Should Individuals Be Regulated Like Wall St. Banks?

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.

Second, we should implement interim safety limits over the course of the loan. For example, if a borrower already has 6x debt/income and wants to take-on more debt, he or she would have to either put up more cash or exhibit increased earnings so that ratio wouldn't increase with a higher loan balance.  If the borrower doesn't have the cash on-hand or higher earnings, they can reduce their discretionary spending for a few months (years) to repay their existing debt.  Such regulation would not only protect existing lenders from increased default risk, but it'd protect borrowers from predatory lending standards. It's fair to ask what would happen under these regulations in an "emergency" situation?  Here, I'm not sure, but riddle me this: how many such situations are caused, or at the very lease exacerbated by years, if not decades of financial irresponsibility?

The third and most crucial regulation is that loan originators should be required to scan copies of official client-provided income, indebtedness, and net-worth information to a clients' electronic file. The originating broker should be responsible for personally inputting this information into the firm's loan application system and, verifying its accuracy.  Then, based upon government-imposed maximum indebtedness, coverage, etc, the originator could decide, based-upon their own scoring, how much debt the borrower is capable of handling, any amount up-to, but not exceeding the government-regulated number.  These firms should have strict compliance and internal controls, empowered internal and external audits, and random federal inspection to ensure they aren't abusing regulations, as well.

In much of my prior work I've expressed significant skepticism of our government's ability to not only create effective regulation, but to enforce it with any success, especially during those times when its needed the most.  While I'm no fan of creating more government bureaucracy, I don't see a reasonable alternative. As much as I'm loathe to admit it, the laissez faire approach has failed. We return to the status quo at our peril.

Would all this added red tape make it more difficult than in 2004-2006 to obtain credit?  For many people, absolutely. But look what happened when we let firms and individuals obtain virtually as much debt as they cared to take-on. We came precariously close to destroying the entire global financial system! Surely, GDP growth may suffer as expectations for consumer spending and home-price appreciation revert back to non-bubble-period means, but we'd be making a marginal sacrifice today in exchange for a much safer financial system down the road, one that would be far less at-risk of credit-fueled boom/bust cycles.

The ideas expressed here are admittedly nowhere near perfect. But the financial regulation debate deserves honesty. We must accept the fact that the crisis wasn't caused just by bad actors on Wall Street, but by Main Street, as well.

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*I'll be the first to admit that one would be hard-pressed to make the case that Wall Street is even tangentially concerned with the "greater-good," so long as its making money.  While he's even more cynical than I, The Epicurean Dealmaker captured what many observers fail to realize:

Investment bankers have almost no interest in why things are the way they are. Rather, they spend all their considerable intellectual and psychological resources on understanding how they can take advantage of the way things are. 

This may be a bit of an over-simplification, seeing as TED, myself, and several others who work(ed) in Finance do exactly that which apparently we do not, but as the recent FCIC hearings illustrated, TED's description certainly seems to apply to those at the very-top of the game.