Consumer Protection / Mandatory Disclosure



Why Mortgage Borrowers May Need Protection 

Mortgage borrowers transact infrequently, in some cases only once in a lifetime, which means that (unlike purchasing cheese) they do not have an opportunity to learn from experience. Because the transaction amount is large, furthermore, the cost of a mistake is extremely high.

The likelihood of mistakes, furthermore, including deliberate ones induced by unscrupulous loan providers, is high. This reflects the complexities of the transaction, and the fact that the loan provider understands them a lot better than the borrower – a condition referred to by economists as “information asymmetry”. 

In most mortgage transactions, the lender writes the contract, and often the borrower doesn’t see it until the closing. Many of the contract provisions are complicated and difficult for borrowers to understand. Mortgage pricing can also be complicated, including multiple lender fees as well as interest rates subject to adjustment. There may also be fees charged by third parties involved in the transaction. 

In addition, because mortgage transactions take a lot of time, the borrower scheduled to close on the purchase of a home reaches a point of no-return with a mortgage lender when there is no longer enough time before the closing date to find another lender. That leaves the borrower committed to the home purchase entirely at the mercy of the lender.

Imperfect Markets Versus Imperfect Government 

The fact that consumers are not being well served by an imperfect market is a necessary, but not a sufficient condition for justifying intervention by Government. Governments are also imperfect, and the remedies they bring to markets may be worse than the disease. Sometimes, furthermore, markets will cure themselves in time if Government stays out of the way. 

The case for intervention, therefore, should be based on a considered judgment that the market will not fix the problem itself, that intervention will fix the problem, and that the new problems created by the intervention will be less serious than the one that has been fixed.

Alternative Modes of Protection 
Governments have attempted to protect mortgage borrowers in any or all of the following ways:

  • Disclosure Rules, where Government stipulatesinformation that must be disclosed to borrowers, and how and when it must be disclosed. 
  • Price Controls, where Government sets maximum mortgage prices. 
  • Underwriting Controls, where Government sets limits on lending terms. 
  • Contract Controls, where Government rules what must be, and what cannot be in a mortgage loan contract. PART



Mandatory Disclosures

The Case For Mandatory Disclosure

Market-oriented economists opposed to all types of government regulation usually make an exception for markets characterized by extreme information asymmetry. It is well understood that markets don't work well when one party to transactions has vastly more information than the other.

Because mandatory disclosure is designed to make markets work better, it is viewed much more favorably than price controls, which distort the allocation of credit; or contract controls, which reduce the options available to consumers.

The home mortgage market is a textbook case of information asymmetry. One party is in the market continuously, the other very infrequently -­sometimes only once or twice in a lifetime. Furthermore, transactions can be extremely complex. There may be multiple instruments from which to select, multiple options with each instrument, complex pricing arrangements, and frequent price changes. For the borrower, there may be a lot to learn and very little time in which to learn it.

To be sure, complexity varies greatly from one country to another -- the US has the most complexity by far. Many other countries are moving in the same direction, however, propelled by the same forces that have operated in the US: the development of secondary markets and increasing competition. In the European Community, integration is intensifying these pressures. Countries moving rapidly toward greater complexity in their home loan markets, and therefore toward greater information asymmetry, will need to consider mandatory disclosure.

Limiting Mandated Disclosures

Perhaps the most important principle for making disclosure policy effective is that the number of items that must be disclosed be limited to 10 per day. If the process extends over 2 or 3 days, the number of mandated items can be increased to 20 or 30. I will explain where these numbers come from shortly.

The rationale for this rule is that consumers have a limited attention span. If you feed them too much at one time, they can't absorb it. Disclosures in the US are so voluminous that for most borrowers they are useless. Disclosing everything has much the same effect as disclosing nothing, since most people will absorb nothing.

Beginning in 1998, I began writing a newspaper column on mortgages that invited questions from readers. I have fielded about 12,000 questions since then, and one recurs with amazing frequency: "Why wasn't I told about...?" The content of the question varies over time, e.g., in 2002 it was mostly about prepayment penalties. But the question usually applies to something that was in fact subject to mandated disclosure, as prepayment penalties are.

Every borrower in the US receives a Truth in Lending (TIL) disclosure that reveals whether or not the loan has a prepayment penalty. But this critical item is shown in the middle of a large form full of other information, some of it distracting, most of it useless. Further, the TIL is received by the borrower on the same day he receives multiple other disclosure forms.

