Legal Commentary

Do We Need More Regulation of Mortgages to Protect Consumers?--Posner

By Richard Posner

The Treasury Department in its "white paper" of June 17 recommended the creation of a "Consumer Financial Protection Agency," and later followed up with a detailed legislative proposal for a "Consumer Financial Protection Agency Act of 2009." The proposal is pending in Congress.

Although the Commission's remit would not be limited to mortgages, risky mortgage lending is the Act's principal target. The supporters of the Act maintain that quite apart from instances of fraud, which are punishable under existing law, many consumers were unable to deal sensibly with the terms of the mortgages that were offered to them during the housing boom of the early 2000s, which peaked in March 2006 and then deflated, bringing down much of the rest of the economy with it, as we know. The mortgage bankers and other sellers of residential mortgages often did not require that prospective buyers demonstrate that they had the financial wherewithal to be able to repay the mortgages; mortgages that required no down payment were sold, often to people of quite limited financial means; prepayment penalties were common, which make it costly to refinance a mortgage if interest rates fall; and many mortgages were "ARMs"--adjustable-rate mortgages, which specified low "teaser" rates for the first few years followed by higher rates when at the end of the teaser period the rates were "reset."

A recent, and very thorough, article, by Oren Bar-Gill, "The Law, Economics and Psychology of Subprime Mortgage Contracts," 94 Cornell Law Review 1073 (2009), argues that many consumers made themselves worse off by taking out mortgages during the boom (in fact the bubble) period because they could not respond rationally to the offers by the sellers of mortgages. Many of them could not compare the terms of alternative mortgages (say a conventional 30-year mortgage and an ARM) because the terms were not stated in an intelligible fashion. In addition many consumers were afflicted by "myopia" and "optimism." "Myopia" in this context means inability to give proper weight to future costs--for example, higher interest rates when the mortgage resets; they do not look behind the "teaser" rates even though the reset rates are disclosed. "Optimism" in this context refers to exaggerating one's future economic prospects--unrealistically believing that either one's income will increase or housing prices will continue rising and by doing so enable one to refinance the mortgage on attractive terms--one's equity will have increased because the amount of the mortgage is fixed.

Bar-Gill's concern with inadequate disclosure of the annual percentage interest rate of mortgages does not present a novel regulatory issue. The Truth in Lending Act requires disclosure of the annual percentage interest rate of a mortgage or other consumer loan (APR), and if the requirements are inadequate (Bar-Gill believes that the APR is not required to be disclosed early enough in the negotiations over the mortgage), or violations not punished severely enough to deter, the Act can be amended. But neither the Truth in Lending Act nor any other statute or regulation, so far as I know, requires that mortgage offers be designed to discourage choices based on myopia or optimism. Bar-Gill himself recommends only requiring earlier and clearer disclosure of APR, though he describes this as a first step in purging the mortgage market of irrationality, rather than a complete solution to the problems he sees.

His analysis is based, as he explains, on findings by behavioral economists, who investigate departures from rationality in economic decision making. But like them, he does not make clear what he means by "rationality." It cannot mean full information, or the ability to process information flawlessly, because these condtions are rarely met in any area of human activity. It does, however, imply consistency and the avoidance of fallacies that cause serious harm, financial or otherwise, to people who harbor them.

It is unclear that either myopia or optimism in the sense in which Bar-Gill uses these terms is irrational. It might seem that if the discounted annualized present cost of an ARM is higher than that of a fixed-rate mortgage, anyone who prefers the former is irrational: he is paying more than he has to. But that conclusion depends critically on the discount rate, which differs from person to person. Some people have very low discount rates; they save a lot of money, or they incur substantial costs in an education that will yield a commensurate increase in earnings only after many years. Other people have high discount rates; they live for the present. These people are not irrational. The difference between them and people with low discount rates is a matter of personality rather than of cognition.

If you have a high discount rate, the low teaser rate in an adjustable-rate mortgage may be a good deal more attractive than the high reset rates. You are "irrational" only from the perspective of low-discount-rate persons, such as Professor Bar-Gill, who has two doctorates, two masters degrees, and a total of 13 years of education after high school.

Optimism is also a personality trait, and, as it happens, one essential to human progress. As I have argued elsewhere with reference to our current economic situation, what Keynes called "animal spirits" and, alternatively, confidence or optimism are essential to entrepreneurship because of the great uncertainty of a business environment. Someone who invests in building a factory that will not produce anything for years is taking a big risk of failure, and because it is a risk that cannot be reliably quantified he is taking a leap of faith, and he will not do that unless he happens to have an optimistic outlook. It is not that rationality implies such an outlook, but that rationality is not inconsistent with it. Optimists are often disappointed, but sometimes are richly rewarded for the risks they take; and as long as the prospect for such rewards confers on them greater ex ante utility than more cautious, pessimistic decisions would do, they are not behaving irrationally. "Nothing ventured, nothing gained" is the credo of the optimist and the terror of the pessimist, but neither reaction is irrational. The optimist and the pessimist just have different personalities. Bar-Gill has made a value judgment rather than an economic judgment.

Now it is possible that the kind of wet-blanket regulation that he might favor if he thought it feasible--which is the kind of regulation that the sponsors of the Consumer Financial Protection Agency Act very much do favor--could be defended on macroeconomic grounds, as conducing to economic stability. Had there not been in the early 2000s a strong market for risky mortgages, there would have been fewer defaults when the housing bubble burst and therefore less damage to the solvency of the banking industry. But whether the proposed Act would do anything to limit risky mortgage lending is unclear. It would authorize the Consumer Financial Protection Agency to require that a prospective mortgagor be shown, and entitled to choose, a "plain vanilla" mortgage that would be very short and easy to read and would alert the mortgagor to the various risks created by different mortgage terms. But if people have high discount rates and (or) are highly optimistic, disclosure of alternatives will not affect their choice.

So the stability issue narrows to how many mortgagors there are who, if only the alternatives to a risky mortgage were presented clearly to them, would forgo the risky option. Doubtless there are some; Bar-Gill cites persuasive evidence of that. But enough to prevent another housing bubble? That seems unlikely, but is in any event unproven.

Full post as published by Becker-Posner Blog on August 30, 2009 (boomark / email).