Subprime Blame Game

That means if a stockbroker convinces an 80-year-old retiree to take a few thousand dollars from the $10,000 left in his pension fund and sink it into speculative stocks, the stockbroker is in violation of the rule — more specifically NASD Conduct Rule 2110 and 2310 — and can be suspended or fined as punishment.

But what about all those subprime mortgages given out in the past couple of years like glow-stick bracelets at a rave? That was essentially providing loans with exotic interest rate schemes to people with blemished credit or low incomes.

Many have taken blame for the surge in home-loan defaults and foreclosures that followed the subprime boom. One group that's gotten its fair share is mortgage brokers, who are usually stand-alone and unregulated. Sen. Charles Schumer, a New York Democrat, referred to mortgage brokers as the "wild West of mortgage finance."

In part, the problem, says Glenn Mueller, professor at Denver University's Burns School of Real Estate and Construction Management, is that the mortgage broker does not represent the borrower — nor does he really represent the investors who ultimately own the loan. Mortgage brokers get paid for matching borrowers to lenders. Period. What happens from there, says Mueller, isn't a broker's concern.

Last week, Rep. Barney Frank (D., Mass.) proposed reforms that would tighten lending standards, including a requirement for federal licensing and registration for mortgage brokers and bank loan officers. It would also ban lenders from paying bonuses to brokers — known as "yield spread minimums" — for persuading borrowers to accept higher interest rates than they're qualified for. (Schumer introduced similar mortgage-broker legislation in the Senate in May.) Mueller says a rule that would more closely match the interests of those who facilitate home loans with those who take them is a good thing.

We spoke with Mueller about the proposed federal regulations and mortgage brokers' and real-estate agents' roles in the subprime blame game.

SmartMoney.com: What was mortgage brokers' role in the subprime mess? Was more supervision what was missing?

Glenn Mueller: With subprime loans, it goes, "tell me what you're income is and we'll accept it." The loan is for close to 100% of the cost of the house, so we don't have to do a normal credit check and appraisal.... "You don't really qualify for a regular loan, so we're going to give you a special loan with a lower interest rate, but it will adjust to a higher rate later." Many borrowers signed away the right to not have to pay a prepayment penalty. [A prepayment penalty is a provision of a borrower's contract with the lender that states that in the event the borrower pays off the loan entirely, he or she will pay a penalty. It discourages borrowers from refinancing to more favorable terms.] Many of them didn't understand that.

Mortgage brokers get paid for making a loan. They get their paycheck, they don't care. Their interests are not aligned with the investors or with the borrower, whereas banks' interests are aligned with the borrower because the borrower is the one who will keep paying them. Mortgage brokers' interests are not aligned with investors'; the investor will end up owning the loan for 30 years. If a bank makes the loan, the bank keeps the loan. No mortgage broker calls back their clients asking about payments. Banks are checking in with clients to see if they're making their payments.

SM: Do you think Barney Frank's proposed legislation is a good way of redressing that problem?

GM: It wipes out that prepayment penalty, so you have to allow borrowers to pay off the loan without the penalty. And regulating the mortgage brokers who were not regulated before is also a good thing. Now when they write down that this person makes so much in income, they have to verify it instead of just taking their word.... It's doing for mortgage brokers what they did for real-estate agents two decades ago.

SM: A lot of criticism has been aimed at lenders and mortgage brokers for the subprime mess. What about real-estate agents? They get paid by the home seller, but work with the buyer too.

GM: It's interesting that mortgage brokers are not licensed and real-estate agents are. Agents have gone through an evolution; they have to disclose information about the house, like if there are defects.... It used to be the real-estate agent represented a seller of the house and all commission was paid by seller. Now you have brokers also showing buyers around. Buyer agents are helping the buyer. The whole real-estate agent thing has evolved over the years. Once you've got someone who found a house they love, you want to help them get into it. You help them shop around for a broker. Most real estate companies have an in-house mortgage group.

The interesting thing is the whole idea of a loan being made [has changed a lot]. It used to be that a bank made a loan and kept the loan, had to service it and watch over it. It was at the bank's peril to make sure it got paid. Now we have the securitization of lending. A mortgage broker does the underwriting and sells it into a pool of loans — that's securitization.... Of course there's really two parts to that market. The original mortgage-backed securities, which the U.S. government helped to underwrite with Ginnie Mae, Freddie Mac and Fannie Mae, the government would guarantee those so customers wouldn't default. With the subprime-mortgage market, the loans are in a whole different category. And they're actually sold through the collateralized debt obligation [CDO] market, where you might be mixing together credit-card debt and a bunch of other stuff, including subprime mortgages.

SM: Do you see any kind of stricter regulation for real-estate agents?

GM: Many states, like Colorado, have [rules saying] agents must disclose if they are working for the buyer or seller. Still, they don't get paid until the buyer buys the house. If the buyer has the right income, it's not part of an agent's job to determine that. They put them together with a mortgage broker or lender.... [You] want buyers to get prequalified, to figure out how much they can take out in a mortgage. Good agents always prequalify their buyers. But if a buyer is telling them, "I'm qualified for X amount, and here's the paperwork," is it the agent's job to say that doesn't sound right, go get another qualification?

Real-estate agents already have a lot of regulation on them. Other than making sure the agent goes through a qualification process with the buyer, maybe you would require additional education for agents. But I doubt the realtors of the world want to take on that responsibility. They've got other things to do in their jobs.

SM: A spokesman for the National Association of Mortgage Brokers said the group had "deep concerns" about Frank's proposal. He argued that we should allow the market to adjust, which it has, rather than impose specific standards. Do you agree?

GM: In a sense, it's true that subprime mortgages can't be made anymore. Now they've tightened regulations again. The free market has adjusted from that standpoint. But I guess if the debt market wants to take the risk of taking loans at 100% instead of 80%, they can do that. If the question is whether the free market should set those standards, the answer is probably yes. But as far as documentation, income verification, credit checks, those are good things that protect the investors in the long run. In the free market, these subprime loans can be open to interpretation.