The Dodd-Frank Wall Street Reform and Consumer Protection Act was, ostensibly, a response to the crisis in the U.S. housing market and the inter-related crisis in the market for mortgage-backed securities ("MBS"). One of the goals of the legislation, presumably, was to prevent another crisis in housing and mortgage finance. And, certainly after what we have seen in recent years, no one could question the importance of that goal. The housing crisis has deprived thousands upon thousands of Americans of not just wealth but of their homes; it has helped drive municipalities to the brink of fiscal collapse; and it has impeded the recovery of the U.S jobs market. The MBS crisis took down major financial institutions in the U.S., and almost caused a complete collapse of the financial sector. We cannot afford a repeat experience.
But Dodd-Frank, even if it is implemented in the far-reaching way that some hope and think it can be, will not address a problem at the heart of the housing and MBS crisis: excessive complexity. The years running up to the implosion of the housing and MBS markets were marked by ever-increasing complexity. This complexity caused confusion and poor judgment on the part of unsophisticated home buyers and owners and supposedly sophisticated securities investors. This complexity also allowed some people and institutions to make an astonishing amount of money originating mortgages that never should have been originated and selling MBS that never should have been sold, at least at the prices they were sold. Dodd-Frank does not do the structural work of simplification we need to prevent this all from happening again once the memories of the current crises fade.
Instead of Dodd-Frank, we need clear statutory reform that limits residential mortgages to a few sensible products, all girded by strict underwriting standards, and that correspondingly produces a well-ordered, transparent market in bonds or securities based on these mortgages. Other countries, most notably Denmark, have maintained a simplified, and hence much more stable, regime of residential lending and finance with reasonable costs of capital for borrowers. Moreover, it would probably be a good thing if reforms brought about lower rates of household investments in home ownership in the United States would be desirable: from a basic economics perspective, American households have long been overinvested in where they live. The approach I advocate -- the simplicity approach, if you will -- is admittedly politically infeasible at present, but if what is politically feasible is only Dodd-Frank, then perhaps our attention needs to most immediately focus on changing our politics and hence expanding the domain of the politically feasible.
The Move to Complexity and Its Consequences
At one point in time, residential lending in the United States was fairly simple, involving few parties per transaction and few instruments. Thirty year fixed rate, fully amortized mortgages were overwhelmingly the mortgage of choice; a significant down payment deposit was required; second and third mortgages were relatively uncommon, at least as part of the initial purchase transaction. In the last twenty years or so, we saw the utilization of a dizzying array of nontraditional alternatives in which rates were not fixed or only fixed for a time, principal was only partially amortized or not amortized at all, and by means of second mortgages or simply through lax underwriting standards, purchases often means little or no upfront, unborrowed cash deposit. At the same time, the number of parties involved in a single loan proliferated. Whereas once mortgages were solicited, originated and held by lenders, now those functions are typically performed by different parties. Mortgage brokers often originate mortgages, and usually sell them as fast as possible to lenders, who in turn quite often sell them again and again. Lenders very often retain servicing on loans they long ago sold. As the big servicers such as Bank of America have recently been forced to admit, the fabric of transactions surrounding a given ordinary residential mortgage can now be so complex that it is no mean feat to determine at a given point in time who exactly "owns" the mortgage.
There has been a corresponding move to complexity in the MBS arena. Mortgages have been securitized for quite a long time in the United States, but until recently, almost all of the securitized mortgages were fixed rate mortgages that were originated using relatively strict FHA or Freddie Mac underwriting requirements and that enjoyed an implicit repayment guarantee of the United States. In the years immediately leading up to the implosion of the housing and mortgage finance market, we witnessed an array of new private label MBS that were much more complex than traditional MBS. The new kinds of MBS had so many tranches and permutations that you needed flow charts and advanced engineering degrees just to map them out. FHA and Freddie Mac sought to compete with private label MBS by loosening their underwriting standards and by producing more and more varied MBS products. The greater complexity in the market for mortgage instruments and in the MBS market were intertwined and reinforcing: The greater and more complex array of MBS fed demand for more borrowers, which was achieved in part by means of new, more complex loan arrangements that targeted households that could not have afforded traditional mortgages.
