34
MR. FULLER: Right. Sure. Thank you.	18	34
So on your first point, as far as a portfolio	19	34
lender, you're right. One of the major differences with us	20	34
is we basically obviously have a large skin in the game.	21	34
So it's -- I think a lot of what we hear or some of	22	34
what we hear the problem is is essentially someone trying to	23	34
put someone in a loan that the goal is that they can't make	24	34
the payment.	25	34
If we do that or any portfolio lender does that, we	1	35
lose also. So obviously we have to be in a situation where	2	35
we -- it works for the borrower before it works for us. And	3	35
we spend a lot of time making sure that that happens.	4	35
As far as the cycles go, you're right that we have	5	35
been through -- as a portfolio lender doing it for 25 years,	6	35
we've been through a number of cycles. And basically what we	7	35
found is if you structure the product correctly -- and we can	8	35
have discussions of what we think that is -- what happens is	9	35
the product works so that when rates go up, the person's	10	35
payment goes up some but they're allowed to defer some	11	35
interest to essentially not have a payment shock, to be able	12	35
to ride it out.	13	35
And then generally because there are cycles,	14	35
interest rates move back down and that's when they pay the	15	35
loan back down. And obviously individual consumers choose	16	35
different methods. Some will pay more at other times than	17	35
others.	18	35
But generally what we're looking for is a product	19	35
that we know there's cycles and it will work through the	20	35
cycles and we won't have a product where there is short	21	35
periods of time, like you're referring to, Paul, where, hey,	22	35
over a two-year period, if it's going to blow up, that	23	35
doesn't work for someone.	24	35
You have to have a product that's going to work for	25	35
the customer over a long period of time when rates have gone	1	36
up and down. And that's the way our product has worked in	2	36
both rising and falling interest rate environments in the	3	36
past.	4	36
MR. OLSON: Then what -- my father, I remember the	5	36
first time I -- second time I took out a mortgage loan, he	6	36
reminded me that I was -- any increase in equity through	7	36
appreciation of the house was speculation, that equity in a	8	36
house came through reduction of principal.	9	36
What do you find -- what happens to reduction of	10	36
principal for the interest only product or the all -- the	11	36
alternative payment products relative to the -- to the fixed	12	36
amortization products?	13	36
MR. FULLER: Right.	14	36
MR. OLSON: Rick, I'd be interested in your comment.	15	36
Either -- both of you, please. Not at the same time.	16	36
MR. LIEBER: Might be challenging.	17	36
I think the first point, Governor, is the average	18	36
loan is actually outstanding today for only about three	19	36
years. And borrowers refinance for a variety of reasons,	20	36
other than they move or they refinance for other features	21	36
that they want to change in the loan. It could be lower	22	36
interest rate, it could be other payment flexibility.	23	36
So the point of that is on a conventional mortgage	24	36
loan, the amount of amortization that is seen in its normal	25	36
life is very modest, is on -- on a typical three-year loan,	1	37
it actually works out to be a little less than three percent	2	37
at today's interest rates. So the equity appreciation	3	37
through amortization is really quite modest in the average	4	37
loan life today.	5	37
And I think we -- we all acknowledge that in the	6	37
history of the United States, or certainly the recent	7	37
history, home prices have gone up dramatically. But even if	8	37
you look back at a much longer period of time, home prices	9	37
have had a nice consistent growth that probably exceeds three	10	37
percent.	11	37
So the equity that would be gained in home price	12	37
appreciation would typically exceed the equity gained through	13	37
the amortization.	14	37
MR. FULLER: I would just add to that I think that	15	37
what we've seen recently at least is that people -- consumers	16	37
want to use their equity and what they're looking for is	17	37
what's the way they're going to use it. Some people use it	18	37
through their equity line of credit, some people use it	19	37
through deferred interest mortgage. And so it's kind of how	20	37
they want to use it.	21	37
Now, what we also see is every borrower is	22	37
individual obviously. We have some borrowers who -- we have	23	37
programs that pay down your equity even faster than normal	24	37
and some borrowers choose those or choose more -- to make	25	37
more than the minimum payment. Other borrowers want to use	1	38
their equity, whether it's through an equity line of credit	2	38
