28 March 2008

Progress In The Credit Markets

The consumer credit marketplace has changed a great deal in the last few years.

Mortgage Lending

Foreclosure Reform

Effective January 1, 2008, a new foreclosure law took effect in Colorado. Under the new law the number of days it takes to foreclose upon a house didn't change, but the amount the debtor needs to pay to get out of foreclosure went down. While this doesn't appear to impact foreclosures filed in 2007, it will provide a greater window of opportunity for borrowers seeking to fine alternate financing, family help or to sell the troubled property so that equity isn't lost in a foreclosure sale.

Under the old law, in the first half of the process, the debtor could "cure" a default by paying all past due amounts on the loan and any associated collection costs. After the cure period expired there was a "redemption" period in which the debtor could get the house back only by paying off the entire loan balance, in addition to collection costs. The new law ended the debtor's right of redemption in exchange for a cure period equal in length to the old cure plus redemption period.

A foreclosure hotline in Colorado has helped tens of thousands of Coloradans facing foreclosure act more rationally in the face of their dilemna.

Homestead Exemption Increase

Colorado has also increased its home equity exemption from creditors. The first $60,000 of a home's equity is immune to judgment liens from creditors who don't have a mortgage or deed of trust, such as judgments for unpaid credit cards, unpaid medical bills or car accident liability. If one of the homeowner's is aged sixty or more, or is disabled, the exemption is $90,000.

Few Coloradans are impacted negatively by federal bankruptcy law limitations upon claiming a homestead exemption. Those changes primarily impact people who live in or move to one of a handful of states with unlimited or very high homestead exemptions. But there is some impact for the narrow class of Coloradans who have moved to the state less than two years ago from a state with more stingy protections for home equity and then filed for bankruptcy here.

Prepayment Reform

New regulations in Colorado have banned new mortgage loans with pre-payment penalties that extend beyond an initial teaser rate. These pre-payment penalties, usually found in subprime loans, had made it hard for distressed buyers who may have qualified for conventional credit to refinance into more manageable loans.

Mortgage broker regulation

Mortgage brokers are now a regulated profession in the state of Colorado, a move that drummed hundred of questionable lenders out of the business and has imposed meaningful obligations on these professionals to consider borrower interests, such as the suitability of the loans recommended for those borrowers, obligations of a kind that have long been imposed upon securities brokers.

Governor investors and lenders have also cracked down on real estate appraisers who cook their numbers to make otherwise not viable real estate deals go through.

Federal Tax Breaks

Federal tax laws have provided relief for taxpayers who lose their homes in a foreclosure or deed in lieu of foreclosure arrangement, when a bank forgives balances due in excess of the equity in the home. Previously, that forgiven debt was treated like taxable income unless the taxpayer could take addition steps to show the IRS that he or she was insolvent.

Private mortgage insurance premiums, required of borrowers in almost all loans with less than a 20% down payment, are now deductible like mortgage interest.

Jumbo Loan Relief In High Cost Areas

Changes to the Federal Housing Administration's loan criteria have greatly increased to availability of FHA loans with fair government set terms and more reasonable rates in high housing cost areas where more expensive jumbo loans were once the only available means of financing a home.

The End of the Subprime Market

The subprime mortgage lending market has virtually disappeared (with dollar volume down about 95% over two years ago) as a result of its own unprofitability, Alt-A mortgage lending market has contracted by about two thirds, and private mortgage insurance underwriting standards have tightened, as have the underwriting standards of all mortgage lenders.

Falling Housing Prices

Housing prices, especially in the less expensive part of the market, have fallen significantly. This eats up the equity of existing homeowners, leaving a record high percentage of them with a loan balance greater than the value of their house. But it also collapses a bubble in the housing market that was making it unaffordable to buy a new home.

Mortgage interest rates, for those who can qualify for mortgages and have a meaningful down payment, are not at an all time low, but they are sitll well below historical average mortgage rates. They are within a pecentage point or so of the market bottom.

