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July 5, 2009

Raise the price of vanilla enough and everyone will order the rocky-road

For mortgages, the specific plan proposed by the administration appears to be strongly influenced by Michael S. Barr, an assistant Treasury secretary. Mr. Barr is a former law professor at the University of Michigan who wrote an important article sketching out these ideas with Sendhil Mullainathan, an economist at Harvard, and Eldar Shafir, a professor of psychology and public affairs at Princeton. 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.

Although the details of this dual ice-cream approach have not been fully specified, the concept has two main selling points.

First, inexperienced borrowers are steered toward the vanilla mortgages, the terms of which are chosen to be easy to understand. Vanilla mortgages would be the equivalent to the green runs at ski resorts that are intended for novices. The rocky-road mortgages would at least come with warning labels (“Don’t even think about going down this run unless you are an expert skier, or have a trusted professional instructor by your side”), and it is possible that for very exotic mortgages, borrowers might have to demonstrate that they understand the risks or have been aided by a certified mortgage planner.

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.

Mortgages Made Simplerby Dick Thaler.

Dr. Thaler is a brilliant economist, but I doubt that this proposal will solve the problem. My understanding is that it is already the law in many (all?) states that insurers must quote a price of insurance for everyone who asks. This is an attempt to prevent insurers from targeting only a particular demographic. It doesn't work. You can force everyone to charge a price, but you cannot force anyone to quote an attractive price. It is easy for insurers to quote horrible prices to dissuade interest from groups that do not interest them. Similarly here, if mortgage issuers feel that ambiguity in mortgage terms is profitable, they will likely quote terms on simple mortgages that make them unattractive relative to the more complex products they offer.

The hope here is to either shift the mortgage market to a new equilibrium of simpler mortgages or shift consumer behavior to recognize mortgage complexity and become more sophisticated. But is any intervention required at all? We are already seeing a massive shift out of more complex mortgage products:

Traditional fixed-rate loans fell out of favor during the housing boom. They dropped from a 75 percent market share in 2002 and 2003 to around 50 percent in 2004 and 2005, according to Inside Mortgage Finance. But with the housing bubble burst and mortgage rates near historic lows, fixed-rate loans -- 30-year, 15-year and other types -- now account for about 95 percent of the market.

'Vanilla' home loans could benefit borrowers
An alternative explanation is that once burned twice shy, and current borrowers may have learned a lot from the mistakes of others taking more complex mortgages in years past. One also has to worry about the composition effect. Current borrowers are likely higher quality on average than those back in 2007.

Posted by OneEyedMan at July 5, 2009 8:49 AM

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