or through a mortgage.	3	38
And I think what we try to emphasize is the	4	38
availability to do that but also a product structure with a	5	38
payment discount that's not too deep that if someone does pay	6	38
the minimum, they're still okay, that that buildup won't be	7	38
too fast to where they're going to run into a payment shock.	8	38
MR. OLSON: Jack, Sandy, or Leonard, questions?	9	38
MS. BRAUNSTEIN: Yeah, I have a couple questions.	10	38
One of the things, you know, that we've heard over	11	38
and over again about these products and that we see are the	12	38
complexity of the products. And I know, you know, even	13	38
looking at them myself, it gets rather daunting and confusing	14	38
because of constant change in terms and payments and interest	15	38
rates can rise and then if you're interest only you might end	16	38
up with negative am on some of these products.	17	38
So I was wondering what do you do -- okay. To add	18	38
on to this, which is pointing a finger at ourselves, frankly	19	38
our TILA disclosures are not the most enlightening products	20	38
in the world for a consumer. So besides the TILA disclosures	21	38
that I'm sure you're giving regularly to be in compliance	22	38
with the law, what do you do to make sure consumers that are	23	38
getting these really understand the implications of these	24	38
products, you know, where their payments could go, the kind	25	38
of payment shock issues and other things? What do you do?	1	39
Do you have something supplemental to that?	2	39
And then I would ask -- and I'm asking the lenders	3	39
that for their products. But then I would ask Kevin and Paul	4	39
what they're seeing from consumers.	5	39
MR. LIEBER: One of the things we've done is develop	6	39
what we think is a very solid disclosure, particularly for	7	39
option ARMs.	8	39
And we first acknowledge mortgages can be quite	9	39
complex. The basic concept is simple, somebody is lending	10	39
money in return for somebody paying it back over a period of	11	39
time with an interest rate. That's the very simple part.	12	39
But I acknowledge it gets very complex, very	13	39
quickly, and there are lots of features. Most of those	14	39
features -- I think actually all the features are designed	15	39
with the best intent to help consumers gain flexibility and	16	39
have more opportunity. But they are complex.	17	39
In the case of option ARMs, one of the potentially	18	39
more complex products, we've developed what we think is a	19	39
very solid, plain English disclosure that goes through the	20	39
key terms of the product and makes it very clear at the	21	39
outset that in -- in the case of an option ARM, the reason a	22	39
borrower would take that product is solely for the payment	23	39
flexibility.	24	39
And then make it very clear that your loan balance	25	39
can rise, and will rise, if you make that minimum payment,	1	40
and that at the end of the loan, certain loan terms, if you	2	40
reach the maximum of the amount the balance is allowed to	3	40
increase or certain time-based periods, you will have an	4	40
increase in the payment.	5	40
So we work very hard to make that clear. We've gone	6	40
beyond just the legalese or the simple -- not simple but the	7	40
requirements regulated so that the borrower can be educated.	8	40
And we've tried to make it simple and --	9	40
MS. BRAUNSTEIN: Is this something you give to them	10	40
in addition to the required TILA disclosures?	11	40
MR. LIEBER: We do. We give it to them after --	12	40
soon after the application process.	13	40
MS. BRAUNSTEIN: After their application?	14	40
MR. LIEBER: Correct. Before they close the loan.	15	40
And before they're at the closing table as well where it may	16	40
be too late.	17	40
MR. FULLER: So we have what we referred to as	18	40
deferred interest disclosure, which is similar to what Rick	19	40
talked about, where we're laying out what the terms are, what	20	40
kind of deferred interest they should have and things like	21	40
that. And we follow through with that with the borrower also	22	40
and have gone through those steps.	23	40
Now, obviously, as we've discussed, I think another	24	40
disclosure goes so far -- another key point is is the lender	25	40
reputable? Is the product good? You know, is it something	1	41
we're going to make sure works for the borrower?	2	41
You know, so we do a strong job in trying to make	3	41
sure the disclosures are accurate and are clear and concise	4	41
and highlighted and they know the key points, making sure	5	41
they don't get buried in the paper.	6	41
But I think, in general, in the market we also have	7	41
to try and figure out for lenders who may not want to do that	8	41
how are we going to deal with this?	9	41
MR. LEONARD: I think I have four things on this	10	41
