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Saturday, August 01, 2009

Plain Vanilla Mortgages

Should the government mandate that lenders offer "plain vanilla" mortgage contracts as an option?:

Thaler Responds to Posner on Consumer Protection, by Paul Solman: Paul Solman: Earlier this month, I was pleased to learn that ... the University of Chicago's Richard Thaler ... had entered the rotation of the NYT's weekly "Economic Scene" column. His initial public offering, Mortgages Made Simpler, applied his gargantuan expertise in behavioral economics ... to home mortgage regulation. ...

A mere 17 days after Thaler's NYT debut, I opened the Wall St. Journal op-ed page and spotted an essay by ... Richard Posner... I was all eyes, and the headline -- Treating Financial Consumers as Consenting Adults ... intrigued me. ...

[W]hat dumbfounded me, and occasions this post, was the extent to which Posner took personal aim at Thaler and his argument. ... So I emailed Thaler to see if he had written a rejoinder. When I found that he hadn't, I invited him to do so, promising that I'd publish it. And so, here it is.

Richard Thaler: ...[T]he proposed Consumer Financial Protection Agency ... is the subject of Judge Posner's essay. As Judge Posner says, one of the jobs of the agency would be to prohibit a product that is likely to "cause substantial injury to consumers" that "is not reasonably avoidable by consumers and . . . is not outweighed by countervailing benefits to consumers or to competition."

Furthermore, the administration wants oversight of consumer finance to be based on "actual data about how people make financial decisions". Posner is horrified by these principles. ... The proposal that particularly draws Posner's ire is the idea that the Agency would designate a few types of "plain vanilla" mortgages and suggest that unsophisticated shoppers concentrate their search on those. The idea is very similar to the standard leases used in most rental agreements. The landlord can change the terms of the standard lease, but those changes are done in a way that makes them quite salient to prospective tenants, and the tenants are alerted to the fact that these terms are not the usual ones. The plain vanilla mortgages would all have the same terms (like the standard leases) and issuers who want to offer different kinds of mortgages would have to make their modifications clear. Only mortgages judged to be very dangerous would be banned.

The administration has not stipulated how many types of plain vanilla mortgages there would be, but the research on which this proposal is based makes it clear that it is reasonable to assume that there would be at least a fixed-rate and some type of adjustable-rate mortgage in the mix. ... Nonetheless, Posner writes as if there would be only one plain vanilla mortgage. This is seriously misleading. An analogy would be to say that we would not want the Consumer Product Safety Commission to regulate the production of cribs because they might decide only to allow pink cribs and some people might like blue ones. Of course the agency would not do that; it would only make sure that whatever color crib you bought would not kill your child.

Posner does not stop at mischaracterizing the proposal. He launches a second line of attack based on the following logic. 1) Behavioral economists such as Thaler have endorsed this plan. 2) Thaler has been known to make mistakes. 3) Therefore, he should not be in the business of helping consumers avoid mistakes. Of all the evidence readily available that I am not perfect, he concentrates on the fact that I have written about the well-known puzzle in economics that the difference in returns between equities and bonds (the "equity premium") has, in the past, seemed to be too large. With the market now down, presumably he thinks this writing makes me look foolish. I plead guilty to joining the hundreds of other economists (most of whom are not behavioral economists) who have written about this historical puzzle. And, as Posner suggests, for many years I did advocate that young investors should consider putting all their money in stocks, and I followed that advice myself until 2000 when the level of the stock market bubble got so ridiculously high that I switched half of my retirement portfolio into treasury inflation-protected bonds (TIPS). But of course, I am not a perfect forecaster. I, like most people, did not get out of stocks last summer. And, I certainly plead guilty to being imperfect. For a long list of particulars, contact my wife.

But, given that I do not claim to be infallible, what does this have to do with whether we should try to help people make better choices? The premise of behavioral economics is that humans are not perfect decision-making machines. We are busy and distracted. We have fields that we know well, but are amateurs in most other domains. If our car breaks down, we go to a trained mechanic. Even the best mechanics will make some mistakes (they are human), but for most of us they still have a better chance of getting our cars to work than doing it ourselves. Even Judge Posner is human, and given the number of books he has written, he must have made a few mistakes in print. But our legal system needs judges, and one of the reasons we have a layered judicial system is so that mistakes by one judge can be corrected by others. Should we abolish our legal system because judges are known to make mistakes?

No government agency (or judge) will be error-free. The goal ... was to create decision-making environments in which it is easier for error-prone human decision makers to choose well. The Agency proposed by the administration is a good example of this kind of thinking. Even imperfect experts can help us achieve better outcomes, just as imperfect judges can help us enforce the law fairly. Until we invent the perfect human (or computer decision-making devise), we have no good alternatives.

    Posted by on Saturday, August 1, 2009 at 12:18 AM in Economics, Housing, Regulation | Permalink  Comments (24)


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