As far as the regulator and the lender are concerned, disclosure about a prepayment penalty is made when the borrower receives the TIL. Yet a large percentage of borrowers in fact don't know whether or not they have one. Mandated disclosure is ineffective because of information overload.

Where did I get the 10 items of information referred to earlier as the limit on disclosed items? From my crystal ball. The correct number may depend on the nature of the disclosed item and many other factors, some of which will vary from country to country. I'm not trying to sell that particular number. I'm trying to sell the idea that there should be such a number.

Setting limits means setting priorities. As a general matter, setting the number low and selecting the most important items increases the probability that those items will be effectively disclosed. As the number of disclosed items increases to include items of less importance, the probability that the most important items will be effectively disclosed declines.

A reader has pointed out to me that some borrowers could extract what they need from the most overblown set of disclosures, suggesting that I have overstated the case. I don't agree. Borrowers who know what to look for don't need mandatory disclosure; they can get the information they want by asking for it. Mandatory disclosure is for borrowers who don't know what to ask for, and therefore don't know what to look for in voluminous disclosures.

Fixing Responsibility

Responsibility for mandatory mortgage disclosures should be lodged in one agency. That agency can be held accountable for the results, whereas if there is more than one agency involved, none of them will be fully accountable.

With multiple agencies, furthermore, limiting the number of disclosure items will be extremely difficult. Neither agency is likely to consider the impact of the other on the borrower's capacity to absorb information. If the agencies are required to consult, expect a turf war in which each is convinced that its items should have priority. In addition, divided responsibility may lead to competing disclosure formats, which confuse borrowers.

In the US until very recently, responsibility was divided between the Federal Reserve System (FRS), and the Department of Housing and Urban Development (HUD). Divided responsibility seemed early on to be a completely logical solution to two different problems. One problem was a wide diversity in the way in which the cost of credit was calculated and reported between different types of credit, and by different lenders in the same market. The legislative remedy, called "Truth in Lending" (TIL), applied to all consumer loan markets, not just home mortgages. It was natural to delegate regulatory responsibility to the FRS, which, as the central bank, had broad responsibilities for all loan markets.

The second problem was a series of abuses in connection with real estate settlement charges. The legislative remedy, called Real Estate Settlement Procedures Act (RESPA), pertained only to real estate markets. Hence, it was natural to delegate regulatory responsibility to HUD, which was the principal Federal housing agency.

But the price of divided responsibility was an ineffective disclosure system. Each agency developed its own disclosure form, without any consultation with the other. The total number of items on both forms was grossly excessive, with useful information intermixed with useless information. There was no way for a borrower to reconcile the information on the two forms.

The system of divided responsibility ended in 2012 with the creation of the Consumer Financial Protection Bureau, which took over responsibility for all mortgage-related disclosures.

Disclosing the Cost of Credit

The cost of credit is the centerpiece of mandatory disclosure. A critical requirement for effective disclosure of credit cost is comparability. A quoted credit cost of "6%" by lender A should mean the same thing as a 6% quote by lender B. Further, the true cost of a 6% mortgage should be identical to that of a 6% automobile loan and a 6% personal loan.

Conceptual uniformity:
One requirement of comparability is conceptual uniformity. The most widely used concept for measuring interest cost is the internal rate of return (IRR). On a mortgage, the IRR is (i) in the equation below:

L - F = P1 + P2/(1 + i)2 +... (Pn + Bn)/(l + i)n

Where: i = IRR
L = Loan amount
F = Upfront fees paid by the borrower

P = Periodic payment
n = Period when the balance is prepaid
Bn = Balance in period n

Expressing all interest cost quotes as an IRR creates comparability across a wide range of methods that have been used historically to calculate interest payments. For example, in the US a 6% home mortgage refers to an instrument on which interest each month is calculated by multiplying .5% (1/12 of 6%) by the balance in the preceding month. Assuming F is zero, the IRR on this mortgage is 6%.

A 6% 3-year consumer loan, however, refers to an instrument on which interest is calculated by multiplying 6% times the loan amount times 3. The IRR on such a loan, assuming monthly payments equal to the loan amount plus interest for 3 years divided by 36, is 11.09%. The quoted rates mean different things but the IRRs are comparable.

