Is plain vanilla the right goal?

Filed in archive mortgage news on June 30, 2009

As part of his efforts to protect consumers, and keep the country from suffering another wave of foreclosures, Pres. Barack Obama has called for the creation of a new consumer protection agency. The agency would have dominion over mortgage lenders. And as part of their new rules, mortgage lenders would have to offer customers what Obama is calling "plain vanilla" mortgage loan products alongside more complex mortgage options.

The goal here is to make sure that consumers know that they can take out basic mortgage loans — without adjusting interest rates, interest-only options or any of the other fancy stuff that got so many borrowers in trouble during the subprime mortgage-lending crisis — if they choose.

But the Washington Post today asks an important question: When does protecting the customer cross over into stifling innovation?

The Post, in its editorial, warns that while plain vanilla mortgages may be fine for many consumers — maybe even most — there are others with the financial savvy and knowledge to make more exotic mortgages work for them. It'd be a shame, the editorial argues, to pass legislation that would discourage reputable mortgage lenders from offering innovative new lending products, so long as they are sound.

I agree with this argument. Take a closer look at interest-only mortgage loans. They've become a burden these days to many homeowners who never should have taken them out. These loans usually come with artificially low interest rates for a set period, usually five to seven years. After this period, homeowners are usually faced with a far higher monthly premium, one that many today can't afford. Lenders always convinced buyers, though, that they'd be able to refinance. After all, housing prices are constantly rising, right?

Unfortunately, during the housing slump, housing prices haven't risen. They've fallen. Many holders of interest-only loans are unable to refinance. They're stuck with those higher payments, whether they can comfortably afford them or not.

The way responsible borrowers were supposed to use interest-only loans, though, was to make sure they could afford the higher payments after the loan adjusted. And while homeowners were paying the lower, interest-only payments during a five- or seven-year period, they were supposed to invest the money they weren't paying on their mortgage into safe, steady investments. It'd be a chance to make extra money.

Of course, I have no idea how many holders of interest-only loans did this. I'd guess that not many of them did.

But that doesn't mean that the few borrowers who did handle interest-only loans properly should have been discouraged from taking them out.

That's the fear with plain vanilla: You might discourage creative, smart money managers from financial success.