Should Negative Amortization Loans Be Banned?

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Having written several articles on Negative Amortization Loans, telling of the details of what is wrong with them, and even destroying the myth of Option ARM cash flow, I sometimes get asked if I would like to see them banned completely.

Well, given the pandemically misleading marketing that surrounds these loans, and pandemically poor disclosure requirements, I am tempted. It only takes one person losing their life savings and having their financial future ruined to make a very compelling story, and I've seen more than one and read about many more.

However, when you ask if they should be banned outright, I have to answer no.

Part of this is my libertarian sympathies. Adults should be allowed to make their own mistakes. But there are economic and a realpolitik reasons as well.

The fact of the matter that just because Negative Amortization loans are oversold under all of the friendly-sounding marketing names such as Option ARM, Pick a Pay, and even 1 Percent Loan (which they are not), does not mean that there is no one for whom they are appropriate or beneficial. People for whom these are appropriate do exist. Consider someone with crushing consumer debt, and no significant usable equity on a home they've owned for a while. They sell the home, they end up with nothing and still have the consumer debt. They can't refinance cash out. But if you put them into an Option ARM for a while, you remove from several hundred to over a thousand dollars per month from their cash flow requirements. In three years, they will pay off or pay down those consumer debts, and then you refinance to put them back on track, and the money that has accumulated means nothing compared to what they've paid off. It's a very narrow niche, but it does exist.

Consider also someone starting a business. Cash flow insolvency is what kills most start-up businesses. Until the customer base builds, they don't have enough money to pay the bills. Lower monthly cash flow requirements on their house can mean the difference between success and failure of their business, far outweighing the cost of the extra money in their balance that they accumulated. Furthermore, the fact is that when their cash flow gets tight, they're not making the mortgage payment anyway. They are likely to lose both business (through insolvency) and property (through foreclosure) if the business fails anyway, and the lowered cash flow requirements of the Negative Amortization loan may give the business more of a chance to succeed, and once it is profitable it will pay back the investment many times over.

There's still a need to really explain what's going on, and all of the drawbacks of the loan, but people in these two circumstances really do have a valid possibility of it being in their best interest. Banning negative amortization loans completely takes away that option, thereby hurting those people.

Furthermore, in realpolitik, it is unlikely that any attempt to ban them will be successful, or permanent if it is successful. Let us presume some public spirited official in Congress or at the Fed decides to make the attempt. What do the scumbags who make their living selling these loans do? They won't go back to selling real loans with real payments - if they could do that, they wouldn't be selling negative amortization loans. Negative amortization loans are a way to sell property without the apparent up front costs of a higher payment that always will be indicative of the housing market. Given a choice between giving up screwing people and fighting back, they are going to fight back. Lobbyists, PAC, and grassroots deception en masse, and probably astroturfing as well. If the average voter gets a pamphlet saying Congress or the Fed is trying to ban these loans that "are the only way middle class people can afford a home!", they are not going to do research in order to educate themselves about what is really going on. They are going to call their congress critter and voice the opinion the negative amortization industry gave them - and they're likely go so far as to go apply for one themselves, unless they already know what a bad deal that loan is. Chances of congress resisting: Basically nil. There is no organized group in opposition, no budget for groups that want to push a ban. Any ban would be politically dead on arrival.

There is an approach that will work, however: Disclosure requirements. If these people have to tell the prospective victims in easy to understand language and easy to read print about all of the problems they are letting themselves in for with these loans, very few people are going to sign on the dotted line. "Caution: If you accept this loan, the 1% is a nominal, or in name only, rate. You are really being charged a rate of X%, and this rate will vary every single month. If you make the minimum payment, your loan balance will increase by approximately $Y per month at current rates, or Z percent within five years. You will have to pay this money back in lump sum if you sell, or with higher payments at a later date. If you cannot afford full payments now, you will unlikely be able to afford them in the future after your balance has increased. There is a three year prepayment penalty on this loan, and if you sell the property or refinance within that time, you will pay a penalty of approximately $A in addition to whatever additional balance has accrued. It is currently under consideration that the mere fact that you have one of these loans will have significant derogatory effect upon your credit rating, even if you never make a late payment, due to financial difficulties encountered by borrowers with this kind of loans in the past." I could go on in bullet points for a couple of pages, but I trust you get my point. You have all of this in writing from the federal government, the least an intelligent adult is going to do is find out what's really going on here.

Furthermore, the only way disclosure requirements could be fought by the industry is behind closed doors. The only way it stays behind closed doors is if nobody raises a political stink, and it's easy to raise a political stink about stuff like this. Newspapers and television reporters and bloggers all converge on the issue, and the industry is left in the awkward position of crying because they have to tell the truth. That doesn't play well with the American public. The way this plays with the American public is the major reason for the successes of Porkbusters. Despite some very entrenched and very powerful enemies lining up against them, they've won on a couple of big issues because of the power of the idea that the American people have that the truth should be told. Take the tack that all you want is for the industry to tell the truth, and watch the political wind die out of their sails. David beats Goliath reliably in American politics when the issue is "Do I have to tell the truth?"

To summarize, it is tempting to try to ban negative amortization loans. But it is far better social and economic policy to go the disclosure route instead, and far more likely to be politically successful.

Caveat Emptor

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This page contains a single entry by Dan Melson published on March 23, 2008 7:00 AM.

Manufactured, Modular, and Site-Built Homes: How Lending Practices Drive the Sales Market was the previous entry in this blog.

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