That the housing and MBS crises were preceded by a move from simplicity to great complexity does not, by itself, mean that the complexity per se was a cause of the two crises. But complexity can operate to lead to sub-optimal decisions, as the behavioral psychology literature illustrates. Faced with a confusing array of choices, people tend to fall back on heuristic biases that do not necessarily result in the decisions that maximize their welfare. In particular, the complexity of mortgage arrangements and instruments likely made it easier for potential home owners and refinancing home owners to fall prey to "the optimism bias." With this bias, it was too easy for many borrowers to believe that housing prices always rise (and certainly never fall) and hence that a no-money down, variable-interest rate mortgage is not just immediately tempting but also prudent. So, too, the dizzying array of MBS choices made it easier for investors to heavily invest funds that were supposed to be reserved for prudent investments, without tackling straight on the possibility that the always-rising-prices scenario might be nothing more than an historical anomaly.
Swindlers flourished in the complexity and the confusion of the housing and MBS markets. The complexity of consumer choice made it easier for unscrupulous mortgage originators to target and sell vulnerable homeowners and home buyers products that they did not understand, could not afford, did not need, or were more expensive than available alternatives. The complexity of the MBS markets and its instruments allowed the originators, poolers, and sellers of MBS to take advantage of their superior information by overcharging and overselling their customers. Complexity made it easier for the MBS poolers and marketers to shop offerings among credit agencies for the best ratings. Complexity helped the credit agencies to meet the implicit demands of the MBS poolers and marketers -- and hence boost their profits -- because it allowed them to tell themselves the story that the offerings, which after all were too complex for them to really understand, somehow might deserve the AAA or AA ratings.
Complexity also has made it harder for the government and private actors to respond sensibly to the housing and MBS crises. One plausible solution to the housing crisis would be the re-working of mortgages to reduce principal and make the mortgages more in keeping of actual market values. There are many reasons we have observed almost no loan modifications with principal reductions, but one contributing factor is the division of individual mortgages into many distinct and often adverse investment interests and the consequent difficulty of gaining approval from mortgage "owners" to significant modifications. The division of the ownership of mortgages from their servicing also has impeded loan modifications.
Finally, complexity helped vested economic interests -- including those making money off the poor choices home buyers and owners and securities investors make in an environment of complexity -- avoid effective regulatory oversight. In the lead up to the implosion of the housing and MBS markets, federal regulators were largely passive, but when they did try to act, they received an enormous push-back from the financial industry and they quickly retreated. The financial industry's enormous clout with both political parties and in Congress and the White House would make it difficult for even the most courageous, well-intentioned regulators try to get anything done that that industry does not favor. But complexity makes it harder for such regulators to try to get anything done, because regulators quite plausibly can be (and are) assaulted with the claim that they do not fully understand the complexities of the relevant markets and hence are not equipped to impose new rules and regulations. Indeed, in the wake of the MBS crisis, regulators had to turn for advice and counsel to the same entities that had helped create and benefited from the bubble in MBS instruments for explanations of those instruments and guidance as to what they really might be worth.
The Simplicity Approach (or Why Not Follow Demark?)
In a simplified mortgage and MBS market, there would be only one or two kinds of residential mortgages available, with the 30-year fixed-rate as the predominant instrument; putting twenty percent down or paying mortgage insurance requirements would be a strict requirement and not easily evaded using second mortgages; and rates among mortgages offered to borrowers thus would not be very varied. The similarity in instruments and the uniformity of the underwriting standards would not support a wide range of rates. Because only traditional, reasonable risk mortgages would be made, there would be no possibility of MBS based on nontraditional mortgages. MBS pools would be based on quite transparent instruments, and investors in MBS thus could make reasoned and reasonable investment choices. In such an environment, the bubbles we experienced and subsequent implosions would be less likely.
