The financial meltdown has many narratives, and many of them revolve around investors in mortgage-backed securities not knowing the risks of their investments and the borrowers in the underlying mortgages not knowing the risks of their investments. My own brief experience with the mortgage industry this quarter has driven this latter point home.
In January, inspired by others we knew refinancing their mortgages, we contacted our mortgage holder and inquired about refinancing. We bought our house in 2006 at 5.625%, so we knew that the pros and cons would be close, depending on the rate, fees, etc. But, since our money wasn't making a positive return on any of our investments, we figured that paying a higher rate of return wasn't that palatable, either. Our mortgage holder promptly emailed us five spreadsheets that were completely indecipherable to us. When we asked questions, the answers made no sense to us. Luckily, my colleague who officed next to me was the director of our Transactions and Economic Development Clinic, and she had mentioned that she recently had helped a neighbor determine whether refinancing was economically smart. My corporate finance tail between my legs, I asked her if she could make heads or tails out of the spreadsheet. She had to spend thirty minutes reviewing it to understand where all the numbers were coming from and what the bottom line was. The bottom line, she said, was that the refinancing was going to cost $5000, or somewhat less than 2.5% of the loan. Plus, the $5000 was tacked on to the loan, adding cost in interest and fees. She encouraged us to "shop around" when our original mortgage holder would not negotiate on the fees.
So, we finally went with a local bank, who presented us our costs in more of a term sheet fashion, outlining a handful of fees that amounted to around $1000 for the same principal amount and interest rate. The bank did warn us that although we were locked in at that rate (4.5%), the backlog of refinancing applications would take awhile to work through. They weren't joking! We signed the closing papers Wednesday on the refinancing we were approved for in January. Although there were a few hiccups (because of the backlog, the payoff amount the bank received did not include the April payment, etc.), the documents were much easier to understand. The local bank also explained that they kept their mortgages.
So, what was interesting to me about all of this?
I am quite willing to believe that many who sign mortgages and particularly refinance documents have no idea what the costs are or what their ending principal balance is. If a corporate finance attorney could not figure out the loan documents and had to ask someone who is an expert in consumer finance documents, then we should not expect those with other types of work/life experiences to be able to do a better job. If it wouldn't scandalize my co-borrower to show your our private finance life, I would post the spreadsheets so that you could get a flavor for the dizziness.
When people are faced with financial documents they don't understand, a first instinct is to say "Just tell me where to sign." I'm ashamed to say that I gave up very easily when I couldn't make heads or tails out of the document and the answers to my questions were even more confusing. I could feel myself think, "It's probably fine. I should just go with it." If I hadn't had a trusted friend to turn to, we might either have overpaid for the refi or just gave up on it altogether.
When borrowers don't understand the loan documents, they don't have a lot of options. No one likes to ask for help, especially with financial questions, but you also need someone to ask. I wasn't really sure I wanted my friend to know how much my house was worth (sort of silly in Champaign where all the houses in our subdivision cost the same amount!) or how much equity we had in it. I also didn't want her to know that I couldn't figure out what all the line items were or what the bottom line was. But I feel very lucky to have had her available to me as long as I swallowed my pride. For someone applying for a refinancing without friends in the finance world, who would she turn to? Unless the borrower has a neighbor who is the director of a clinic that helps people with consumer finance, then she may not be able to find anyone better able than she is to make a rational refinancing decision.
With all the laws to make consumer lending more transparent, why is it so opaque? In my practice, I often created or reviewed term sheets for commercial loans and corporate bonds. Those term sheets were in English and made sense. Why would documents in a consumer financing be so hard to understand? At our closing, the "Uniform" documents the bank had to use were the most confusing. The documents that were generated in-house, including a two-page letter telling us what the principal amount was, the interest rate, the term, and the fees, was the simplest.
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1. Posted by Gordon Smith on April 9, 2009 @ 10:24 | Permalink
Great post, Christine. We went through this a couple of months ago, and I (again) had to educate myself on the fees. I have owned four homes and done even more loans, but I still find the various fees (some of which are clearly just padding) confusing. In the end, however, we have been pleased with our new loan, which has freed up lots of cash for other things. We are doing our best to boost the local economy by spending all of it!
2. Posted by fedgovernor on April 9, 2009 @ 14:02 | Permalink
You don't state which "mortgage holder" it was who tried to rip you off.
Why not?
I strongly suspect that it was Countrywide, which is now owned by Bank of America, a recipient of TARP tax dollars.
Can you confirm that Countrywide tried to rip you off?
