Complex Loans Didn't Cause the Crisis. By TODD ZYWICKI
And Obama's Consumer Financial Protection Agency wouldn't protect us from another one.
WSJ, Feb 19, 2010
Regulatory reform that can improve competition and consumer choice in financial services is long overdue. But no new federal bureaucracy such as the Obama administration's proposed Consumer Financial Protection Agency (CFPA) is needed to bring that about.
More importantly, the administration is incorrect in claiming that such an agency would have prevented the present financial crisis and is necessary to prevent the next crisis. On the contrary, such an agency might be the first step toward more problems.
During the housing boom bankers made a raft of extraordinarily foolish loans. Some were the result of lenders defrauding borrowers; probably at least as many were the product of borrowers defrauding lenders. But there is no evidence, as Elizabeth Warren (a champion of CFPA and chair of the TARP Congressional Oversight Panel) recently asserted on these pages, that lender fraud was the overriding cause of the crisis.
The bank loans were not foolish because borrowers didn't realize what they were doing. They were foolish because of the incentives they created for borrowers, especially when housing prices turned south.
There were three distinct stages of the housing crisis. In the first, the Federal Reserve's extremely low interest rates from 2001-2004 induced consumers to switch from fixed to adjustable rate mortgages and drew short-term speculators and house-flippers into the market in certain cities. The Fed's increase in short-term interest rates over the next two years increased homeowner payments and precipitated a round of defaults.
My own research confirms the analysis provided by University of Texas economist Stan Leibowitz on these pages last July: The initial onset of the foreclosure crisis was a problem of adjustable-rate mortgages, whether prime or subprime. It was not initially a subprime problem.
In the second phase, falling home prices provided incentives for owners whose mortgages were under water to walk away from their houses. And in the third phase, which we are now experiencing, traditional macroeconomic factors like unemployment led to more foreclosures—especially where homeowners' mortgages are already underwater. Reflecting this situation, the Mortgage Bankers Association reports that the fastest-rising segment of foreclosures in recent months has been traditional prime, fixed-rate mortgages.
None of this analysis has anything to do with fraud or consumer protection problems. Consumers rationally switched to adjustable-rate mortgages when their prices fell relative to fixed-rate mortgages—a pattern that has repeated itself numerous times since the 1980s. And when housing prices fell, underwater homeowners rationally responded by walking away from their houses. The proliferation of mortgages with minimal downpayments, interest-only or even negative amoritzation terms, and cash-out refinances meant that many consumers fell into negative equity territory much more rapidly than they would have otherwise.
Regulators may want to limit mortgages that provide so many borrowers with such strong incentives to walk away when housing prices fall. They may want to prohibit lenders from making loans with minimal downpayments or interest-only loans that result in consumers having minimal equity in their homes. But that's an issue of safety and soundness, not protection against fraud. With respect to ARMs, the obvious solution is a less-erratic Federal Reserve interest rate policy. ARMs have been in widespread use for 25 years (and are common in the rest of the world) without mishap like in the current cycle.
So the problem isn't consumer gullibility or ignorance. Borrowers have shown they understand, and act on, the incentives they face all too well.
It is worth remembering that, although the banking crisis was a national crisis, the foreclosure crisis is concentrated in four states—Arizona, California, Florida and Nevada—that comprise almost half of the mortgages in foreclosure. Even within those states, foreclosures are concentrated within a handful of hot-spots such as Las Vegas, Miami, Phoenix and the Inland Empire region of California. It is unlikely that borrowers in these cities are more gullible than borrowers elsewhere. Evidence does suggest, however, that there were a larger number of speculators and home-flippers in those cities than elsewhere.
This is not to deny that we are overdue for a comprehensive reform of consumer credit regulation. Over the years, federal laws governing disclosures have become encrusted with an ever-thickening coat of litigation- and regulation-imposed barnacles.
One example, according to Federal Reserve economists Thomas Durkin and Gregory Elliehausen in a book to be published this year, involves the Truth in Lending Act, which has grown from a simple effort to standardize disclosures on consumer credit to a morass.
Regulatory mandates and lawsuit fears are largely responsible for the mind-numbing length of a typical credit-card agreement and monthly statement. The most recent mandate-induced clutter requires the monthly statement to disclose how long it would take to repay the balance by making the minimum payment while making no new charges. According to a Federal Reserve Study by Mr. Durkin, only 4% of consumers would even consider this option.
Similarly, a 2007 Federal Trade Commission staff report by economists James Lacko and Janis Pappalardo documented the convoluted nature of current mortgage disclosure rules (which fail to convey key costs) and presented prototype disclosures that significantly improved key mortgage cost disclosures. Yet such common-sense proposals remain buried in the bureaucracy.
What's needed is simplified and streamlined regulation, not another agency.
Policies based on a misdiagnosis of the true nature of the problem might actually lay the seeds for the next crisis. For example, Ms. Warren rails in her op-ed about "tricks and traps" such as "universal default" provisions in credit-card contracts, where a failure to pay one credit-card bill can trigger a default on another one. Yet it is obvious that a consumer's failure to pay some of his bills provides valuable information about the likelihood of default on his credit-card bill (universal default provisions are common in commercial loans for this reason).
Thus a lender's elimination of universal default will have to be offset by higher interest rates or fees. To the extent that a CFPA makes access to credit cards less available, excluded borrowers will inevitably shift to more expensive alternatives such as payday lending or pawn shops. If the CFPA were to impose bans on efficient risk-based pricing by lenders in the name of vague claims about "fairness," the likely result will be to increase overall risk and make the next financial crisis more likely.
The financial crisis resulted primarily from the rational behavior of borrowers and lenders responding to misaligned incentives, not fraud or borrower stupidity. Policies that fail to appreciate the difference will not protect, and may hurt, the very consumers they are intended to protect.
Mr. Zywicki is a law professor at George Mason University and a senior scholar at the Mercatus Center. This op-ed is based in part on a Mercatus working paper, "The Housing Market Crash."
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