Moreover, there are models -- and not just historical ones -- for such a simplified regime of mortgage finance. In Denmark, the form of residential mortgages is tightly regulated -- so much so that there is really only a single mortgage rate good for virtually all new mortgages on any given day. Mortgages are financed with bonds, such that banks are able to off-load interest rate risk while retaining creditworthiness risk. The Danish system, which no less prominent an investor than George Soros has suggested as a model for the United States, was adopted in the wake of late nineteenth century housing bubbles and has proved highly effective in preventing bubbles. At the same time, the cost of capital for mortgages in Denmark compares favorably with the rest of Europe and the United States. If a simplified regime can satisfy the needs of home buyers and owners in Denmark while achieving admirable stability, why, at least in theory, can the United States not do the same?
Dodd-Frank does not even come close to offering greater simplicity. It is a massive piece of legislation. The bill does not bar nontraditional mortgage instruments; it does not even require that potential home buyers be given a lucid explanation of how a plain vanilla mortgage would compare to less traditional, higher risk alternatives. Perhaps implementing regulations could require mortgage brokers to at least offer traditional mortgages to customers who can afford them, but even that modest reform seems unlikely given the clout of the financial industry. Moreover, it is hard to imagine that courts will uphold regulations that in effect re-insert into Dodd-Frank provisions Congress quite plainly removed from it as part of the process that allowed for its ultimate passage and enactment into law. Congressional intent that Dodd-Frank be limp and lax and not terribly protective of consumers is in no way admirable, but is quite plain for all to see.
Dodd-Frank also does not restrict what kinds of mortgages can be securitized or how they can be securitized. It is true that Dodd-Frank may make certain mortgages riskier than before for investors by giving borrowers who feel they were sold an unsuitable mortgage some recourse against foreclosure. But if recent history teaches us anything, it is that investors in MBS sometimes can be sold on securities based on mortgages that are in fact quite risky -- indeed, that in a search for a higher rate of return, they may gravitate to such investments whether they understand what they are doing or not. We can be assured the financial industry will seek to tap the ever-present yearning for higher return.
The Choice-Is-Always-Good/Innovation-Is-Always-Good Objection
One central objection to a simple regime of mortgage finance is that complexity is beneficial when it gives consumers (home buyers and owners and investors) greater choice and thus allows them to maximize their preferences. After all, if choice is good, isn't more choice better? And if innovation is good, why isn't financial innovation in mortgages and MBS good, too? Even after the recent crises, it is still commonplace for politicians, business leaders and elite commentators to opine that financial innovation is a key American comparative advantage that we must not undermine in the interest of reform.
As noted above, however, more choice does not always translate into better informed, better-reasoned choice. Moreover, even if one (unrealistically) assumed that people always do maximize their own narrowly-understood welfare through more choice, the fact is that the many people are affected by other people's choices that impact the stability of the housing market. Children who lose their family home because a parent entered into an imprudent mortgage, neighbors whose housing values plummet and basic services disappear because of foreclosures, and retirees whose pensions go underfunded because the pension fund invested in overvalued MBS all lose out as a result of other people's choices.
Perhaps in some part because housing is a domain where such externalities abound, there is in fact a long tradition of constraining individual choice and requiring the use of certain standardized forms in the area of real property law generally and in the context of mortgages in particular. What makes a mortgage a mortgage rather than an installment land contract, legally, is that mandatory rights and obligations are read into the agreement between borrower and lender whatever the parties, as a matter of their contractual intent, actually intended. Viewed in the broader swath of Anglo-American legal history, the essence of mortgage law is legal constraint on ad hoc innovation in the interest of preserving social stability and protecting the vulnerable.
