by Jeff Sovern
Yesterday the Pittsburgh Post-Gazette ran a piece I wrote about how the Fed's TILA disclosures misled the subprime borrowers. Because of space constraints, the Post- Gazette had to cut the piece; I've posted it below in its original form:
Only part of the story of how the Fed contributed to the economic crisis has been told. The part that has not received attention involves the Fed's failure to enable subprime borrowers to tell what their monthly payments would be. Obviously, borrowers who cannot predict their monthly payments cannot predict whether they will be able to make those payments,
The story starts more than forty years ago, when Congress passed the Truth in Lending Act (TILA). TILA requires that key loan terms be boiled down to a single comprehensible page, so borrowers can make the right loan decisions. Congress also directed the Federal Reserve to create rules to make that happen.
Fast-forward to the eighties, when adjustable-rate loans became common. It is impossible to know at the time the borrower takes out such loans what future payments will be, because by definition with such loans payments change from time to time. So regulators adopted a two-prong strategy. First, soon after the borrower applied for the loan, the lender would provide the borrower with some disclosures. Later, at the closing, the borrower would see the final loan terms. The problem for the many subprime borrowers who took out adjustable-rate loans is that the first of these disclosures was of only limited value, while the second was actually misleading.
Take the early disclosures. The Fed's model form gives borrowers a historical example of how payments shift over time. But the form notes that the rates it assumes may be different from the borrower's actual rates. That means borrowers cannot tell from the form what their payments will be. In addition, the form is based not on the borrower's actual loan amount, but on a $10,000 loan. Not many subprime loans were for $10,000.
The final loan disclosures are even worse. To see why, imagine that you took out one common form of subprime loan, in which you received a low "teaser" rate for the first two years, after which the rate would adjust every six months, typically to a higher rate. The Fed's arcane Commentary directs lenders to assume that interest rates at the time of the future adjustments will be whatever they were at the time of the loan closing. So the TILA form might show a low monthly payment for the first two years--the teaser rate--followed by 28 years of a somewhat higher monthly payment which never changes again. This is misleading in two ways. First, if interest rates were generally low at the time of the closing but higher at the time of the adjustments after the two years expired, the actual payments could be much higher than the TILA form showed. Second, while the TILA form might show that payments would be unchanged for 28 years, in fact they could change every six months, wreaking more budgetary havoc. And unlike the early disclosures, this form did not indicate that the actual numbers might be different from those shown. No wonder so many borrowers defaulted.
Perhaps some borrowers turned to the loan agreements to figure out what their payments would be. But these contracts are even more bewildering, with references to LIBOR and change dates and long complicated clauses. Some agreements spell out in one place how the payments are determined, and then carry an "adjustable rate rider" with another formula for calculating the payments.
Maybe other borrowers turned to their mortgage brokers. Now many loan originators are honest, but not all are, which may explain why one study found that the overwhelming majority of borrowers with adjustable loans in one part of Chicago thought their rates were fixed: according to the study the originators "neglected to mention that the terms for which the rate was 'fixed' was limited to 12 to 36 months."
What is the solution? The Fed should not be in the consumer protection business. It makes about as much sense for an agency tasked with managing monetary policy to protect consumers as it does for it to protect the environment. Just as we have a separate Environmental Protection Agency, we need a separate Consumer Financial Protection Agency, something the House of Representatives has now voted for. Tellingly, it was Congress, not the Fed, that last year changed the law to require lenders to tell borrowers what their highest monthly payments might be. But Congress, preoccupied with other matters, cannot micro-manage consumer protection laws. Neither, apparently, can the Fed.
The Post-Gazette's version can be found here, under the headline "Adjustable mortgage a pig in a poke." I've elaborated on this in my article Preventing Future Economic Crises Through Consumer Protection Law or How the Truth in Lending Act Failed the Subprime Borrowers. I plan to post more on this subject in the coming days.