Should People Be Protected?

Last summer, in a post titled Valuable Lessons About Debt, it was noted that buying a home today is much like buying a car was ten or fifteen years ago - if there was something that you really wanted, someone would loan you the money.

In previous decades, borrowing money to buy an automobile or using credit cards taught people about managing debt before they would go off and make a major purchase like real estate. When buying a home, the barrier to entry used to be much higher - hefty down payments were required and qualifying was difficult.

That has changed dramatically in this decade.

The result, of course, has been the creation of trillions of dollars in credit and debt helping to create a world wide real estate boom that has unmistakably been good for the economies of the world when gauged using traditional measures such as economic growth and employment - the long-term impact is yet to be seen.

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Many predict the massive amount of new credit and debt will one day cause serious problems, while others are dismissive of these warnings, claiming that our current condition is the natural result of a new world of global finance.

They say complex financial instruments and processes have fully quantified risk and we are reaping the rewards - credit has been extended to more people in more ways in recent years than ever before, and that's just the natural evolution of a dynamic, flexible world economy.

It is, of course, impossible to know how this will all work out, however, one thing is clear today.

Individuals have taken on more debt in recent years than ever before, and with the help of low interest rates and lax mortgage lending standards, more and more of the money owed has been borrowed against the value of real estate.

The matter of "lessons learned" was addressed in the post referenced above, which closed with the question:

"Is the entire Anglo Saxon world about to be taught a valuable lesson about debt?"

Now that higher interest rates are starting to affect people in material ways with foreclosures and bankruptcies on the rise, today we consider if mortgage lending should have been done differently in recent years. Should people have been prevented from borrowing so much money:

"Should people be protected from taking on too much debt?"

Free Markets and Consumers Awareness

It seems the discussion here reduces to two issues - free markets and consumer awareness. The freedom of markets to determine the best outcome in an economy, weighed against the awareness of consumers regarding the manner in which they are participating in the economy, and most importantly, the possible consequences of their actions.

If the worst fears of housing bears are realized, the debate about free markets in mortgage lending is likely to continue for many years. How much should the government regulate lenders? Should they be regulated at all? Is guidance sufficient?

Regulation in recent years has been mostly non-existent, as regulators seem wary of enforcing their will on a system that is showing few of the traditional signs of stress. Mortgage foreclosures rates, while rising, are still historically low and troubled lenders are still few and far between - bank failures seem to be a thing of the past.

By traditional measures, there is little stress on the system.

Traditional banking, however, only accounts for a portion of outstanding mortgage debt, much of which has been securitized by Wall Street firms and sold to investors along with insurance in one form or another via derivative products. As these products have not been "stress tested", there may be a good deal of unwarranted complacency, but within the banking system today there is little reason for concern.

On other side of the lender-borrower relationship is the average American homeowner, who, after mostly watching the stock market boom from afar, has participated in the current real estate boom in a very big way. Many average Americans do not understand simple interest, let alone the myriad of complex loan products that have become wildly popular in recent years.

Average Americans do, however, understand a few things.

They understand that some of their friends and relatives have made big money in real estate in recent years. They also understand that getting a real estate loan these days is easier than ever before. And, they understand monthly payments (or at least the initial monthly payments).

Many of today's home buyers have little knowledge of broader market trends and are surely influenced more by friends and relatives heeding their advice rather than the dire warnings emanating from some parts of the media about a potential bubble in housing.

When you hear stories about people viewing home equity withdrawal as income, then you know that there is a basic misunderstanding about the role that credit and debt are now playing in people's lives.

Condo flippers who barely graduated high school can be despised, however, they will get their comeuppance. But, unlike stocks in 2000, there are a lot more innocent bystanders in today's housing market who really don't understand what they've gotten themselves into in the last few years as easy money has coursed through the land.

Many average Americans think that somehow fundamental changes have occurred and their standard of living has been permanently improved - they have little understanding about what their future debt service will be like.

What to Do?

So, should people be protected from taking on too much debt?

Should mortgage lending standards be dialed back to the pre-bubble days?

On one side of this argument are those who contend that the market should be left to work its magic and that the best lessons in life are learned first hand. Let banks and consumers battle it out and see who's left standing when it's over.

At the end of the day both parties will be smarter and the world will be better off for it.

On the other side of this argument are those who say that you just can't educate people well enough for them to resist the lure of rapidly evolving lending products designed to make the American Dream a painless and profitable undertaking.

Now, many consumers find themselves in way over their heads.

Since mortgage lenders will seek profits in any manner that a free market will allow, and borrowers are in many cases ill-informed and/or ill-equipped, should somebody be preventing these people from taking on too much debt?

Should people be protected?