Let's Treat Borrowers Like Adults

The problems with a financial products safety panel.

TODD J. ZYWICKI

Imagine a man in California who speculated in real estate at the height of the housing bubble. He bought a house with no money down and an adjustable-rate mortgage. But before he could flip that house for a profit, the market collapsed. He then owed more than his house was worth, but he knew that under his state's laws it would be impossible for his bank to sue him for the balance of his loan if he abandoned the house to foreclosure.

What is this man likely to do?

Several hundred thousand people have found themselves in a similar situation in recent years, and they have walked away from their real estate investments. Nothing down, interest-only mortgages taken out by speculators in states with default-friendly laws have fueled the foreclosure crisis and have come to be seen as a major threat to the American financial system.

Chad Crowe

They have also led the Obama administration to propose creating a consumer financial product safety commission to protect homeowners from dangerous loans. The premise of this proposal is that the financial crisis was created by predatory lenders taking advantage of hapless borrowers.

But do consumers really need such protection? Or would such a commission make it harder and more expensive for consumers to find the loans they need?

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.

Virtually every credit product is valuable to some consumers. Low-documentation loans are a boon for homeowners with a lot of equity who want to refinance their mortgages (even as they are a dangerous thing to offer speculators).

And unlike toasters, borrowers have substantial say over whether their loan "explodes." Foreclosures have risen throughout the country, but an epidemic exists only in a handful of areas -- Las Vegas, Phoenix, Miami and the Inland Empire region of California are all places where foreclosure rates are five to 10 times higher than the national average. These areas saw price bubbles that have now popped, giving many homeowners who owe more than their house is worth strong incentives to walk away from their loans.

Treating all consumers as hapless victims rather than recognizing that many consumers rationally respond to incentives is a recipe for unintended consequences. It can lead to counterproductive regulation that makes loans more expensive and harder to get.

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.

Moreover, the absence of prepayment penalties in prime mortgages has exacerbated the foreclosure problem. Millions of Americans have stripped equity out of their homes by refinancing (essentially paying off their old mortgages with new larger loans). This has made it more likely that these homeowners would be underwater once home prices plunged.

European home values have also fallen. But foreclosure rates are lower in Europe partly because homeowners there haven't stripped their homes of equity to the same extent.

Similarly, adjustable-rate mortgages are standard in Europe and have been very common at times in the United States. It was the Federal Reserve's erratic monetary policy that made adjustable-rate mortgages here "explode," not the loans themselves.

As these examples indicate, there is nothing sacred about 30-year, fixed-rate mortgages with an absolute right to prepay. Yet as the Associated Press has reported, the proponents of a consumer financial products safety commission seem to believe that the 30-year fixed should be the gold standard by which all other mortgages should be considered "exotic" or "risky."

This obsession with simplicity threatens innovation as well as competition. Thirty years ago credit cards were exceedingly simple. They charged high annual fees just to own them (often $40-$50), high fixed interest rates (approaching 20%), and offered no cash rebates.

Today credit cards are more complex, but they are also better. They offer no annual fees for no-frills cards, flexible interest rates, and more benefits. Competition is fierce and consumers have a wide range of choices.

One wonders whether the credit card revolution would have been possible under a consumer financial product safety commission.

A final concern about the Obama administration's proposed new commission is that governmental agencies tend to expand their jurisdiction. Eventually, the commission will nudge up against the authority of the Federal Reserve.

If the safety commission is given enforcement authority, including the ability to impose massive fines, it could one day undermine the soundness of financial institutions and therefore come into conflict with the Fed. Such a regulatory conflict would create the kind of policy inconsistencies and turf battles that the Obama administration says it wants to eliminate.

Instead of a new consumer financial products safety commission, Washington should revise the disclosures it mandates for mortgages, its tax and other incentives that encourage overinvestment in housing, and the incentives for homeowners to walk away from their homes. Our current problems are caused by misaligned incentives and the rational response of consumers and lenders to those incentives. It's not a crisis of consumer protection. A new agency premised on the erroneous belief what consumers need is to be protected from themselves is likely to do more harm than good.

Mr. Zywicki is a professor of Law at George Mason University School of Law and a senior scholar of the University's Mercatus Center.