Resident Fellow Ted Frank

Bangladeshi banker Muhammad Yunus won a Nobel Peace Prize for bringing credit to people too poor to qualify for traditional bank loans. The availability of nontraditional credit has helped millions of Third Worlders out of poverty.

Similarly, in the U.S., homeownership rates are near an all-time high because of recent financial innovations that made lending to people without pristine credit feasible. But trial lawyers and legislators are seeking to reverse this progress. If they succeed, measures purportedly aimed at helping borrowers will end up hurting them.

Individuals with poor credit must pay higher interest rates because of the greater risk of default. In recent years, however, mortgage securitization--where pools of the principal and interest payments for mortgages are bundled into securities that can then be sold to investors--has made these so-called subprime loans increasingly possible. It does so because the diversification reduces the risk of lending to borrowers with suboptimal credit. It also permits pension funds and other investors, who would not be able or willing to invest in individual mortgages, to bring capital to the mortgage market. These two factors increase the supply of capital, which in turn reduces the price--the interest rate--that both prime and subprime borrowers pay for that capital. As a result, the subprime market has grown to $640 billion of new mortgages in 2006 from $35 billion in 1994.

While millions of new homeowners benefited from the new lines of credit, some made poor financial decisions. Moreover, con artists abound wherever there is money, and the mortgage business was no different: Some fly-by-nighters broke existing laws by selling mortgages while misrepresenting terms and conditions. On the other end, many defaults reflect fraud by borrowers, lying about appraisals or their income; and some lenders were so careless that they did not even ask borrowers to fully document their income.

But markets adjust. Banks lose money when borrowers cannot pay their loans--foreclosure only partially compensates these losses because of the expense of legal proceedings. Lenders thus have every incentive to lend only to those who can repay. Those banks that judged poorly have been driven from the field or forced to make changes in management or underwriting practices.

This is not good enough for some activists, the ones that George Mason University Professor Alex Tabarrok calls "credit snobs" because they take the position that the hoi polloi cannot be trusted with the risks and benefits of credit. (This snobbery is hardly limited to mortgages: Witness the December SEC regulations further limiting who may invest in hedge funds, thus depriving the middle class of financial opportunities available to the rich.) In the eyes of a credit snob, if a homeowner defaulted, it must be because of "predatory lending." And where there are paternalistic uprisings against faceless banks to be had, a lawsuit is sure to follow.

As a cause of action for the plaintiffs' bar, simply suing mortgage banks has limited profitability. Legitimate banks lent responsibly and did not violate the law; lawsuits against them are generally rebuffed, though not often or quickly enough to avoid raising the costs for the honest. For other defendant banks, it is difficult to characterize poor money-losing business decisions in lending as "predatory," rather than self-destructive. But worse for trial lawyers, such banks have often already lost most of their money before the attorneys can get to it.

The trial lawyers' entrepreneurial solution is to go after the deep pocket. And so we have lawsuits alleging that the investment banks providing financing to the mortgage banks are "aiding and abetting" the alleged fraud through securitization.

What would be the upshot? If an investment bank is potentially liable for every conversation and every phone call involved in the underlying mortgages, the costs of due diligence becomes prohibitive, far outstripping the fees it can bring in for packaging the loans. Nor can the upstream financer analyze the subjective merits of the mortgage with the same hindsight as a jury. The securitization simply will not take place.

The liability theory is preposterous, but the bad news is that some courts are buying it. A class action by tort kingpins--Scruggs Law Firm, Leiff, Cabraser, Heimann & Bernstein, and Milberg Weiss--has been brought against Lehman Brothers on the grounds that Lehman "knew" that the now-bankrupt First Alliance Mortgage was violating the law when Lehman agreed to securitize First Alliance mortgages. They "knew" this, allegedly, because First Alliance had previously been sued. Of course, all mortgage banks have been sued at one time or another, and First Alliance's lawyers told Lehman that they had legitimate defenses to the suits.

Nevertheless a district court in California permitted a jury to hear the case and award damages of $50 million to the plaintiffs. In December a panel of the Ninth Circuit Court of Appeals pooh-poohed Lehman's objections to the unprecedented legal theory and to the procedural irregularities of the class action, affirming the judgment. (The court did send the damage award back for recalculation.)

To make matters worse, the House Financial Services Committee held hearings last week on writing this judicial mistake--and more--into federal statutory law. Committee Chair Barney Frank (D., Mass.), wants to hold not only the packagers of mortgages liable but also the purchasers in the secondary market. "Anybody, including the original borrower, can make a claim, and the liability would go up the chain," Mr. Frank told the press. "People say it may discourage certain kinds of lending. But that's precisely what we want to do. We will pass a bill that won't allow companies to loan people more money than they can pay back or loans for more than the value of the house."

It is not speculation to say that the results will be disastrous if such a bill becomes law. Several states learned this the hard way. For example, the 2002 Georgia Fair Lending Act created unlimited liability to purchasers of mortgages for any legal violations by the loan originator. "If anyone wondered why the financing for subprime mortgages dried up in Georgia after the state legislature enacted assignee-liability rules in 2003, the First Alliance case provides the answer," says Brian Brooks, an attorney at O'Melveny & Myers who advises banks. "The prospect of paying millions of dollars in damages for someone else's lending practices doesn't sit well with Wall Street firms."

Indeed, American Securitization Forum's George P. Miller reports that all three of the major credit ratings agencies (S&P, Moody's, and Fitch) announced they could not rate any securitization containing any loans subject to Georgia law for fear that the entire security would be tainted by unquantifiable liability. Liquidity for the state's mortgage market disappeared and the Georgia legislature quickly repealed the worst parts of the law to restore access to credit.

Such a credit crunch today would be poorly timed just as many subprime borrowers will be seeking to refinance adjustable-rate mortgages, multiplying the number of defaults.

Sadly, Mr. Frank's Republican counterpart on the committee, Spencer Bachus (R., Ala.), supports legislation making lenders and investors in mortgages liable to compensate borrowers who are victims of "predatory lending." Shouldn't at least one of the two political parties have someone heading up the House Financial Services Committee who understands financial services?

Ted Frank is a resident fellow at AEI.