Vanilla Mortgages Gain Appeal

“Once upon a time, choosing a mortgage was easy. Nearly all mortgages were of the 30-year, fixed-rate variety, required a 20-percent down payment and were devoid of tricky features like balloon payments, teaser rates and prepayment penalties….Fast forward to 2008, and the world of mortgage shopping had become a much more complicated place.” This glib history of mortgages provides the backdrop against in which one behavior economist defends the government’s efforts to overhaul the mortgage system.

Critics of mortgage reform argue that free markets and consumer choice will yield the best system for allocating mortgages. The problem with this notion, however, is that it hinges on a couple false assumptions. The first is that information is symmetrical; in other words, both lenders and borrowers have access to the same relevant information. The second assumption is that all borrowers/consumers are inherently rational, and hence have only themselves to blame if their choice backfires.

According to behavioral economists, these assumptions are not realistic: “What if consumers believe the following: ‘Creditors reveal all information about me and the loan products I am qualified to receive.Brokers work for me in finding me the best loan for my purposes, and lenders offer me the best loans for which I qualify. I must be qualified for the loan I have been offered, or the lender would not have validated the choice by offering me the loan. Because I am qualified for the loan that must mean that the lender thinks that I can repay the loan. Why else would they lend me the money? Moreover, the government tightly regulates home mortgages; they make the lender give me all these legal forms. Surely the government must regulate all aspects of this transaction.’ “While most borrowers aren’t naive enough to believe everything there, the vast majority must believe that the fact they were issued a certain mortgage inherently means they are qualified for that particular mortgage. Given the increasing number of defaults and mortgages, this is clearly not the case.

In steps the federal government, whose latest proposal is to increase transparency, simplicity, and fairness in the mortgage process. Specifically, consumers would be presented with a concise summary of risks/benefits, costs, and terms. Their ability to afford the mortgage would have to be thoroughly verified by the bank. And here’s the kicker: they would be encouraged to take out a plain-vanilla mortgage, rather than a more complicated alternative.

Critics of this proposal insist that the current rules (stipulated by the Truth in Lending Act) are adequate, and that a simple disclosure of risks should be enough to enable a consumer to take out a mortgage deemed risky by the government. Behavioral economists counter, “Even if meaningful disclosure rules can be created, sellers can undermine whatever before-the-fact or ex ante disclosure rule is established, in some contexts simply by ‘complying’ with it: ‘Here’s the disclosure form I’m supposed to give you, just sign here.’ ” In other words, it’s disingenuous to argue that most consumers read lengthy disclosure documents, which are often many pages long and written in legal jargon.

Under the new system, it would be much easier for borrowers to compare vanilla mortgages offered by different lenders, because the terms/conditions would presumably be identical. The paperwork burden would be lower, and hidden fees and prepayment penalties would be banned. Sounds pretty good to me! No wonder mortgage industry lobbyists are fighting it tooth-and-nail…