Similarly, in some countries, mortgage interest may be calculated quarterly, semi-annually or annually. The IRRs on 6% mortgages in these cases are 6.02%, 6.04% and 6.09%, respectively.

Period Over Which the IRR is Calculated:
If a loan includes upfront fees, the IRR declines with the passage of time. For example, on a 6% 30-year loan of $100,000 with $4,000 in upfront fees, the IRR is 6.39% when calculated over the entire term. But if the balance is paid in full after 10 years, the IRR is 6.58%, and if full payment occurs after 5 years it is 6.98%. Which is the proper IRR?

This is not an academic question. Suppose a borrower was trying to choose between the loan above, and a 6.5% loan with no fees. The IRR on this loan is 6.5% regardless of when the loan is paid off, but whether this is higher or lower than the IRR on the first loan depends on when the other loan is paid off.

In mobile societies where few loans run to term, this is a major problem. The optimal way to handle it is to calculate the IRR over the period requested by the individual borrower. When generic IRRs are shown, as in media advertising, they could be shown at term and for 1 or 2 shorter periods.

Nominal Versus Effective:
The IRR is a "nominal" rate because it does not take account of monthly compounding. The "effective" APR on a 6% monthly payment mortgage with no fees, that does take account of monthly compounding, is 6.17%. In principle, it would be better to express all rates as effective rates because it would provide comparability between monthly and weekly or biweekly payment mortgages. As a practical matter, however, the differences are too small to justify the added complexities.

Definition of Fees:
The fees that should be included in the IRR are those that would not arise in an all-cash transaction. All fees associated with a refinance should be included, but on a purchase transaction fees that would arise if the borrower paid cash should not be.

The fees should include payments to the lender of any type, plus payments to third parties providing services required by the lender as a condition for granting the loan. These include reporting on the credit history of the applicant, appraising the property, verifying and perhaps insuring the validity of title to the property, and insuring the mortgage. All such third party charges are part of the cost of credit and will be paid for, directly or indirectly, by the borrower.

A possible exception is fees paid to governments in connection with the loan, for example, a stamp tax or mortgage recording tax. Since these fees are outside of the lender's control, it doesn't make any difference whether they are included or excluded from the IRR so long as treatment is uniform.

Disclosure of Other Contractual Provisions

Mandated disclosure also should include important provisions that may vary from loan to loan and that may be disadvantageous to the borrower. Examples include prepayment penalties, restrictions on assignability, late charges, and the right of the lender to call the loan. The list of such features is likely to vary greatly from one country to another.

Contractual provisions that are standardized by law or custom, or that benefit the borrower,need not be a part of mandatory disclosures.

Testing Disclosures With Borrowers

The agency with responsibility for mandatory mortgage disclosure should be required to test disclosure forms with borrowers for effectiveness. If not required to do this by law, the natural inclination of a disclosure agency is to check only its political constituencies. These might include, for example, lenders, developers, and community groups, but not borrowers. Since the agency responsible for disclosures is not likely to have the skills needed for testing effectiveness, there is much to be said for mandating that the agency contract with a private firm to do this work. The firm would be charged with determining the extent to which borrowers understand and digest the information disclosed, and also whether the proper information is being disclosed. Since markets, instruments and contracts change over time, the review function should be repeated periodically.



Price Controls

Mortgage prices include the interest rate which is paid over the life of the mortgage, and fees paid upfront to the lender and to third parties involved in the transaction. Adjustable rate mortgages may have other price components, such as a maximum lifetime rate and/or a maximum rate change.

Controls on Interest Rates

Government imposed price controls almost always take the form of a maximum interest rate. In theory, if the market power of lenders maintains market rates above what they would be under competition, Government could make the market work better for borrowers by setting a maximum rate equal to the competitive rate. But this would require that Government have the knowledge and tools needed to determine the competitive rate, the discipline required to apply this knowledge consistently, and the flexibility to adjust the rate as needed, which could be daily. This is too much to expect of government.

More likely, government will set the rate too low, resulting in few loans being made, or too high which may result in market rates higher than those that would have prevailed otherwise. So long as there are multiple loan providers that borrowers can shop, Governments should leave the interest rate unregulated.

