Wednesday, August 18, 2010

This is Where it Gets Sticky

A large part of this week's discussion has been devoted to a paper entitled "Behaviorally Informed Financial Services Regulation," co-authored by Michael S. Barr. At the time that the paper was published in 2008, Barr was a law professor with the University of Michigan. Today he is the Assistant Secretary of the Treasury over Financial Institutions and a major proponent of financial reform. This week, as the Treasury Department holds its summit to find new ways to disclose mortgage products and credit card terms, I thought that looking at Barr's writings on the subjects could provide some genuine insight into what we may expect from the new forms.

We have already seen that Barr wants to change the game of lending by shifting from a rules-based disclosure model to a standards-based disclosure model. His premise is that it is not enough to give borrowers forms to sign which explain their loan product, because they often don't understand the forms, so he wants to move to a different standard where the courts and a powerful new consumer financial protection agency can determine after closing whether the forms adequately explained the terms of the loan.

However, remember that Barr's basic premise is that individuals left to themselves cannot be trusted to make good choices--either in the loan products they select or in the provider of those loan products (the mortgage broker). Therefore, the only way to achieve desirable results is to limit and control the choices that the consumer is presented with in the first place.

To achieve this, we need to dramatically change the way we present mortgage loan options to the borrowers. "While the causes of the mortgage crisis are myriad, a central problem was that many borrowers took out loans that they did not understand and could not afford. Brokers and lenders offered loans that looked much less expensive than they really were, because of low initial monthly payments and hidden costly features. Families commonly make mistakes in taking out home mortgages because they are misled by broker sales tactics, misunderstand the complicated terms and financial tradeoffs in mortgages, wrongly forecast their own behavior, and misperceive the risks of borrowing." Barr and his co-authors go on to discuss possible solutions to this problem. For instance, Barr says that improved disclosures might help, but good marketing can overcome product disclosure. Product regulation might help by "reducing emotional pressures related to potentially bad decision-making by reducing the number of choices and eliminating loan features that put pressure on borrowers to refinance on bad terms." But there is always a danger that product regulation will backfire because "the government may simply get it wrong."

Therefore, Barr writes, "we propose a new form of regulation. We propose that a default be established with increased liability exposure for deviations that harm consumers. For lack of a better term, we call this a 'sticky' opt out mortgage system." Barr devotes several pages to explaining the "sticky" opt out system and how it would work to induce lenders and borrowers to prefer good loans over bad loans.

Here's how it would work: The mortgage lender can offer a thirty year fixed rate mortgage full income documentation mortgage. The lender could charge whatever interest rate he wanted to on this package. The lender could also offer other mortgages if he wanted to, but the thirty year fixed rate mortgage would be the "default mortgage." In order to get a different type of loan, the borrower would have to opt-out of the standard loan and choose a different loan which would come with increased disclosures explaining the risks.

Now to the "sticky" part. Merely having to opt-out of a loan and read an additional package of disclosures does not provide enough motivation for the lender to strongly encourage the borrower to take the standard thirty year fixed rate loan. So as an extra incentive, if the borrower chooses any loan other than the thirty year fixed rate mortgage, the lender faces legal consequences if that loan defaults. "If default occurs when a borrower opts out, the borrower could raise the lack of reasonable disclosure as a defense to bankruptcy or foreclosure. Using an objective reasonableness standard akin to that used for warranty analysis under the Uniform Commercial Code, if the court determined that the disclosure would not effectively communicate the key terms and risks of the mortgage to the typical borrower, the court could modify or rescind the loan contract." Barr also anticipates that a consumer financial protection agency could take responsibility for supervising the disclosures by imposing fines on lenders if the disclosures for any mortgages other than the standard mortgages were found to be "unreasonable."

Barr's premise is that such a system would force virtually all borrowers into a 30 year fixed rate mortgage. And that is true--by creating a system where the only loan that is safe from excessive scrutiny is the thirty year fixed rate mortgage, regulators ensure that this is the only loan a borrower can expect to receive. But here is what Barr does not say--the thirty year fixed rate mortgage is not the cheapest, most cost effective mortgage on the market. It's not even close. The 15 and 10 year mortgages offer much greater cost savings to the consumers. Even though the payments are higher on these mortgages, the interest rates are markedly lower and the borrower saves a lot of money over the lifetime of the loan by paying a higher payment over a fewer number of years. While these mortgages are not appropriate for many borrowers, over the last two or three years as interest rates have dropped, we have seen many borrowers refinance from a thirty year to a twenty year, fifteen year or ten year mortgage while lowering their rate and keeping their payment almost the same. Such refinances can save the borrower hundreds of thousands of dollars if done during the early years of the loan. But the system that Barr proposes would cause such punitive consequences for lenders that they could not afford to sell these other loan products.

And even Barr and his co-authors admit that there would be casualties to his approach. "Implementation of the measure may be costly and the disclosure requirement and uncertainty regarding enforcement of the standard might reduce overall access to home mortgage lending...Low income, minority or first-time homeowners who have benefited from more flexible underwriting and more innovative mortgage developments might see their access reduced if the standard set of mortgages does not include products suitable to their needs."

And that is true too. A "one size fits all" approach to lending is going to leave a lot of borrowers behind. We are seeing that more and more in lending now as many people who would like to purchase or refinance cannot qualify to do so. But then, to address a problem that Barr himself has created, he changes the rules once again. "One might develop 'smart defaults' based on key borrower characteristics, such as income and age. With a handful of key facts, an optimal default might be offered to an individual borrower. The optimal default would consist of a mortgage or set of mortgages that the typical borrower with that income, age and education would prefer." Yet this approach creates still another problem which Barr also acknowledges, "it may difficult to design smart defaults consistent with fair lending laws."

No, Mr. Barr, try impossible. The Equal Credit and Opportunity Act and Fair Housing Laws make it illegal to look at a person and choose their loan product or access to credit for them based on age, race, sex, national origin, religion or familial status. Those laws dictate that all borrowers must be treated equally and given equal access to credit. And that would take us back to just one loan product.

The overall problem with this approach is that it assumes that adult human beings are not smart enough to make their own choices and so the government must dictate those choices for them. Whenever, the government begins dictating what we can have, everyone is going to have less. Of course, when people have a lot of options available to them, they are going to make mistakes. However, many people are going to make good, sound choices. When we deny someone the ability to make mistakes, we also deny them the ability to make choices that would benefit them. The flip side of freedom to succeed is freedom to fail, and when we are not free to fail, we are not free at all. In the past, we have chosen to believe that as a society all of us have a right to participate equally and to make our own decisions about our lives. With that understanding, we have also chosen to understand that sometimes we as individuals and we as a society are going to make bad choices which will then have bad consequences. But that is an acceptable risk in a free society. Legislating good sense is about as difficult as legislating morality--it just creates a sticky mess for everyone.

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