A duty to whom? Part 1, the stimulus
Does a lender have a duty to talk an applicant out of borrowing, or out of choosing a particular financial product?
Fulfill your obligations
Whether or not they do, a lender loses if a borrower defaults. But what about the lender’s agents — such as mortgage originators— who receive up-front fees and have no ongoing liability? Do they have a duty on the lender’s behalf?
Quacked if I know
As reported (
Bobblehead Einstein says Yes!
Federal banking regulators yesterday issued a strongly worded warning to lenders about the growing use of nontraditional, or “exotic,” home loans, telling them they must make sure consumers have the money to repay the loans.
The warning, called a “guidance” [link in .pdf, 5 Meg file] has been opposed by many lenders, some of whom have earned record profits by aggressively promoting such loans, which include such variants as interest-only mortgages.
Setting aside for the moment the apparently paradoxical idea that lenders might not be making sure consumers can repay their loans, the new regulatory guidance effectively imposes on lenders a fiduciary duty, which we may loosely define as follows.
Fiduciary duty
Imposing a tacit fiduciary duty means that, even before an applicant becomes a customer and borrower, a lender — and, I presume, by extension its agents — has a consultancy obligation to give the applicant good advice, the financial equivalent of asking the applicant if her eyes are bigger than her stomach.
I need a loan bad
This will make it harder to make loans. It will make some customers unhappy because they will be rejected by lenders or mortgage originators saying parentally, “I know what’s good for you.” Is it wise?
That depends, in part, on how the home mortgage originator sequence is divided into independent actors who hand off their work product one to the other, and how the incentives of front-line troops — individual originators — may be badly misaligned compared with those of either the customer or the lender. As the Post reported some weeks back:
Despite regulators’ warnings that some popular types of mortgages are risky, lenders are still making them, and mortgage insurance companies have begun pleading with federal banking agencies to act quickly to restrict them.
Whoa! Where’d those insurers come from?
In the modern American home mortgage market, we should distinguish among six distinct actors:
American home mortgages: the six players
- Individual mortgage agents, smiling faces who shake hands with customers across a desk, walk them through a loan application, and offer them a choice of financial products.
- Mortgage originators, companies that employ mortgage agents. Typically an originator splits the originator fee with the agent (that is, half or so is for the individual, half for the house) as the price of creating a platform, a storefront, and a back office IT infrastructure.
- Investing lenders, financial institutions that actually write the loan, paying money to the originator in exchange for the customer’s mortgage. (The customer’s loan is secured by a mortgage drafted by the originator but technically and financially issued by the lender.) Investing lenders get their capital either from depositors (if the lender is a bank) or from the capital markets (if the lender is a securities issuer).
- Mortgage servicers. A company that collects monthly payments, remits them on to the investing lender, and issues statements to borrower and lender. Usually highly automated and operating at enormous scale. Of the six players, only the servicer is not involved in the origination phase.
- Mortgage insurers, financial institutions that put out no up-front capital but that provide payment insurance; if the borrower defaults, the mortgage insurer will take the first loss. Typically the insurance runs in favor of the investing lender, although it could also run to the securities issued by the lender.
- Securities buyers, large financial institutions who buy pools of securities (financial instruments) whose principal collateral is mortgages (hence the witty term, Mortgage Backed Securities, MBS, or even collateralized mortgage-backed securities, CMBS).
If we think of the borrower as the sun around whom all else revolves, these are the six planets, each one further away.
This makes mortgage insurers and securities buyers the gas giants
Each more distant actor has a bigger orbit, and correspondingly less ability to perceive individual variations in loan quality. As you can imagine, therefore, scaling up as we do relies on two things:
- Standardization. Large securities issues work because each loan is a like a swatch of carpet: rectangular, monochromatic, and made of the same fiber as all the others.
- Risk assumption. Fundamental to any securitization is that the person closer to the action takes the first-loss risk. Hence securities buyers look to insurers, who look to investing lenders, who look to mortgage originators, who look to their agents.
I’m counting on my agent to protect me.
Also, as a general rule, the closer you are to the action, the faster you are paid. Agents get their money at closing; securities buyers need the loan to perform over its whole interval. Hence the industry has evolved so that the financial compensation paid to each member is supposed to incorporate risk assumption and risk tolerance.
Thus when the insurers are screaming, it’s an indication that actions happening closer in the solar system — that is, closer to the customer —-are exposing them to intolerable and unmanageable levels of risk.
I got exposed to a little too much risk
A populated ecosystem like the foregoing will remain in equilibrium among its ecota provided that the industry is working with the same nutrients — the same loan products. Introduction of new loan products that same the payment-risk profile destabilizes the ecosystem, because it adds new untested elements of risk:
The loans under scrutiny include interest-only mortgages …
Before we (and the journalists) get completely lost, let’s break the traditional mortgage payment into pieces —
To appreciate the game, you have to see how the pieces move
[Continued tomorrow in Part 2.]
