Chicago Fed Chief: Educate Borrowers to Avoid Defaults
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- Kirk Haverkamp | August 27, 2010
Educating borrowers to make better financial decisions might be a better way to protect them from risky mortgage products rather than banning such products entirely, one of the governors of the Federal Reserve has proposed.
Speaking on how to prevent a repeat of events such as the subprime mortgage crisis, Charles Evans, president of the Chicago Federal Reserve Bank, cited studies showing that financial education can lower default rates among subprime borrowers. Such an approach, he suggested, could help steer such borrowers away from risky mortgage products while still making those products available to the small pool of borrowers who might benefit from them.
“The mortgage crisis was caused in part by the use of inappropriate mortgage products,” Evans said, addressing a meeting of the Indianapolis Neighborhood Housing Partnership this week.” While economists usually give great respect to individual choice, in this case it seems that many borrowers made poor choices and that at least some lenders abetted those poor choices.”
Some borrowers benefit from nonstandard loans
Evans said that simply eliminating nonstandard mortgages would be one way to ensure that unqualified borrowers don’t get into risky loans. However, since there are certain borrowers for whom such mortgages make sense, he said such a policy would have certain costs.
Though Evans did not say so specifically, nonstandard mortgages – such as adjustable rate loans, interest-only mortgages, no-documentation loans and the like – were traditionally products used by financially savvy borrowers to purchase higher-priced homes, prior to being extended to subprime borrowers during the expansion of the housing bubble. Eliminating such products entirely, the thinking goes, could crimp the recovery and eventual normal functioning of that part of the housing market.
Counseling found to reduce defaults, risky loans
He noted that one Indianapolis program designed to shore up the finances for low- and moderate-income borrowers to prepare them for home ownership succeeded in significantly reducing early default rates compared to other borrowers, even though participants entered the program with worse credit.
Another program in Chicago required that borrowers with low credit scores or taking out high-risk mortgages in certain areas go through a mandatory counseling session before the loan was closed. Evans said that while the counseling itself did not appear to influence borrower’s decisions as to whether to go ahead with the mortgage, it did seem to help limit nontraditional loans.
Some lenders, he said, became more reluctant to offer risky loans to marginal borrowers, over concerns of having their loans scrutinized and being accused of predatory lending. And some borrowers simply opted to go with more traditional mortgage products to avoid the counseling requirement.
Cost a significant issue
“My take is that financial education can work, but the programs must be very well designed and rigorous for financial education to be truly effective,” Evans said. “Whether such programs can be implemented on a wide scale at reasonable costs is an open question.”
Noting that wide-scale consumer financial education could be very costly, Evans said another possibility would be to give consumers choices, but provide incentives to encourage them to choose low-risk options, much as occurred with the borrowers in the Chicago program who opted for traditional mortgages instead of going through counseling.
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