Indeed, as Henry Smith of Yale Law School and Thomas Merrill of Columbia Law School have argued, what arguably distinguishes the domain of property law from that of contract law is that property law insists upon a high degree of standardization and, in that sense, simplification. Smith and Merrill root property's traditional demand of standardization in the benefits of reducing transaction costs for third parties to property transactions, but the recent housing and MBS crises suggest that this tradition can also be defended as a means of protecting parties to property transactions from the cognitive pitfalls of complexity and from the underhandedness of those who would take advantage of those pitfalls. The recent crises also underscore the wisdom of the tradition in property of constraining and overriding private party choice in the interest of preventing or overcoming excessive fragmentation of interests in real property.
The Ownership Society Objection
If mortgages and MBS were standardized and simplified, the average costs of borrowed money for purchase money mortgages might not climb but it is certainly possible both that (1) some buyers would be not be able to buy as expensive a home as they otherwise would have, and (2) some buyers with poor credit histories or limited income and assets would be unable to buy a home at all. With respect to the first possibility, I think the best response is, why would that bad thing? Until very recently, the average size of new U.S. homes has steadily increased as the size of the households occupying them has declined or at most remained steady. The result is more sprawl, more fossil fuels consumption, more greenhouse gas emissions, and not necessarily more happiness, as far as anyone can objectively measure happiness. Moreover, households that have invested heavily in homes are not acted in accord with standard portfolio theory, which teaches that the best way to temper financial risks is to diversify one's investments. From this perspective, many households that sank all their available capital and committed all their anticipated earnings in a single asset -- a house -- would have been much better off diversifying by buying less house while investing more in their human capital (e.g. education) or other, more liquid forms of capital (bonds, stocks, life insurance).
But what about people who would be left out of the housing-ownership market altogether under a regime of only traditional mortgage instruments and straightforward, reasonably strict underwriting? The ownership-society school of social policy and popular commentary teaches that by owning homes, people achieve greater personal and familial success, communities become more stable, and social ills are reduced. If ownership equals greater individual and social welfare, is not anything that reduces that rate of ownership a bad thing?
Recent scholarship calls into question the necessary connection between ownership and stability and human flourishing, but even if we accept that connection, the fact is that owning a fee simple is not the only way to gain the emotional attachment and longer-term perspective that we believe is the mechanism by which "ownership" confers individual and social benefits. In the United States, there are relatively few protections for residential renters from displacement by landlords, government action, or market forces. Most available leases are one-year or month-to-month, and there are very few protections in more than a handful of locations against landlord's decisions not to renew leases or to drastically increase rent at the time of lease renewal. If the menu of rental arrangements available to low-income households included ones that offered more of the stability that (sometimes) is offered by a fee simple while costing less than a fee simple and thus being genuinely affordable to these households, then many of the benefits of the ownership society could be achieved. Providing people with greater ownership in their places of employment and in their local schools also could go a long way to achieving the benefits of an ownership society.
The Hard Reality of Politics and the Need for Campaign Finance Reform
So what is to be done? If Dodd-Frank gets us (almost) nowhere and something more radical and much more simple is needed, how can that be achieved? The answer is only through new Executive leadership or new legislation, and there is no reason, under the current politics, to anticipate either. Thus, the only "solution" is a terribly hard one: to change the politics. But as many commentators have noted, both political parties appear aligned with, if not captive to, the interests of the financial industry and the apparent goal of that industry to essentially go on now as if the housing and MBS crises never happened. At least in part, this alignment reflects the reality of the huge financial contributions that industry makes and (after Citizens United) will be freer to make than ever before. What that means is that new legislation is needed to reform campaign finance and to pressure the Supreme Court to temper its First Amendment absolutism when the interests of large corporations are at issue. Hence the catch and the challenge: we need (at a minimum) new rules for campaign finance to get a better politics, but until we get a better politics, we cannot get the new rules. So, somehow, we need to achieve meaningful, constructive political change even under rules that have led to dominance by two parties that cannot or will not undertake the reforms that are needed for our public welfare. It is a hard challenge but our politics has overcome even harder challenges -- the Great Depression, World War II, Jim Crow -- and prevailed. We can do that again.
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