Since the beginning of the crisis, the debate on financial regulation has focused on placing limits on financial services firms' behavior, based on the idea that the government has to protect Main Street from Wall Street. Recent history suggests that bankers lack the incentive or will to avoid unsustainable, economically disastrous, and downright predatory behavior.
But just as a securities trader can focus on short-term profits and ignore the incremental systemic risk introduced with each transaction, the average American often ignores the incremental risk he incurs with his own financial behavior -- each credit card opened, or each mortgage refinance. If we acknowledge that bankers lack the will-power to judge how much is too much*, then we must acknowledge the same failing in the common man, who lacks the banker's financial background.
The average American deserves protection not only from Wall Street, but also from himself. What if, hypothetically, we imposed regulations on individuals similar to those imposed on banks? Here are three ideas for saving average Americans from our own worst impulses.
First, the government should require borrowers to make at least 20% to 30% down payments (twice what Congress is asking) on residential real estate, unless the potentially borrower has income and/or savings sufficient to cushion against significant home price depreciation. Interestingly, after I began this experiment, the FHA announced "more stringent" requirements for certain borrowers, as the WSJ points out:
The FHA will keep minimum down payments at the current 3.5% level for most borrowers. But the agency will require riskier borrowers with credit scores below 580 to make a minimum 10% down payment. While the FHA doesn't have a credit-score cutoff, most lenders require a minimum 620 score.
Some housing analysts have pushed for higher down payments on FHA-backed loans, and a bill in Congress would raise down payments to 5%, from the current 3.5%.
It looks like the Government is making steps in the right direction, but I don't think its nearly enough. First Fair Issaic reports that ~13% of the general population has a FICO score below 600, while Experian reports ~20% are below 619. I'm curious why the new FHA rules would require the riskiest 10% - 20% of borrowers to put only 10% down when buying a home (whether credit scoring is an accurate or appropriate measure to use is another story). Most data suggests low-"quality" borrowers are long-term risks for lenders, and this is especially pertinent since the subprime meltdown. Thus, the government should mandate that high-risk borrowers must exhibit verifiable and stable high income and/or put down 20% if not 30% equity at closing.
Critics of this approach may argue that riskier borrowers compensate lenders by paying higher interest rates. But the same critics often fail to acknowledge that bringing more equity to the table generally helps the borrower -- with a larger cushion against declines in home prices and lower monthly payments. A higher interest rate hurts the borrower by imposing higher monthly payments, the bulk of which will be allocated to interest for the first few years of the loan, often the riskiest ones. Indeed, we've seen that ARM recast/resets have accelerated delinquencies, and in some cases, defaults.
This approach would correct biases -- like borrower over-confidence -- that are often discounted or ignored by lenders. If a potential borrower can't afford the higher down-payment, they should find an affordable rental in the short term. Chances are the amount they'd spend on rent will actually be roughly the same (and perhaps, less than the) amount of interest many low-quality borrowers would otherwise pay in interest over the first few years of the mortgage, when only a tiny portion of the monthly payment gets allocated to principal reduction.