Controls on Lender Fees

Shopping is less effective if borrowers have to concern themselves with differences in lender fees as well as in rates. The worst of all worlds for borrowers is the practice of charging different fees for different services, which are not fully disclosed until the borrower is well along in the transaction.

Government can easily take fees out of the picture by setting a single charge for all lenders. This would allow borrowers to shop the interest rate. A second best would be to require that every lender post one price covering all their services. Borrowers would then have to consider differences between lenders in fees as well as in rates, but at least they would know what these are upfront.

Controls on Third Party Charges

The mortgage process may involve services contributed by third parties, such as appraisals, credit reports, title insurance, flood insurance, mortgage insurance, and closing/recording services. Borrowers will be over-charged for these services if they are required to pay for them. If lenders are required to pay for these services, passing the cost along in their rate and fee, it will cost borrowers less.

Lenders pay less for third services than borrowers. Lenders purchase in bulk and are knowledgeable purchasers, borrowers aren’t. When lenders purchase, the service providers must compete in terms of price. When borrowers purchase, they rely on the lender to select the service provider, who compete for referrals from lenders. This is sometimes referred to as “perverse competition” because it raises prices rather than lowering them.

Bottom line: Government should require that any service required by a mortgage lender as a condition for the granting of a mortgage must be paid for by the lender.



Underwriting Controls

Loan underwriting is the imposition of a set of requirements for loan approval designed to minimize risk of loss from borrower default.

  • Requirements that the borrower have sufficient income relative to their current and prospective debt payment obligations are designed to assure the borrower’s capacity to repay the loan.
  • Requirements that the borrower have a credible history of meeting obligations are designed to assure that the borrower is willing to repay.
  • Requirements that the property have value in excess of the amount borrowed are designed to assure that in the event that the borrower does default, sale of the property by the lender will cover all or most of the amount owed.
As a general rule, lenders protect themselves against loss very well and there is no need for government involvement. Indeed, Governments often view private lenders as excessively cautious, denying credit to many worthy applicants. This has been the rationale of many special loan programs supported by government that offer less restrictive underwriting rules.

But there is one important exception. During a housing bubble, in a system in which mortgage lenders securitize mortgages for sale to investors, underwriting restrictions that are not constrained by Government may be unduly liberalized. Rising home prices induce investors to overlook underwriting deficiencies. This is what happened in the US during the period 2004-2007, and when the house-price bubble burst, investors all over the world were burned.

But this is a cyclical issue, as opposed to a structural one, and does not call for a permanent set of Government-imposed underwriting restrictions. Rather, the appropriate remedy is stand-by authority to impose such restrictions when circumstances make them necessary.



Contract Controls

Since lenders typically write mortgage contracts, it is not surprising that the contracts are structured to serve lender interests. But this is as it must be to induce lenders to lend, and the only rationale for Government involvement is where a contractual provision is abusive and unnecessary. An example is a provision that gives the lender the right to demand immediate repayment for any reason. A number of contractual provisions have valid uses but could be abusive if borrowers receive no benefit from them or are not fully aware of them when they sign on. For example:

  • A balloon provision requires the borrower to repay the loan balance at the end of some specified period that is shorter than the term, allowing the lender to reduce interest rate risk. It shifts that risk to the borrower, who must pay the current market price to extend the loan.
  • A prepayment penalty requires the borrower to pay a penalty for early repayment of the loan balance, partially offsetting the loss of income that results from early repayment. Such a penalty can make a refinance unprofitable for the borrower.
  • A provision for negative amortization allows the borrower to make monthly payments that don’t fully cover the interest due, resulting in a rise in the loan balance. Lenders do this to expand their market and borrowers are enabled to purchase houses they could not otherwise afford. 
All of these provisions have been made illegal at one time or another in some jurisdictions. The first two are often considered unfair to borrowers, without necessarily considering whether borrowers received a quid pro quo for accepting them. The third is considered dangerous to the borrower because of the rising future payments that result, without necessarily considering whether the borrower will have the capacity to make the payments.

Because these provisions may be useful to borrowers, good mandatory disclosure generally is a better way of dealing with them than contract controls.


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Jack Guttentag

Jack Guttentag

Jack Guttentag is a Professor-Emeritus of Finance and has been a member of the faculty of the Wharton School since 1962. Dr. Guttentag is presently co–director of the Zell/Lurie Real Estate Center’s International Housing Finance Program.