Chicago Fed Explores Effectiveness of Home Buyer Counseling

Federal Reserve Bank of ChicagornPresident Charles Evans pointed directly to a major problem with the economicrnsystem in a speech before the Indianapolis Neighborhood Housing Partnership on Wednesday: a serious deficitrnin the country's financial literacy. </p

His solution, however is aimed less atrneliminating that illiteracy than at incentivizing it in appropriate directions.</p

Evans spoke at the Indianapolis Neighborhood Housing Partnership (INHP) Community Breakfast on the roots of the housing crisis and current plans to end it, but his speech differed a bit form the formulaic presentation given over and over by financial and housing officials.  While others have pointed to the use of inappropriate mortgage products as one cause of the crisis, rather than vilify these products such as option mortgages or those with zero amortization, Evans made room for them at the table.</p

“While economists usually give great respect to individual choices,” he said, “in this case it seems that many borrowers made poor choices and that at least some lenders abetted those poor choices.”  Evans said that people who had no business getting exotic mortgages not only got them, but got them without any verification of their ability to pay.  There are two policy approaches to insuring that a housing meltdown does not happen again.  One would be the imposition of stringent regulations that eliminates those inappropriate products.  This would certainly prevent unqualified borrowers from obtaining them, but these products might be perfectly appropriate to certain people and certain situations, so strict regulation could have some real costs.</p

An alternative, he said, would bernto place few restrictions on the choices available to borrowers but to betterrneducate them about home ownership and mortgages. rn”This would make borrowers better prepared to make informed financialrndecisions.  Such an approach might keeprnthose who should not have exotic mortgages from getting them while leaving suchrnmortgages available to the small group of people for whom they arernappropriate.  </p

In effect, Evans was preaching tornthe choir.  INHP operates an innovativernfinancial coaching program which has been the subject of a Federal Reservernpaper on the subject, a fact which Evans alluded to in his speech.  However, he said, “The big question isrnwhether financial education can work.” </p

Chicago Fed staff has recentlyrnundertaken a review of studies evaluating the effects of financial educationrnand they found that the evidence on its effectiveness is mixed.  Some programs have improved financialrnoutcomes due to increased financial literacy however other programs are lessrnsuccessful.  Evans said that, while more researchrnis needed, his own opinion is that programs must be very well designed andrnrigorous.  Further, he said, it is anrnopen question as to whether effective programs can be implemented on a widernscale at reasonable cost.</p

The INHP program was included inrnthat evaluation.  It is aimed at low-andrnmoderate-income households, and designed to prepare them for home ownership.  Under the program, prospective homeowners arernassigned a coach who will work with the client for up to 24 months to providernguidance and education on money management, improving credit scores, reducingrndebt, negotiating collection balances, and saving for a down payment on a home.  In addition to monthly meetings with therncoach, the client also attends formal classes.   While the program is completely voluntary, itrnhas strict requirements and clients who do not fully participate may be askedrnto leave.   Evans said an important component of thernIndianapolis program is its continuation following the home purchase andrninvolvement with the client should problems arise.</p

Other research had already showedrnthat the INHP clients improved their credit scores during counseling, makingrnthem better candidates for mortgages, but the Federal Reserve study indicatedrnthat the training did indeed translate into improved loan performance.  Compared to other borrowers, the INHP clientsrnstarted the program with significantly lower FICO scores and lower incomes andrnhad accrued smaller down payments.  Yet,rndespite their financial condition at entry, they had a lower default rate – 3.8rnpercent compared to 6.4 percent – than other borrowers over the course of arnyear.  When researchers controlled for anrnarray of additional influences, the differences grew.  The 12-month default rate was typically 8 torn9 percentage points lower than for comparable borrowers who had notrnparticipated in the INHP program.</p

However, Evans said, thernsuccess of counseling is certainly not guaranteed.  Fed researchers also looked at a counselingrnprogram in Chicago created under a mandate by the Illinois Legislature.  The law grew out of concerns that predatoryrnlenders were taking advantage of naïve, less sophisticated borrowers in certainrnmarkets and required that mortgage applicants with low credit scores and thoserntaking out nontraditional high risk mortgages in certain zip codes undergo arnbrief counseling session with a HUD-approved counselor before closing on thernloan.  The session, which typically occurredrna few days prior to the closing, was designed to educate the borrower about thernterms of the loan and to discuss whether that product was appropriate for thernapplicant.  The Fed researchers foundrnthat the counseling had little effect, “perhaps unsurprising,” Evansrnsaid, “given its extent and when it took place.  Increasing participants' financialrnsophistication is not easy.” </p

There were, however, somernpositive effects from the program.  Thernresearchers found that fewer high-risk loans were originated because somernlenders preferred to exit the market rather than having their mortgage termsrnscrutinized by counselors and being accused of predatory lending.  Other dubious loans were not made becausernborrowers opted for alternatives to avoid the mandatory counseling.  “While one can argue that this decreasernin the supply of mortgages had a downside in terms of decreasing borrowers'rnchoices, the analysis found that the borrowers who were able to obtainrnmortgages performed significantly better than similar applicants in zip codesrnwithout the counseling requirement.</p

Evans pointed out that the twornprograms each affected the performance of loans, but they did so in quiterndifferent ways; one by affecting the behavior of potential borrowers which helpedrntheir performance on their mortgage arrangements, the other had a positive resultrnbecause some lenders avoided the new environment and some borrowers choose productsrnthat did not require counseling.</p

“These findings fitrnquite well with the principles of a relatively new school of thought known asrnbehavior economics, which recognizes that people frequently make substantialrnmistakes in their economic decisions,” Evans said.  “In fact, these mistakes are sornsystematic that it is possible to alleviate many of their worst consequences byrnmarginally adjusting the context in which the decisions are made.  The costs resulting from the adjustment mayrnbe relatively minor and less costly, for example, than the consequences ofrnprohibiting certain products altogether. In mortgage markets, prohibitions ofrnproducts intended to “protect” borrowers could result in significantrnreductions in the availability of credit. rnThis could prove costly as it would preclude some qualified customersrnfrom obtaining higher-risk mortgage products that they readily understand andrncan repay. </p

But behaviorists would alsornargue, he said, that mass-scale counseling could be costly and difficult.  They would instead give consumers choices,rnbut then incentivize them to make the proper choices.  He cited the Chicago example as one type ofrnlow-cost incentive to avoid the high-risk product by “nudging”rnborrowers toward the low risk option which would be the “properrnchoice” from a policy perspective. rn”We may,” he said, “look to behavioral economics morernoften as we evaluate new policy options aimed at avoiding the mortgage marketrnproblems we have seen in the recent past.”</p

MND says: WHY NOT BETTER EDUCATE LOAN ORIGINATORS SO THEY CAN BETTER EDUCATE BORROWERS?

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