Reasonable interest rates and falling housing prices combined have made it a buyer's market for first time homeowners who qualify for an FHA loan because they can come up with a 10% down payment, have credit sufficiently good (typically FICO scores of 620 or better), and have a steady income commensurate with the price of those in light of their other debt burdens.

A decline in rental vacancies and rise in rents as a result of large number of people who are easier foreclosure victims or who don't buy homes because they can't qualify for FHA loans has both spurred a shift from condominium development to apartment building develop, and has improved the affordability of buying a home relative to renting.

Credit Card Minimum Payment Increases

Major credit card companies have increased their minimum payments as a percentage of the total balance. For those who were carrying balances at the time and just getting by paying minimum payments, this was a catastrophe that probably pushed many of them over the bring into default and bankruptcy or garnishments. But for customers accruing balances after this time, it is dramatically reduced the length of time it will take them to ultimately pay off their balances, and will, as a result, greatly reduce the total amount of interest paid on their loans. Higher minimum payments will also make it harder for cardholders who tend to borrow until they can't pay the combined minimum payments anymore from going as deeply into debt as they did under the old minimum payment cutoffs.

Payday Loan Reform in Colorado

Another major change in the consumer credit market in Colorado, which will be huge if adopted, would impose a maximum annual interest rate on payday loans of 45% per annum, Colorado's usury rate for all other types of loans. Currently the interest rate on payday loans exceeds 300% and can be as high as 450% per annum. The bill has passed the state house and the house version passed on reading on the floor of the state senate. A committee vote, another couple of state senate floor votes and the signature of Governor Ritter are still required to pass the bill. But it appears that there is sufficient support in the Senate to pass the bill, quite possibly unamended (its first floor vote was 19-16 in favor), and the odds that the Governor will sign the bill seem good.

If the payday loan bill passes, the number of payday lenders in the state would plummet, from current levels in which they a ubiquitous and in a major expansion mode, largely ending one of the most exploitative elements of the consumer credit system. Other states have taken this step and have not seen the harm to the working class customer base that tends to use these loans that payday loan lobbyists claimed would arise.

Bankruptcy Reform

The 2005 bankruptcy reforms are hurting the economy right now.

Most importantly, the requirement of the new law that Chapter 7 debtors obtain credit counseling before filing, and all debtors have their paperwork lined up in advance of filing, has made it much more difficult to prevent a foreclosure with a last minute bankruptcy petition. As a result, mortgage lenders in foreclosures where there is some equity have received windfalls, while what would otherwise be an asset available to pay priority and unsecured creditors has been removed from the estate. Studies of Chapter 7 debtors referred to credit counseling has revealed that in the vast majority of cases, approaching 99%, credit counselors agree that a Chapter 7 bankruptcy is the debtors best course of action.

Debtors who make more than the state median income are forced into five year repayment plans under Chapter 13 in which all income over a certain allowed amount must be turned over to creditors. Given the less than 50% success rate for completing these plans back when they were three year plans and the amount paid to creditors was permitted to be much smaller, debtors advisers are reluctant to recommend Chapter 13 to debtors who have more than the state median income. Also many debts that used to be dischargable in a Chapter 13 plan but not under a Chapter 7 plan through the so called "superdischarge" are no longer entitled to be discharged. There are times when Chapter 13 can be appropriate, particular for debtors only a little over the state median income who hence have fairly small payments under their Chapter 13 plan, who also have very large consumer debt burdens and want to keep their homes.

Colorado's saving grace in the face of bankruptcy reform is that the state has a fairly high median income. As a result, many debtors who would have to file Chapter 13 bankruptcies to obtain relief in other states can file Chapter 7 liquidations in Colorado.

