Truth in Government Lending is Long Overdue

Monday, March 26, 2012
By: Edward J. Pinto

The federal government has taken over large swaths of consumer lending, most notably the $10 trillion home mortgage and $1 trillion student lending markets. The government's share of new loans for each now approaches 100%.

Government monopolies in financial services pose risks to taxpayers as well as borrowers

The housing and education lobbies strongly favor government involvement in financial services. Their actions are based on two beliefs: (1) that the government is able to charge lower rates for loans-which comes as no surprise given the numerous advantages the government has over the private sector; and (2) that since the programs are designed to be self-sufficient; they pose no risk to the taxpayer.

If only this were true. Over the years, taxpayers have had to bail out failed government insurance programs such as the Federal Savings and Loan Insurance Corporation, Fannie Mae, and Freddie Mac. Others are insolvent: the Federal Housing Administration (FHA), the Pension Benefit Guarantee Corporation, and the National Flood Insurance Program to name but a few.

The Federal Deposit Insurance Corporation avoided insolvency thanks to the Troubled Asset Relief Program (TARP) and the Fed's imposition of artificially low rates for years, resulting in the transfer of hundreds of billions of dollars from savers to debtors.
Government insurance programs suffer from three fundamental flaws: (1) the government cannot successfully price for risk; (2) government backing distorts prices, resource allocation, and competition; and (3) political pressure and congressional demands for a quid pro quo inevitably arise, politicizing the programs.

This last point was central in the growth of the housing bubble and ensuing bust. Home lending had become politicized as low and moderate income housing mandates and demands for innovative and flexible lending standards impacted the entire market.
The federally guaranteed student loan program may be creating yet another bubble. The cost of four-year private and public college educations has gone up by 27% and 49% respectively (in constant dollars) since 2001, yet federally guaranteed student loans have increased by over 100% (in constant dollars). How fast can you say Fannie Mae and Freddie Mac?

Government insurance programs consistently underprice risk

A feature of the government's inability to price for risk is a conscious decision by Congress to underprice risk. The worst risks are inevitably priced about the same as the best ones and the lowest risk guarantees are used to cross-subsidize those with the highest risk. The US Department of Agriculture's (USDA) single-family guarantee program is the poster child for underpricing risk. A borrower with a FICO score of 620 (a score in the twentieth percentile) is able to get a zero down payment loan of say $150,000. The all-in cost of the USDA loan is at least $12,000 below what Freddie Mac would require for the same borrower paying five percent down. Up until recently, Freddie didn't price for risk. This has changed, at least while it is in conservatorship. The risk premium required by Freddie is high because about one in every five of borrowers with these characteristics is expected to fail.

When the government treats high and low risk borrowers in the same way, those with poor savings and bad credit habits are rewarded, while the low risk borrowers are penalized. At the same time, this policy encourages low-risk borrowers to take on more risks. The FHA's pricing experience demonstrates this: it requires a minimum down payment of 3.5% and has an average down payment of 4%. Whether one makes a 3.5% or a 20% down payment, the insurance premium is virtually the same. There is therefore no incentive to make a bigger downpayment, and the policy sends the wrong message to the home buyers.

A two-fold solution is needed

First, government insurance programs must be restricted to being prudent providers of guaranteed financial services to low- and moderate-income Americans. These programs must end their promotion of high-risk behavior.
Second, consumers themselves must be protected from the lack of pricing transparency in government insurance programs. This lack of transparency is used to mask imprudent guarantees from credit applicants. The solution is to pass a Truth in Government Lending Act (TIGLA). Each consumer applying for a government guarantee would be given an easily understandable disclosure form within 72 hours of application and at closing. The document would explain the expected failure rate of individuals with risk characteristics similar to the applicant's.

The federal student loan program also clearly demonstrates the need for TIGLA. The Department of Education reports that early default rates for guaranteed student loans range from about 5% for four-year public and private four year colleges to 15% for for-profit four year colleges with the average for all students being about 9%. While this wide difference is a serious enough problem, a new study published by the New York Federal Reserve Bank found that actual student loan default rates are more likely 27% or triple the rate reported by the Department of Education. Like the FHA and other government insurance programs, the student loan program uses specialized accounting and reporting rules not applicable to other types of consumer credit. After adjusting for these effects, the NY Fed study concluded that about 27% of students who had graduated and were in the student loan repayment phase were delinquent. Equally ominous, 75% of these past due borrowers were over the age of 30. Providing this information would help new students evaluate the relative risks and returns of their chosen institution of higher learning and field of study.

Ignoring risk does not eliminate it

Today, the four fastest growing government insurance programs are the FHA, the USDA's single-family guarantee program, Ginnie Mae, and the direct federal student loan program.

We have seen this movie before and a bad ending is inevitable. Government insurance programs must be reined in before the government's control of multiple financial sectors leads not only to further bailouts, but to uninformed and imprudent risk-taking by consumers.