3. Posted by David on April 9, 2009 @ 19:42 | Permalink
What makes these BIG BANKERS any better than Madoff ? In fact, they are worse - they have conspired to steal, by fraud, billions - maybe trillions - of dollars from us.
I have seen that they take "bailout" money and pay obscene bonuses, make acquisitions and pay for corporate play.
The bailout money has given them the cushion they need to foist a round of APR hikes on us consumer citizens, unless we care to "opt out" and close our account, which will detrimentally affect our credit.
ENOUGH !!! I say charge them under RICO (Racketeering Influenced and Corrupt Organization). Jail them. Get the money back. Half measures will only perpetuate business as usual.
I'm serious.
David
4. Posted by Mike Madison on April 10, 2009 @ 16:18 | Permalink
"The local bank also explained that they kept their mortgages."
That's the most telling line in the post. Is it the case that banks that keep their own loans have no reason to cloud term sheets, and banks that sell loans do (have a reason)? If you can't tell what you're borrowing, then loan buyers may have little better idea regarding what they're buying. Cf. Akerlof.
5. Posted by Jake on April 10, 2009 @ 19:23 | Permalink
Nice post, Christine. In an effort to refinance our mortgage, we are going through the same water-boarding with a major TARP-recipient bank. We refinanced in 2002 and 2004 and found it nearly effortless. Now it seems different. The big lenders, having given away so much easy credit in recent years (now to their chagrin), and currently enduring in terrorem treatment by Treasury and the Fed, are presently over-reacting in the direction of caution in underwriting mortgage loans. The bank also seems to be laying off anyone who knows what they are doing, and replacing them with people who are clueless.
6. Posted by fedgovernor on April 11, 2009 @ 15:56 | Permalink
"'The local bank also explained that they kept their mortgages.'
That's the most telling line in the post."
It's also a lie. The Federal Reserve regulates loan products that banks may offer in the United States. And the Federal Reserve does not allow a member bank to offer a loan product which is non-transferable.
This bank likely does not have a customer for its mortgage portfolio (owing to the lack of a market for such products at the moment), but it always retains the right to sell your mortgage at any time to anyone it chooses.
7. Posted by local Champiagner on April 12, 2009 @ 12:30 | Permalink
The bank I think Christine is referring to does not sell its mortgage loans. It doesn't say it can't sell them, but simply that it does not.
So it's not a lie--they just keep the loans as a business decision, even though they could sell them.
8. Posted by Adam Levitin on April 14, 2009 @ 23:55 | Permalink
"With all the laws to make consumer lending more transparent, why is it so opaque?"
The purpose of the laws is to induce disclosure. Consumer advocates have long thought that disclosure means transparency. But the financial services industry loves it because disclosure allows them to head off substantive term regulation and they've mastered the art of obfuscation by disclosure. The disclosure paradigm for consumer credit is seriously flawed--it just doesn't work with complex deals and products. So we have two options if we care about consumer protection--simplify the deals and products or move to substantive regulations.
9. Posted by Jon Hendrix on April 15, 2009 @ 6:57 | Permalink
I think the difference is between Disclosures Which Are Required, and Disclosures For Information.
Mortgage and note documents are incomprehensible to the layperson because the information is required - either because it has the legal language necessary to make the document work, or because the law requires things to be disclosed. I had a client which was a small lender who would disclose anything because people wouldn't understand it, and would still sign. (Because legal language necessary for the operation of the document is confusing, I think simplification will lose out to substantive regulations, if any changes are made).
A disclosure for information is designed to actually communicate the information. An excellent example is the Truth In Lending boxes showing interest rate, how much is borrowed, etc. Another would be a warranty that a law professor used in class which said in plain language that the manufacturer disclaimed all warranties, and had no duty etc. The obvious downside is that this follows some sort of linguistic Gresham's law - confusing language drives out clear, understandable language - because consumers may not sign an understandable document.
10. Posted by LJ on April 15, 2009 @ 10:14 | Permalink
"When borrowers don't understand the loan documents, they don't have a lot of options."
The bankers often don't understand the documents.
We recently refinanced our home equity loan. The bank officer (a money center bank) closing the loan went through each of the documents with us. She came to the paragraph in the deed of trust captioned "Rules of Construction" and explained it at follows: "This means you need to get permits and the like before you build anything."
I giggled but my wife shot me a look that said "don't be a jerk," so I didn't say anything. Maybe this is only funny to a commercial lawyer like me, but it also illustrates the larger issue that the vast amount of documents and disclosures needed to close home loans results in way too few people understanding the details of the transaction.
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