Should We Ban Prepayment Penalties?

Mike over at Rortybomb disagrees with a claim I made yesterday that the government would probably have had to regulate underwriting requirements in order to have really squashed the subprime bubble. Instead, he thinks a federal ban of prepayments would have done the trick.

He suggests that mortgage brokers and banks were eager to hand out subprime mortgages because they instituted prepayment penalties. That way, once the borrowers realized the terrible mess they'd gotten into after rates reset, they would have to pay an exorbitant fee to refinance. That's what allowed originators to lure them in with lower payments initially.

When I learned about mortgage-backed securities back in 2003, it was explained that residential mortgages generally do not contain prepayment penalties. My manager teaching the group of us even explained that, since he was so savvy about mortgages, he once begged his home mortgage originator to include a prepayment penalty in order to get a lower rate. The originator agreed, and much to my manager's chagrin, he ended up having to move shortly thereafter and pay the penalty anyway.

He also explained that for commercial mortgages prepayment penalties are very common. The assumption is that businesses are savvier about borrowing and understand that they will be penalized for refinancing their loan.

So, like Mike, I find the possibility that so many subprime mortgages contained prepayment penalties somewhat disturbing. At first glance this looks like a pretty underhanded tactic that mortgage brokers were using to trick borrowers into a hidden fee once their interest rate reset, their payments skyrocketed, and they had to refinance. I'm not so sure.

First, let's identify the purpose of a prepayment penalty. Originators like them because they deter borrowers from paying off a mortgage more quickly than expected. That means the mortgage investors have one less risk to worry about -- the cash flows they will receive and the time for which they will be receiving them are now more predictable, because the borrower probably does not want to pay a penalty. That's why commercial mortgage-backed securities generally have less prepayment risk than residential mortgage-backed securities.

So while it's easy to theorize that mortgage brokers were instituting these prepayment penalties just to take advantage of subprime borrowers, I'm not entirely convinced. That may be the case, but they could just as easily have wanted to make the mortgages they originate more attractive to investors who buy the mortgage-backed securities containing those mortgages they originate.

Clearly, this would make the bubble inflate faster, but I'm unconvinced that prepayment penalties had any kind of significant causal relationship to the bubble's very existence. The way the real estate was exploding, someone would have designed other strategies to make subprime mortgages more profitable -- prepayment penalties were just the easiest and most direct way to do so for adjustable-rate mortgages. For that matter, why stop at prepayment penalties: just eliminate adjustable-rate mortgages. That would have helped too.

While many factors might have helped, my suggestion was to say that the only way to have been sure to prevent the subprime bubble would have been to regulate underwriting. A path that I explained I am not too keen to venture down.

Now let me be clear: I am not saying I like the idea that residential borrowers would be unknowingly targeted by prepayment penalties. I am not even really against the suggestion that the practice should be banned, just lukewarm to it. I think in a better world, borrowers would have better information and understand the risk a prepayment penalty poses to them. Like my former manager, financially savvy consumers probably should be allowed to request prepayment penalties if they choose. He ended up regretting it, but he only had himself to blame.

I want to quickly respond to one more argument that Mike makes. He says fees like prepayment penalties are also bad because they should instead be incorporated into the ongoing cost of the mortgage -- the interest rate.

What's wrong with prepayment penalties at a higher level? In general, our banking system has moved to a system of fees. What would be good is correctly identifying what is a genuine fee from what is a transaction cost, as well as making financial agents less incentivized to making a profit through collecting fees and instead through providing a good/service. Making your profit off of fees and transaction costs takes attention away from the actual underlying, the service we want to encourage.

We need to be clear on terminology, and this agency can help. In many cases, these aren't fees. The burrito maker charges me a fee for my burrito (It is not from the benevolence of the burrito maker...), and I love him for it. In the case of a prepayment penalty, it's a transaction cost. The proper "fee" is the interest rate on the loan. This penalty is a transaction cost - it prevents money from going to where it needs to go, and gummy ups the market. Markets hate transaction costs. (His emphasis.)

I share his concern that fees don't provide an incentive for the service aspect of a mortgage the way interest does. But I'm not sure his complaint is properly directed, using prepayment penalties as an example. If the prepayment penalty were somehow incorporated into the interest rate, then it would cease to be a way to mitigate prepayment risk -- that would just make the interest rate even higher and consequently actually encourage the borrower to pay off the loan more quickly. That's why a prepayment penalty fee is the only way to mitigate prepayment risk