The Home Mortgage Market and Planning For Life

1
The Home Mortgage Market and Planning For Life

• Jack Guttentag
• Delivered at the Annual Meeting of Certified
  Financial Planner Board of Standards, Inc.
  
• August 4, 2006

2
The Home Mortgage Market and Planning For Life

• PART I GETTING A FAIR SHAKE IN THE MORTGAGE
  MARKETPLACE
  
• PART II MAKING THE RIGHT FINANCIAL DECISIONS

3
Part I Getting a Fair Shake In the Mortgage
Marketplace

• Importance of the Home Mortgage Market
• 3 Trillion of Home Loans Made in 2005
• Roughly 6 times the value of total car sales
• Average Individual Loan About 180,000
• Roughly 7 times the size of average car loan
• Space Allocation of Consumer Reports, the Bible
  of Informed Shoppers
  
• Roughly 20 of pages devoted to cars
• Less than 1 devoted to mortgages
• Why is that?

4
An Implication of Infrequent But Very Large
Transactions

• Consumers Lose Their Most Important Shopping
  Tool Trial and Error
  
• Assume Shopping For Wine Is As Difficult as
  Shopping For a Mortgage
  
• It doesnt matter because the cost of mistakes is
  low
  
• You learn from experience and keep trying till
  you get it right
  
• You cant use that strategy with mortgages
  because transaction costs are so high

5
Mortgage Shopping Can Be a Nightmare

• The Most Difficult of All Financial Instruments
  to Shop
  
• Information Asymmetry Loan Providers (LPs)
  Know More Than Borrowers Reasons
  
• A. Instrument diversity and complexity
• B. Pricing nichification
• C. Multiple price dimensions
• D. Price volatility

6
A. Instrument Diversity and Complexity

• Many Kinds of Instruments
• FRMs with different terms
• ARMs with different rate periods and indexes
• Options
• Payment options, waive escrows, prepayment
  penalties, buydowns and buyups
  
• Each Instrument Option Is Separate Priced
• LPs know these pricing structures better than
  borrowers
  
• Another Implication Borrowers Make Mistakes

7
B. Pricing Nichification

• On Given Type of Loan, Price Depends on
• Purpose of loan
• Borrowers credit score/Loan size
• Type of documentation/Type of property
• Down payment/State
• This Results In Very Complex Pricing Structures
• Millions of combinations are possible
• LPs know these much better than borrowers
• But LPs make many pricing mistakes

8
C. Multiple Price Dimensions

• All Mortgages
• Interest rate/points/other lender fees/third
  party fees
  
• Mortgages With Less Than 20 Down
• Mortgage insurance premium vs piggyback second
• Additional Price Components of ARMs
• Index/margin/rate adjustment cap/maximum rate
• Negative amortization ARMs have more
• Implication of Multiple Price Dimensions
• Borrowers frequently make decisions without
  knowing what all the price components are
  
• When they do know, they may face difficult
  tradeoffs
  

9
D. Price Volatility

• Lenders Reset Prices Every Day, Sometimes Within
  the Day
  
• Implications
• Borrowers cannot effectively shop lender A on
  Monday and lender B on Tuesday
  
• Provides opportunities for loan providers to
  low-ball

10
Remedies For Information Asymmetry

• 1. Make Loan Providers Responsible For Disclosing
  Information Defined by Govt
  
• 2. Make Loan Providers Responsible For the
  Suitability of Loans to Borrowers
  
• 3. Make Loan Providers Responsible For the
  Suitability of Information Provided to Borrowers
  
• 4. Certification of Loan Providers

11
1. Mandatory Disclosures

• The Existing System
• Truth in Lending
• Real Estate Settlement Procedures Act
• Three Decades of Failure
• Information disparity too wide
• Borrower absorptive capacity too limited
• Time period too short
• Wrong information is disclosed
• Selection process is politicized and
  bureaucratized

12
2. Loan Suitability Standard

• Currently Being Pushed by Community Groups
• Would Make Lenders Responsible If
• A loan goes bad, and
• There were negatives in the file indicating that
  the loan should not have been made
  
• This Would Be a Disaster
• Almost every file has negatives
• Result would be a drastic tightening of
  underwriting requirements

13
3. Information Suitability Standard

• Make Lenders Responsible For Adequacy of
  Disclosure
  
• A Replacement For Existing System
• Instead of Government writing the script, lenders
  would prepare their own
  
• Good Idea With No Constituency

14
4. Certification of Loan Providers

• Information Asymmetry Remains, But Loan Providers
  Dont Use Their Superior Information to
  Disadvantage Borrowers
  
• Certification Is By a Trusted Third Party Who
  Accepts Responsibility For Violations
  
• Certification is private, Govt not involved
• Principle Illustrated by Upfront Mortgage Brokers
  (UMBs)

15
Upfront Mortgage Brokers (UMBs)

• UMBs Relinquish the Right to Make as Much as They
  Can On a Transaction
  
• Instead, They Negotiate All-Inclusive Fees For
  Their Services With Borrowers
  
• I Have Been the Third Party Guarantor
• I set the requirements for certification
• I investigated and resolved complaints
• This year, I began to transfer responsibility to
  UMBA, a non-profit corporation

16
The Economics of Certification

• Some Loan Providers Participate Because It Is the
  Way They Want to Operate
  
• Most Will Go Where the Bucks Are
• They join if they can make more money practicing
  disclosure than by practicing deceit
  
• Guarantors Must Also Generate Revenue
• UMBA charges UMBs membership fees
• Certification Has a Future as a Business Model

17
Part II Making the Right Financial Decisions

• If a Borrower Deals With a UMB
• He will receive a competitive wholesale price on
  his loan
  
• He will pay the broker a competitive price for
  the brokers services
  
• But Will He Make the Right Decisions?
• Will the UMB Advise Him Knowledgeably?
• Often the Answer to Both Questions Will Be No
• Few LPs Are Qualified To Give Advice
• Most Operate In a Sales Mode

18
A Partial List of Mortgage Decisions

• Select FRM or ARM?
• Interest-Only Option?
• How Large a Down Payment?
• How Should I Document?

• Which FRM or ARM?
• Waive Escrows?
• Which Rate/Point Combination?
• Accept Prepayment Penalty?

19
Characteristics of Mortgage Decisions

• They Are Usually Central to Any Overall Financial
  Plan of a Household
  
• They May Have Major Lifetime Consequences
• They Are Often Extremely Difficult to Assess
  Properly
  
• I have been helping borrowers since 1998
• There are 44 calculators on my web site that I
  developed for this purpose
  
• Most borrowers cant use them
• More professionals can but few do

20
Mortgage Loan Providers Should Be Financial
Advisors

• They Are On the Spot
• They Are Being Paid For It
• A self-sufficient borrower able to shop
  effectively on-line can find a better price than
  he will get from an LP.
  
• As On-Line Shopping Increases in Importance, the
  Need For LPs to Justify Their Fees Will Become
  Increasingly Evident
  
• I Am Working With Steve Heideman, President of
  UMBA, to Develop a Certification Process For UMBs