While Chapter 7 bankruptcies are more expensive to file due to the increased paperwork and attorney liability involved, and require more leadtime, on the merits Chapter 7 bankruptcies for the average below median income Colorado consumer debtor are only slightly less beneficial than under prior law. Secured creditors rights are strengthened, particularly car loan lenders who can repossess cars with loans in default during a bankruptcy with less paperwork and have a greater ability to force a car to be given up unless than full amount of the loan is reaffirmed. There are greatly limits on the ability of debtors to discharge "luxury purchases" made on the eve of bankruptcy on credit. There is less bankruptcy court interference in evictions pending at the time of a bankruptcy. Child support and alimony collection proceedings can now virtually ignore bankruptcy proceedings. The federal law governing exemptions from creditors has been tightened up, but that doesn't apply in Colorado which requires debtors to us its own homegrown set of exemptions from creditors.

Repeat bankruptcy filings close in time by the same person or with regard to the same piece of real estate are prohibited more severely.

In a nutshell, bankruptcy has been made inconveniently more difficult for working class debtors in Colorado, but not prohibitively so. But bankruptcy is a much less viable option for upper middle class debtors overwhelmed by consumer debts than it used to be prior to 2005.

One thing I like about Presidential candidate Barack Obama is that he has proposed a package of important targeted reform to the 2005 bankruptcy law. Presidential candidate Hlllary Clinton voted for the 2005 law, which made some worthwhile reforms and closed some legitimately loopholes, but also made significant changes for the worse in existing law and was poorly drafted and thought through.

Pending Legislative Action

There is a whole swirl of pending federal proposals to bring about further reform. Among them are freezes on ARM triggered interest rate hikes, proposals to allow cramdowns of mortgage debts in bankruptcy (which reduce the princpal on the debt to the value of the collateral and then include the balance owed in a larger discharge of indebtedness, rather than requiring the home to be surrendered), greater regulation of the mortgage lending industry, encouragements for lenders to negotiate more favorable deals with customers perhaps partially forgiving debts in some cases, and more.

Pawn lending will still exist, and that isn't likely to be reformed, but that industry doesn't carry the same kind of instant gratification temptation element that drive the subprime and payday lending industries, because you have to give up possession of something that you value to get the loan.

The rent-to-own business may see a short term boost, as alternative ways to buy the good life on the installment plan at outrageously inflated prices have evaporated. But it would hardly surprise me if a state legislature willing to take on the payday loan industry this session, if it retains the current balance of power in the 2008 elections, which seems likely, might institute significant regulation of the rent-to-own industry in the 2009 legislative session.

The Economic Impact of the Changes As A Whole

The bottom line for a lot of working class consumers will be that the never ending temptation to try to consume at a middle class level with high interest rate loans with unfair terms is going to largely evaporate. The myth, which is only partially valid with respect to this group of consumers, that bankruptcy relief is much harder to get than it used to be, could also contribute to a major working class flight from consumer debt. I expect to see responses a number of conseqeuences of these changes.

A Return To Traditional Commercial Banking

At the business level, I expect to see significant growth in regulated lending. These are low dollar amount, high interest rate loans (still subject to the 45% interest rate cap and other consumer loan regulations). While it isn't nearly so profitable as the ubiquitous payday lending industry (there are more of them than there are McDonalds and Starbucks combined and the intensity of low income neighborhoods is particuarly great), and as a result supervised lenders will not flood low income neighborhoods the way that payday lenders did, there will be a slow and steady increase in this kind of lending. No longer facing competition from unscrupulous but consumer friendly predatory lenders, banks and credit unions may begin to recolonize low income and minority neighborhoods that they had been squeezed out of by their flashier and more profitable competition.

At the consumer level, I expect to see the old fashioned savings accounts, Christmas funds and emergency savings in checking account become much more common. The fact that payday loan customers and rent to own customers manage to make regular installment payment at the excessive rates charged for that credit or quasi-credit with surprising low default rates despite the low and sometimes irregular incomes and poor credit histories of that population suggest that even the American working class in an era of stagnant income has significant income that could be devoted to savings rather than debt payments if the economy favored that choice.