one. One is -- I mean, I would go back and not -- I mean, I	11	41
think that the great -- perfect disclosures would be great	12	41
and are never going to happen, number one.	13	41
Number two, I think it's really about the role of	14	41
regulators in determining reasonable and responsible	15	41
underwriting standards, which I know you are taking a look at	16	41
now, and applying them in a rigorous way across the entire	17	41
lending industry, through FDC authority or -- and we would	18	41
hope that you would issue mandatory regulations rather than	19	41
voluntary guidance on these matters, or in addition to	20	41
voluntary guidance I should say.	21	41
Third, there has to be some establishment of real	22	41
fiduciary responsibility of brokers, that brokers are right	23	41
now not accountable enough in this process. And we've seen	24	41
it time and time again in a number of instances across the	25	41
country where -- particularly an example recently in	1	42
Montgomery county of the discussion about implementation of a	2	42
local fair lending law that was to take effect and where we	3	42
saw that retail lenders were staying in -- were staying in	4	42
Montgomery county at imposition of this new fair lending law,	5	42
but lenders were pulling out -- who were relying on their	6	42
brokers were pulling out of Montgomery county.	7	42
So the brokers are not really accountable in this	8	42
process. And they're the ones who are really sort of at the	9	42
front lines of what, Governor, you referred to as this	10	42
knowledge asymmetry. And I think unless there's a clear	11	42
fiduciary responsibility that's established that there will	12	42
always be knowledge asymmetries.	13	42
MR. OLSON: Let's stick with that. But they're also	14	42
at the front edge of the push marketing.	15	42
MR. LEONARD: Uh-huh.	16	42
MR. OLSON: And there is a limit as -- there are	17	42
limits to regulations, in particular, or laws that can catch	18	42
up with a rapidly moving marketplace.	19	42
MR. LEONARD: Yes.	20	42
MR. OLSON: And especially when you see	21	42
overwhelmingly societal value -- I would -- if you care to	22	42
challenge this presumption you can -- overwhelmingly societal	23	42
value in more money being made available to more borrowers.	24	42
MR. LEONARD: Correct.	25	42
MR. OLSON: So number one, how -- what are you folks	1	43
doing also to help bridge that information gap or to alert	2	43
people to some of the risks of being in that marketplace in	3	43
the front end?	4	43
MR. LEONARD: I think two other points. Suitability	5	43
standard to make sure that there is some screen that applies,	6	43
that is in federal law that applies, to make sure that -- as	7	43
in the securities industry -- that a product is reasonably	8	43
advantageous to the borrower. That would help.	9	43
And finally, I can imagine some kind of a	10	43
third-party mechanism and structure being put in place that	11	43
borrowers can reasonably turn to to sort of -- who have more	12	43
informed -- more knowledge and have no skin in the game, as	13	43
it were, to turn to -- to get assistance and guidance through	14	43
the process.	15	43
And right now we have a -- we have a federal housing	16	43
counseling program under-funded, not utilized, certainly not	17	43
utilized for the vast proportion of loans that are made, and	18	43
I could imagine the creation of some substantial expansion,	19	43
public interest campaign, 1-800 numbers for people to know	20	43
that they can call and review the characteristics of a loan	21	43
with somebody who is seasoned and understands the dynamics of	22	43
the mortgage marketplace and can give them an independent	23	43
third-party review as to whether that loan is a suitable loan	24	43
for them.	25	43
MR. CHANIN: Paul, let me follow up on that and then	1	44
we'll let you get off the hot seat if you will.	2	44
And the suitability issue or fiduciary obligation,	3	44
et cetera, is something that has come up at some of the other	4	44
hearings as well. And my question is when ARMs came out I	5	44
guess a couple of decades ago, there was certainly concern.	6	44
The agencies adopted a number of regulations, disclosures to	7	44
address those. There was great concern on the part of	8	44
consumer groups. There was fear the consumers would not	9	44
understand these.	10	44
But now it seems that with these products, there has	11	44
been a shift away from trying to, if you will, educate	12	44
consumers, trying to improve disclosures, and saying that	13	44
there's something, at least implicitly, something	14	44
fundamentally different about these, so that people have	15	44
suggested imposing a suitability requirement.	16	44
And is there a fundamentally different market in	17	44
place now than, for example, a decade ago or why -- why is	18	44
there that push now to --	19	44
