The CFPB Should Prioritize Mortgage Reform

Earlier this spring, the new Consumer Financial Protection Bureau (CFPB) launched its official website and started actively soliciting public input for its policy initiatives.

Created as part of the landmark 2010 Dodd-Frank Act, CFPB is set to fully launch in July. So in just two months, the agency will be fully staffed with 1,000 workers and wield immense authority over a wide range of consumer financial products.

One of the CFPB's chief challenges will be reforming the mortgage industry. Dodd-Frank grants the agency sole oversight over the two major federal mortgage laws -- the Truth in Lending Act and the Real Estate Settlement Procedures Act. And in January, the Federal Reserve handed over much of its mortgage-rulemaking authority to the CFPB.

Obviously, the rules currently governing the housing market are insufficient. Since the start of the current recession, over 5 million homes have been reclaimed by lenders. And an estimated 13 million more will be foreclosed by 2015.

There is still a fundamental misalignment between the economic interests of mortgage buyers and lenders. Without reform, America will continue to be burdened by bad loans, banks will continue to have an incentive to sell off their mortgages to get turned into dangerous derivatives, and we as a nation will continue to run the risk of another major economic downturn.

So, what should be the CFPB's top targets of mortgage reform?

First, banks need to be given incentives to keep mortgages on their books. Too often, lenders sell off home loans to third-party investors, who in turn fold that loan in with others to create a larger financial device that gets sold to yet another outside investor.

The major problem is that banks are left with little reason to ensure that their mortgages are healthy. After all, they aren't the ones who will bear the costs in the event the buyer defaults.

On the flipside, when banks keep mortgages on their books, they're enabled and encouraged to develop a more intimate relationship with the buyer. The bank has a financial incentive to, say, consider mortgage modification in the event the homeowner unexpectedly falls on hard times. And that intimacy tends to lead to less dangerous loans, happier customers, and lower foreclosure rates.

Indeed, new research from Ohio State University professor Stephanie Moulton finds that among some 20,000 low-income homebuyers who took out a mortgage between 2005 and 2008, those who borrowed from a local lender had markedly lower rates of default and delinquency than those who used more distant banks or mortgage companies.

As Professor Moulton has explained, "if there's a relationship, the borrower may feel more obligated to make their payments. And the banks may provide more education and information to the borrowers, equipping them to be better home owners."

A simple way to keep mortgages with the original lenders and cultivate that relationship with homebuyers it to require lending institutions to own at least 5 percent of the risk of a mortgage before they're allowed to securitize it.

Additionally, policy makers should institute more tax incentives for customers to take out shorter-term mortgages. It's often unaffordable for banks to keep the clunky, 30-year behemoths that have become the industry standard. Five, seven, and ten year mortgages, amortized over 30 years, come with less risk.

On the customer side, instituting at least a 20 percent down-payment requirement would force homebuyers to prove that they can indeed handle the financial responsibility of a mortgage. And because such a requirement gives people immediate, substantial equity in their homes, homebuyers would have a financial incentive to work with their lender to adjust their terms in the event of financial hardship -- as opposed to just walking away from their home, as millions of Americans have done during the latest crisis.

Another top CFPB priority should be increasing transparency in the mortgage purchasing process. The average home loan is hundreds of pages, written in dense, opaque legal language that very few people can understand. As a result, homebuyers are often in the dark as to what exactly the loan is going to cost them, and they end up paying thousands of dollars in extra fees like title insurance and prepayment penalties.

Buying a home does not have to be confusing. And customers deserve to be told in plain English the terms of their loan.

Fortunately, Elizabeth Warren, the Harvard law professor tasked by President Obama to lead the creation of the CFPB, seems committed to improving mortgage transparency. In a recent letter to Congress, she wrote, that "we are working to reduce [mortgage] forms into a single, readable document that would be easier for consumers to understand and cheaper for lenders to execute"

The mortgage market needs to be fixed. And the CFPB is the agency to do it. By focusing on the key problems driving irresponsible lending practices, policymakers can improve the financial outlook for millions of homebuyers and prevent another crisis.