The Subprime Housing Market Pounds American Pocketbooks!

The subprime mortgage market has hurt the American economy. How often have you heard that statement lately? The fact of the matter is that it was abusive and predatory lending practices that got many unwary consumers in a bind, which in turn is harming the American economy. So is there actually some good that can come from subprime loans, and, if so, how can we differentiate harmful subprime loans from helpful ones?

First we need to see if there truly is such a thing as a "good" subprime loan. A subprime loan is simply a loan to someone who might not otherwise be able to obtain a mortgage, and therefore a home, and this loan will be offered at a higher rate than is normally offered in order to offset for the additional credit risk.

Sounds like good old capitalism at work, doesn't it? And if the issue were that simple then we could stand behind all subprime lending as a method for informed consumers to obtain a home. Even the National Association of Realtors has an article supporting subprime lending - as long as it is fair and informed.

And this of course is where the lines start to get blurred. Most people are familiar with balloon payments, and how those can shock the consumer. But because most people are aware of the dangers of balloon payments they are able to make an informed decision about whether or not they wish to enter into such an arrangement. But there are other lending practices that may cross over into predatory or abusive lending practices.

Prepayment penalties can be one way in which "good" subprime lending can cross over into a predatory practice. When a substantial penalty exists for loan prepayment, the borrower may find it impossible to refinance the loan and take advantage of a substantially changed marketplace only a few years after taking out the original loan. While technically "disclosed" in the contract, this information may not have been sufficiently disclosed to inform the borrower, and simply buried in the contract. Other practices, such as allowing the borrower to accept a payment as high as possible and failing to properly disclose the additional costs of taxes and insurance can further put borrowers into positions where they can no longer afford their homes.

Although there are scores of practices designed to allow subprime borrowers to obtain a home while making and securing money for the lending institution, and it is actually the manner in which these subprime loans are made and their proper or improper disclosure that pushes a "good loan" over into the "predatory practices arena," the two examples above serve us well in analyzing the situation.

FIRST - we have a buyer beware situation. Unfortunately in this caveat emptor environment it is simply too much to ask that the common borrower be up to speed and fully informed on all the practices that may jeopardize his home in the future. There must be some method in place to protect the borrower, as it is unreasonable to expect people who are untrained in mortgage lending practices to be sufficiently wary of all the methods that can easily become predatory in nature.

SECOND - the root of the problem must be addressed. While we respect NAR's basic ideas listed in the article above, the solutions presented primarily address the symptoms, and not the problem itself. Understanding the issue and asking "Why?" is paramount to developing a true solution for the consumer.

THIRD - Informed consent must be mandatory in all lending practices. "Informed consent" does not mean disclosing a potentially predatory practice in small print on the eighth page of a twelve page contract. Nor is informed consent achieved by having a representative of the lending institution gloss over any such practice in a twenty minute sales speech in order to secure the loan.

In reference to item one we believe that less legislation is better than more legislation as long as it is not zero legislation. While legislation will serve to provide some guidelines and standards in the industry, it would be impossible to enact legislation that would cover every predatory practice and would likely harm otherwise good subprime loans. But neither can the issue be left entirely to private organizations such as NAR. Some responsible form of legislative protection is in order. Additionally consumers need to be informed as to the difference between a Realtor and a real estate agent, and realize that Realtors are held to a much higher standard, and, in theory, should provide them with protections greater than that provided by a real estate agent that is not a Realtor.

In regards to item two we have two competing forces in the marketplace from the lending institution. The first is the institution itself which enjoys the increased revenue from mortgage loans that do not go into default, but abhors the ones that do go into default as they are extremely costly for the institution. No one wins in a foreclosure!

As such lending institutions have a framework in place to help identify good subprime loans from bad, but the nature of competition is such that some institutions will institute looser credit requirements in order to obtain the business that is rejected from institutions with a tighter credit structure. Couple those looser credit requirements with a commissioned salesperson who is solely interested in benefiting his bottom line and we lay the roadwork for predatory practices.

However removing the commission structure for the sales staff at a mortgage lending institution could significantly affect the bottom line of the institution itself, as the lazy salesperson could then make as much as the one that works hard to obtain good loans.

This situation leads to the issue discussed in item three; informed consent.

Although a scream of protest will likely go up throughout the world of real estate agents - the true solution to the problem is to hold the real estate agent responsible for providing true informed consent to the consumer.

Currently agents act as facilitators, or go-betweens for most steps of the purchase and sale process. Although this allows for less training and more salesmanship skills, the time has long passed in which real estate agents should have a significantly more intimate knowledge of the process - especially when it deals with mortgage lending.

While the consumer could always choose his own lender, agents should be required to present at least three options to the consumer. If the consumer faced less than three options, either by choice or because the subprime nature of the loan allowed for only one or two options, the consumer needs to sign a waiver of the three institution rule. It would then be the agent's responsibility to provide answers (informed consent) about a laundry list of potentially predatory practices - going over each item and comparing the three lenders in regards to each item, and having the consumer sign off on each of these items indicating an understanding of the differences between institutions. This can be accomplished with a standardized form checklist.

While this would undoubtedly require additional training initially and continued ongoing training specific to mortgage lending practices, this would help ensure that consumers did not unknowingly take on loans that could not be paid off early, take loans with balloon payments unknowingly, take "maximized" loans without full knowledge of how taxes and insurance add to the monthly payment, or otherwise become involved in mortgage schemes that may negatively affect the borrower.

No, this added involvement and responsibility of the real estate agent will not eliminate the foreclosure and subprime default situation. However pushing some of the responsibility for informed consent to the real estate agent is likely to have the following effects:

• Consumers will be better informed as to their options, and how one institution relates to another. They can actively pose questions to the agent - questions they may not even know to ask without a structured informed consent comparison of lending institutions.

• The subprime default situation is likely to be made better - it would essentially take three potentially predatory lending institutions, three predatory mortgage lending salesmen, one unethical real estate agent and one somewhat informed consumer to enter into a contract that had a high probability of default.

• Real estate agents, as they make their progression from facilitator to expert in their field, would likely be able to demand a higher salary in the form of rising commissions. As is the case with all competitive endeavors, a balance is reached between the costs to do business (such as increased costs of ongoing education) and passing those costs onto the consumer while balancing those price increases against the agents' competition.

There is no simple solution to eliminate foreclosures. In fact, foreclosures will never be eliminated in their entirety. Despite that, the shifting of responsibility to well trained agents can help alleviate the problem and make all involved more aware when a loan is of a subprime nature. This can help create the "good" subprime loans while minimizing the ones that result in foreclosure.

The information in this article is merely an opinion. No statement within this article should be viewed as a suggestion or statement to buy or sell real estate for investment purposes or any other purpose! The data was garnered from sources believed to be accurate but is not guaranteed.

See our Real Estate Predictions for 2008! See our Coeur d'Alene Real Estate Article here!