MR. LEONARD: Well, I think that what you've seen in	20	44
the mortgage market is a much greater awareness of predatory	21	44
lending as a systemic problem that has played itself out.	22	44
The large wave of state laws has only happened since the late	23	44
1990's. In North Carolina, home of my organization, we were	24	44
involved in passing that law in 1999.	25	44
I think the second thing that's important to point	1	45
out is by and large, and certainly here in California, the	2	45
introduction of new and innovative products into a	3	45
marketplace that has not been tested through the cycle.	4	45
We've been in a largely up-cycle over the last -- over the	5	45
entire period in which most of these products have emerged.	6	45
So I think there is some differences in the	7	45
marketplace. And I think the pace -- the pace and the	8	45
introduction of these products, the increasing aggressive and	9	45
corporate as larger national chains who are -- institutions	10	45
who are involved in this, more aggressive push marketing	11	45
systemically, I think all of those things raise the stakes	12	45
for borrowers who are least able to and least well-informed	13	45
in the mortgage marketplace.	14	45
MR. RICHARDS: Rick, you mentioned relatively short	15	45
life of a mortgage loan. I wanted to ask the panel at large	16	45
about prepayment penalties, how frequently they're imposed,	17	45
how complex they may be, whether you see them more often with	18	45
certain types of loans, and what risks might be involved.	19	45
MR. LEONARD: I'll take that one.	20	45
MR. LIEBER: All right, Paul.	21	45
MR. LEONARD: We have worked very hard to	22	45
substantially limit or eliminate prepayment penalties for	23	45
subprime mortgages. We're particularly concerned in this	24	45
context where there isn't asymmetry between the payment reset	25	45
date and where the prepayment penalties will extend beyond	1	46
the initial prepayment reset date, where borrowers are	2	46
trapped either way, that is, they -- if they refinance before	3	46
the reset date, they're having to pay a substantial	4	46
prepayment penalty. And if they -- otherwise they're	5	46
faced -- facing a payment shock that they can't really	6	46
afford. So they're losing out either way.	7	46
They are extremely prevalent particularly here in	8	46
California where we see roughly 70 percent of the subprime	9	46
market having prepayment penalties. They're particularly	10	46
problematic here in California because they are tied --	11	46
they're tied to the interest rate of the loan. And they're	12	46
usually six months -- six-month penalty on 80 percent of the	13	46
unpaid balance.	14	46
The correlation with the interest rate means that	15	46
the borrowers who are paying the highest rates also pay the	16	46
highest penalties. And we think that is -- that is really	17	46
problematic.	18	46
MR. LIEBER: And we certainly believe prepayment	19	46
penalties have to be reasonable and fair, and we're certainly	20	46
very much against a penalty that would go longer than the	21	46
period of time as the fixed rate period.	22	46
I think there's also just a reality here in that --	23	46
as a practical matter, there is no free lunch. A lender	24	46
makes a commitment to lend money to somebody for 30 years,	25	46
for a full 30 years. The borrower has the choice of paying	1	47
it back either faster or slower. It happens to be the	2	47
average is three.	3	47
And to get some of the features that exist in a	4	47
product such as a no-cost mortgage so that the lender will	5	47
actually pay for much of the cost to get that low mortgage	6	47
originated, appraisal fees, closing fees, doc fees, et	7	47
cetera, the only way to be able to do that economically is	8	47
say, "Tell me I will have the loan for at least two or three	9	47
years."	10	47
And if we eliminated prepayment penalties, the	11	47
practical matter is interest rates would have to go up to	12	47
cover the fact that -- or interest rates would go up or the	13	47
elimination of the no-cost mortgage would occur, so the	14	47
borrower would have to come up with the costs at the outset.	15	47
MR. OLSON: There's secondary market implication to	16	47
the prepayment also -- there's -- through dynamic hedging, if	17	47
you're hedging against a prepayment risk, that has a pricing	18	47
implication to it.	19	47
Now, does the -- I was -- my wife has an MBA, so	20	47
she's not -- not an uninformed consumer. But I was trying to	21	47
tell her the link between a prepayment penalty and pricing.	22	47
And I was unable to do it. And I know a little bit about	23	47
dynamic hedging, but it was -- it was very difficult for me	24	47
to try to explain why that could be -- why that could impact	25	47
pricing. But it does, does it not?	1	48