Another big change I expect to see at the consumer level who have its greatest impact on the black and Hispanic middle class living in predominantly minority neighborhoods. Many of households in these situations have historically used subprime and predatory lending operators because their less affluent peers with fewer options use them and because they are ubiquitous in their neighorhoods. Yet, about half of the people who got subprime mortgages, a disproportionately minority group, would have qualified for FHA mortgages with far lower interest rates and far more fair terms. Deprived of subprime choices, many middle class minority households will earn of the more favorable conventional FHA lending options available to them and not be exploited by predatory for profit subprime lenders. Similarly, if rent-to-own and payday lending options no longer available, many predominantly lower middle class and middle class minority customers of those financing arrangements will learn that qualify for more conventional small loans and conventional credit cards, in both cases often though banks, that charge far lower interest rates.

Is The Homeownership Impact Bad?

Of course, many people who qualified for subprime mortgages will no longer be able to afford a house. But as I've noted before at this blog, there are real reasons to doubt that securing home ownership through subprime lending is in the economic best interest of the people who do it, relative to renting for a longer period of time and trying to save up for a down payment.

Furthermore, as I've noted in another previous post at this blog, most subprime lending is made to existing homeowners to finance consumer debts with second mortgages or refinances of first mortgages, an activity that does not increase the homeownership rate. Empirically, the number of foreclosures resulting from subprime loans going bad equals or exceeds the number of first time home purchases made with subprime loans, with the bottom line conclusion being that the recent modest increase in homeownership rates to all time highs can be attributed entirely to an increase in more conventional, lower interest rate FHA lending.

So, while the homeownership rate is likely to fall modestly, this does not mean that marginal homeowners are worse off economically as a result. The fact that home ownership is an important way for the vast majority of homeowners with conventional or FHA loans to build wealth and economic security does not mean that the same is true for marginal homeowners who pay excessive interest rates and incur obligations that render them economically insecure to do so.

Incentives To Save and Their Virtues

As the option to get goods and services first and pay for them later, or to use the ability to borrow money as an emergency fund evaporates, there will also be a very strong economically incentive for people who have made heavy use of high interest debt and lived paycheck to paycheck to instead get a paycheck or two ahead with savings in order to have funds to cope with emergencies or make big consumer purchases.

If the unavailability of high interest rate debt does indeed reduce the debt burden of and increase the savings rate of working class families and individual and minority middle class households, the economic benefit to those households and to the stability of the greater economy could be great. This is because saving first and buying later is a lot cheaper in the long run, making those families better off financially overall. Lots of these individuals don't know at a emotional level just how great of a burden not paying predatory lenders interest and fees would save them, but once forced to pursue less exploitive purchasing habits, a whole generation's attitudes towards borrowing, saving and consumer spending could be transformed for the better.

Playing by the rules does lead to economic success in America. But a lot of us have forgotten that one of "the rules" for those who are chasing the American dream is to postpone consumption, including purchases of particular houses and consumer purchases, until you can afford them, and this rule's corollary, which is to devote some of your income to savings so that you can make major purchases and buffer future economic hardships, rather than living paycheck to paycheck.

Isn't This Economic Paternalism?

Do the regulatory agenda and economic trends, partially completed and partially in process, impose some economic paternalism upon many poor, working class and middle class minority consumers? Yes, it does.

It subcribes to the theory that many people in this economic class are taken advantage of by amoral business interests who systematically exploit their lack of economic sophistication leading them to make decsions which are not in their enlightened economic self interest. Lassiez faire economics assumes that people act in their own rational economic self-interest, but in real life, people don't act quite like that and the worse abuses in our economy arise in situations where the rationally self-interested economic actor is least accurate in describing a typical person involved in a transaction.

These regulatory reforms target economic irrationality by using something like a substantive economic unconscionability analysis. They presume that someone is economically irrational and is being exploited in situations when it would be exceeding unlikely for a well informed economically rational person to engage in such a transaction, and either give special scrutiny to, or prohibit those transactions.

Sometimes parents have good advice. These changes will mean more of these households will be less able to live the good life now. But it also means that are far larger percentage of these families will be put on a sustainable path to a more comfortable life in the long term, gimmick free. We'll have to wait and see, but I believe that the larger package of state and local reforms that are coming together in the wake of the subprime mortgage collapse and related economic downturn, will make our economy both more sound and more just.

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