Thaler and Barr’s Solution Misses the Root Cause of the Mortgage Crisis

9
Jul/092

Over the weekend, Richard Thaler wrote an article in the New York Times endorsing a proposal from Michael S. Barr, Assistant Treasury Secretary for Financial Institutions to require financial institutions to offer “plain vanilla” mortgages along side exotic “rocky road” mortgages. The rocky road mortgages would have extra warning labels to protect consumers. Under this proposal, most consumers would be steered into plain vanilla mortgages.

Barr’s proposal will certainly help people at the margin, but it misses the root cause of the mortgage crisis. The root cause was easy credit in the global financial markets led to easy credit in the mortgage market. Easy credit in the mortgage market led to an explosion in Alt-A mortgages, where incomes and jobs weren’t documented. Consumers and speculators took the Alt-A mortgages to bid up home prices. Rising home prices led to more people rushing into the market to make money, and the easy credit available in the form of Alt-A mortgages meant lenders didn’t turn anyone away. With an Alt-A mortgage, a consumer wasn’t constrained by their income, so they could either buy a larger house or big the same house up to a higher price.

Alt-A mortgages, had a much larger role in driving home prices higher than the mortgage loans Barr and Thaler are trying to prevent. An Alt-A mortage could look like a plain vanilla 30-year fixed rate or a 5-year ARM, except the lender never asks the borrower to document his income or job. There is no harm done to the consumer. In fact, it is an easier transaction for the consumer because they have to provide less paperwork to the lender.

When credit is easy, borrowers will take out loans no matter what the warnings are. It is similar to Warren Buffett’s famous quip about under pricing insurance: “If you offer an underpriced insurance policy and are sitting in a rowboat in the middle of the Atlantic Ocean, an insurance broker is going to find you.” It is the same with easy credit and borrowers. When credit is easy, borrowers are going to find ways to borrow.

The entire financial crisis wasn’t caused by unwitting consumers who were duped into taking out rocky road mortgages. The crisis was caused by easy credit which also led to bad commercial mortgages and bad leveraged buyout loans. In fact, it was LBO bank loans that started the the first seeds of the crisis in August 2007. Certainly the borrowers in the commercial real estate and private equity worlds were sophisticated and still succumbed to the siren song of easy credit.

Barr is certainly noble minded in his pursuit of trying to save the consumer from bad mortgages, but Thaler is overstating the benefits of this solution by implying that the finanacial crisis would have been averted had consumers stuck with plain vanilla mortgages. Their solution will certainly help consumers in the future, but I’d venture to guess it’ll be at least a decade before any rocky road mortgages are sold to consumers.

If Barr and Thaler really want to help the economy by bringing stability to the housing market, they should propose that Fannie Mae and Freddie Mac must not buy any mortgage loan unless the borrower’s income, job and other assets are verified. This would prevent Alt-A mortgage market from ever coming back to the size it was in 2006 and 2007.

The task of taming the credit cycle to prevent future periods of easy credit is a tougher problem. However, due to our collective experience over the last 24 months, it is not a problem we’ll have to deal with again in the next few decades.