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Excerpt: How to Avoid the Next Financial Crisis

The following is excerpted from Financial Shock: A 360-degree Look at the Subprime Mortgage Implosion and How to Avoid the Next Financial Crisis (Pearson Education, 2009) by Mark Zandi, chief economist and cofounder of Moody’s Economy.com. Here are four policy changes Zandi recommends to prevent the next financial crisis. Read all 10 in his book.

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Policy Step #1: Adopt a voluntary mortgage write-down plan

Many troubled mortgages could be salvaged if lenders would agree to modify them, typically by reducing the principal owed. The borrower would get to stay in the house, the lender would avoid a costly foreclosure, and the economy might avoid falling into a destructive self-reinforcing cycle in which house price declines beget foreclosures which beget still more price declines. Thus it seems both reasonable and urgent to encourage this wherever possible.

While there is no silver policy bullet that will address this problem, a number of proposals have circulated that could help. Most involve a small commitment of taxpayer dollars.(1)

Passage of an effective mortgage write-down plan faces several hurdles, including reasonable concerns that it would end up helping those who least deserve it. Lenders who faithfully observed sound underwriting methods would not benefit; nor would those homeowners who are working hard to keep their mortgages current despite financial strains.

The counter-argument is that the housing problem is so serious that it threatens the honest and diligent as well as those who made big mistakes. The cost to the overall economy in lost jobs, wealth, and tax revenue if troubled borrowers do not receive financial help will almost certainly be greater than the cost of bailing them out.

Although there is no guarantee that such a plan will be adequate to the problem, it is worth the effort.

Policy Step #2: Establish clear mortgage lending rules

A number of steps have been proposed that could prevent a repeat of the housing meltdown once the current crisis is past. Most notable would be the Federal Reserve’s adoption of clear guidelines for appropriate mortgage lending: Under the Fed’s proposed rules, lenders must consider the borrower’s ability to repay and also verify the borrower’s income and assets. Prepayment penalties are barred if a homeowner refinances within 60 days after an adjustable loan reset, and borrowers must establish escrow accounts for taxes and insurance.

These commonsense lending rules would apply to all mortgage lenders given the Fed’s broad authority.(2)

Policy Step #3: License mortgage brokers

There is widespread agreement that all mortgage brokers must be licensed. Unregistered brokers were among the most unscrupulous lenders during the housing boom. State banking regulators are working to set tougher standards for brokers by requiring applicants to pass proficiency tests and to be fingerprinted by the FBI.

State regulators have also launched a nationwide lender information system: an Internet database with pending enforcement actions and background data for all licensed mortgage brokers and lenders.

Policy Step #4: Expand data collection

A lack of timely and accurate information hobbled policymakers’ ability to respond to the subprime financial shock. Data on mortgage delinquencies and defaults comes from a variety of mostly private sources, making it nearly impossible for regulators or others to see the crisis as it grew. No government agency tracks the number of mortgage foreclosures, for example, and the various private sources of such information are limited in various ways.

A ready mechanism for expanding the government’s data collection already exists under the data collection efforts required by the Home Mortgage Disclosure Act. HMDA requires most mortgage originators to report some information on all loan applications and approvals. This includes data on the lender, location, income, and ethnicity
of the borrower, whether the loan is a first or second lien, whether it is a purchase loan or refinancing, as well as the loan’s amount and its interest rate.

Reporting requirements should be expanded to include mortgage servicers, who in most cases are also the lenders already reporting under HMDA. Servicers can provide information on delinquencies and defaults as well as on whether various types of loans and borrowers are having credit problems. Reporting under HMDA should be more frequent—it currently occurs annually—and data releases should be accelerated.

The HMDA data for 2006 wasn’t fully released until the Fall of 2007. More frequent updates and more rapid reporting would help policymakers and lenders spot credit quality problems earlier and allow them to respond better to developing problems.

Endnotes:
(1) Most notable include the plan cosponsored by Congressman Barney Frank and Senator Christopher Dodd described in Chapter 13 (see inancialservices.house.gov/FHA.html). FDIC Chairwoman Sheila Bair has also proposed a write-down plan (see www.fdic.gov/consumers/loans/hop). Zandi has also put forward a proposal (see www.economy.com/mark-zandi/documents/Home-Appreciation-Mortgage-Plan.pdf)
(2) As discussed in Chapter 10, the Federal Reserve was granted this authority under HOEPA.

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