Thursday, July 9, 2009

Consumer Financial Protection, Vanilla Products

Posted on Rortybomb by Mike:

Noam Scheiber has found out that several lobbying efforts are gearing up to do a “Harry and Louise”-style ad campaign against the Consumer Financial Protection Agency. Since I’m currently running a similar thought exercise agency out of this webpage, I’ll take this personally, and sign up to be one of the econ blogosphere point men on arguments against this agency and the good it could accomplish. There’s going to be a few trial runs to figure out the best way to talk about this over the next couple of weeks.

Vanilla Options

Over the weekend, Richard Thaler wrote a piece about Vanilla Options for consumer protection in the New York Times.

As the administration plan describes it, lenders could be required to offer some mortgages they call “plain vanilla,” with uniform terms. There might be one vanilla 30-year, fixed-rate mortgage and one five-year, adjustable-rate mortgage. The features of these plain mortgages would be uniform, much as in a standard lease used in most rental agreements.

Lenders would also be free to offer other exotic mortgages — perhaps called “rocky road” mortgages? — along with the vanilla variety, but these offerings would receive more intense scrutiny from regulators…

First, inexperienced borrowers are steered toward the vanilla mortgages, the terms of which are chosen to be easy to understand…

Second, because the terms of the vanilla mortgages are all the same, they are more easily comparable; just as in the good old days, the A.P.R. will be a good basis for assessing the cost of the mortgage.

This is a pretty smart idea. What are some arguments against it?


John Carney argues that this will throw out all the innovations of the past 25 years in the mortgage industry.

Here’s the problem: Thaler thinks he’s protecting the unsophisticated but his dreamy Golden Era of simple mortgages actually exploited unsophisticated borrowers in a way that enriched banks. You see, under the old mortgage regime, low-income borrowers tended to exhibit what the bankers called “low-prepayment risk.” This was code for the idea that bankers could make more money from the poor because they wouldn’t refinance their home loans, even when interest rates dropped and big savings were available. The poor just kept on paying their old mortgages at the higher rates.

His reforms threaten to bring back this era of exploitation, re-introducing the class division that reigned in the past. The sophisticated people will be able to access mortgages that allow them to take advantage of low rates, while the huddled masses will toil once again as the “low-prepayment risk” engines of profits they once were.

I don’t understand what over the past 25 years in terms of “financial innovation” has lead to prime mortgage holders refinancing more. Prime mortgage holders refinance if the cost of the benefit is greater than the transaction cost plus the hassle. Arguably the transaction cost has gone down, but I believe that has more to do with technology, standardization and perhaps scale rather than something about the mortgage contract itself. More likely consumers became more aware that there was money being left on the table. What would standardizing a base mortgage contract do to change either of those?

Actually, financial innovation went the opposite direction. 75% of subprime loans, the poster child of financial innovation, featured a prepayment penalty. This refinancing has nothing to do with consumers trying to take advantage of interest change movements, and less to do with banks trying to offload negative convexity, and it had a lot more with banks trying to take on direct exposure to the housing market (rather than secondary risk-centered exposures).

I actually think having a large chunk of mortgages be certified government standard vanilla will help with the big innovation of the past 25 years, mortgage bonds. But I’ll flesh that argument out at another time.

Treating Like Adults

Professor Zywicki in the Wall Street Journal:

[1] The idea of a financial product safety commission comes from Elizabeth Warren, a Harvard Law professor and the chairwoman of Congress’s oversight panel for the Troubled Asset Relief Program. She says that such a commission is necessary because consumers cannot buy a toaster that has a one-in-five chance of exploding, but they can get a subprime mortgage that has a one-in-five chance of ending in foreclosure.

But this simple-minded analogy misses the point. An unsafe toaster is a hazard to anyone who buys it. That’s not true for loans…

[2] Consider, for example, prepayment penalties in subprime mortgages. Banks charge such penalties because prepaying a mortgage makes it less profitable and subprime loans are already less profitable than prime loans.

Empirical studies show that there is no link between penalizing borrowers for paying off their loans ahead of schedule and increased foreclosures. Yet, consumer advocates say these penalties are one reason why subprime borrowers find themselves underwater.

If we listened to consumer advocates, prepayment penalties would be banned. But if we did that, lenders would likely charge riskier borrowers higher interest rates. These higher interest rates would, ironically, make it more likely that subprime borrowers would default on their loans.

Point 1: I’m assuming that if I was a degenerate crackhead who snuck into your neighborhood and mugged you for $50, the Wall Street Journal Opinion Page would want me thrown in jail. Now imagine that I’m a degenerate crackhead who took out a subprime loan to move next door to you, in an arrangement that I’m likely not going to pay off. I might not even make one payment. If I default you’ll lose 10% of the value of your home from the externality effect. Assuming your home is worth $300,000, there’s a 20% chance I default in 2 years (realistic numbers), and you lose 10%; 300,000*.2*.1 = I’ve just robbed you for $6,000 while the Wall Street Journal Opinion Page cheered me on. And that’s one house – I’ll have a dozen neighbors. Now mind you, the product was great for me – I got to smoke crack indoors, in a house I could never realistically afford, which was a big plus. The subprime lender sold my loan to a pension fund in Denmark for a nice fee. It goes in the win column for us.

So out the door financial instruments can cause harm to others. I’ll think through and write more about these questions, but the libertarian argument is only going to hold so much water with me.

Point 2: “But if we did that, lenders would likely charge riskier borrowers higher interest rates. These higher interest rates would, ironically, make it more likely that subprime borrowers would default on their loans.” Why? Assuming markets works, the NPV of the loan will be the same in either case; there is no free lunch in arranging a fee in one place versus smoothing it out. I can always find an interest rate that makes a person indifferent between two series of cash flows, and assuming markets work they’ll converge to that one. Mind you the uncertainty is with short-term cash flows, and prepayment penalties particularly hurt there.

Now I think it is better to smooth payments rather than cluster them (to pay a little extra in every period rather than taking a chance you have to have a big payment in one period) when we are otherwise indifferent to hedge against income volatility. I think there is a strong obligation to “nudge” people there – and anyone who wouldn’t should explain clearly why having people concentrate short term risks in one period is smarter than smoothing them out across all periods.

So why be up in arms? Because prepayment penalties were moved to create a situation where the banks wanted to exercise them not to hedge negative convexity on their loans (good financial use) but to get a piece of rising house prices (bad financial use – we don’t want banks doing this through embedded options). Where the initial rate on an ARM was already too high to be manageable, thus forcing prepayments inside the penalty zone. I’ve covered that elsewhere, and I believe it is where the elite research is going to end up.

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