And most of the -- isn't the significant amount of	2	48
the subprime product actually going into the secondary market	3	48
now? Does anybody know the answer to that?	4	48
MR. LIEBER: I believe the vast majority.	5	48
I'd like to make a point on that in general. We do	6	48
actually sell most of our loans into the secondary market.	7	48
And I do certainly respect portfolio lenders. But it really	8	48
means for us is that we have customers on both sides. We	9	48
have customers in our borrowers and we also have customers in	10	48
the people we sell the loans to.	11	48
So it's very critical for us that those loans	12	48
perform to the expectations of the people we sell them to.	13	48
And although we may not have direct skin in the game on that	14	48
loan today, we clearly have skin in the game that the loans	15	48
that we sell to those investors perform over the long-term.	16	48
And performance comes in two key measures, the	17	48
credit performance so that the borrowers -- we put borrowers	18	48
into loans where they can make the payments. But the other	19	48
piece of it is that the loan stays outstanding for the length	20	48
of time expected.	21	48
And if I could try to make it very simple -- and	22	48
maybe I'll oversimplify -- most people who lend money lend	23	48
money at variable rates. So they borrow their money. Say,	24	48
"Hey, if I'm borrowing money to buy a loan, my interest rate	25	48
is going to go up and down every day. But I've got a	1	49
borrower on the other side who I've made a commitment to that	2	49
their interest rate won't go up for two years, three years,	3	49
ten years, or 30 years."	4	49
So giving that disparity costs money. And the way	5	49
to cover that cost is to say, "Hey, guarantee me the loan	6	49
will be outstanding for two or three years so I can enter	7	49
into those transactions for hedging, et cetera, so that I can	8	49
deal with the mismatch between borrowing on a variable rate	9	49
and lending on a fixed rate."	10	49
Now, I either made that very simple or overly	11	49
complex or made no point at all.	12	49
MR. STEIN: Well, I think I understand that and can	13	49
appreciate that, but I also think that this is part of the	14	49
problem, that -- as you were talking about with World, and I	15	49
think as you expressed it, Governor, so you have -- you have	16	49
concern for what those loans look like because you're holding	17	49
them. You have to take responsibility for them.	18	49
With the fact that the vast majority of subprime	19	49
loans are sold to the secondary market, there's a diminution	20	49
of the sense of responsibility. And, in fact, we think all	21	49
of the incentives are kind of running the wrong way, running	22	49
towards the investor and away from the consumer on all	23	49
levels.	24	49
I mean, we were talking about disclosure before.	25	49
It's not in the interest of those on the ground who are	1	50
selling the loans to make sure people completely understand	2	50
what they're looking at. And that's why we urge yield spread	3	50
premiums to be included in the HOEPA trigger. We talked	4	50
about prepayment penalties. We urge them to be included in	5	50
the HOEPA trigger.	6	50
I mean, I don't know how anyone could say seriously	7	50
that consumers are bargaining for the prepayment penalties so	8	50
that subprime borrowers to a much, much greater degree, 70,	9	50
maybe 80 percent of the subprime loans, have prepayment	10	50
penalties. In the prime market it's a single digit	11	50
percentage. I'm not sure exactly what it is. There's a huge	12	50
disparity. People are not bargaining for this.	13	50
We conducted a study a few years ago where we	14	50
actually talked to over a hundred consumers of subprime loans	15	50
in California, and for a significant number of them, they had	16	50
this dynamic that Paul described, which I think is	17	50
significant, where you had the prepayment penalty extending	18	50
beyond the initial interest rate of the loan.	19	50
And sounds like three of -- three of us who have	20	50
spoken to this agree that that's a problem.	21	50
MR. FULLER: Four.	22	50
MR. STEIN: So that's -- meanwhile, we believe most	23	50
lenders don't agree. So I guess I'm glad that we're	24	50
sitting -- you did get the good guys. So thank you.	25	50

Professional Reporting Services, Inc., Walnut Creek, California, 800-261-4814

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2006 Hearings

Building Sustainable Homeownership: Responsible Lending and Informed Consumer Choice

Federal Reserve Bank of San Francisco 101 Market Street, San Francisco, California 94105 June 16, 2006

Building Sustainable Homeownership:
Responsible Lending and Informed Consumer Choice

Federal Reserve Bank of San Francisco
101 Market Street, San Francisco, California 94105
June 16, 2006