Any reasonable person understands the need for a strong, if limited, government in a modern economy. Setting the rules that guide market behavior, enforcing property rights, and maintaining a basic social safety net are essential lubricants for economic prosperity. It is an expensive, but necessary, part of the process.
Rules are never perfect. They tend create sharp lines in a world that is ever so fuzzy. This means that sometimes a rule will fail to fully accomplish what it is designed to do. Take the rule about what constitutes an intoxicated driver in California. The .08% BAC rule is very sharp—above it and you lose your license. Below it and you're fine.
This rule is at best flawed and at worse capricious. Some people are serious hazards on the road at much lower BAC levels, and others (typically a member of the Commonwealth) are quite capable of driving safely at higher levels. In the case of the drunken driving rule there may be little that can be done—after all, measuring someone’s absolute level of intoxication is close to impossible. We as a society have to accept some basic BAC level as a cutoff, and hope it provides the best social outcomes.
There is a cottage industry of economists who are always trying to come up with better rules to help the regulating process become more efficient. Sometimes it’s only a function of setting the correct height for the bar. Some efforts try to shift away from hard rules to altering incentives—don’t tell individual firms how much they can pollute, have them instead ‘buy’ pollution credits so those with the lowest mitigation costs will do the most to reduce pollution.
My own view is often to stop enacting hard rules that treat the symptoms of a problem and instead try and deal with the underlying causes—if possible.
A classic case of not dealing with the underlying causes of a problem comes from a recent announcement by the Consumer Financial Protection Bureau (CFPB) defining the conditions under which a mortgage loan can be considered ‘conforming’—a desirable status for lenders as such loans will give far fewer recourses to a borrower who is being foreclosed on, making the loan cheaper to service.
The rules are fairly common sense. They forbid interest only or negative amortization loans, restrict the up-front fees that can be charged, and cap the DTI (total debt payments to income) at 43% along with carefully specifying that such calculations are made only on the basis of a 30-year fixed rate product.
As the real estate recovery continues, these rules (which mean little now in a still credit constrained borrowing market) will start to become more chaffing to the mortgage industry. Few institutions will be willing to grant higher risk sub prime loans, since they will not get the same legal immunity. As a result many marginal but potentially successful buyers will be unable to enter the market. And it is just as certain that some buyers with conforming loans will still find themselves with too much debt and end up in foreclosure. There is no ‘right’ answer as to what the DTI should be—we simply have to accept that it’s a sharp rule in a fuzzy world.
Or do we?
The issue that causes foreclosures is clear: buyers don’t fully understand the product and the risks. Of course they are supposed to have specialists helping them—namely real estate agents and mortgage brokers who are facilitating the transaction and handling the paperwork—and paid handsomely for it.
And here is where the problem lies. While it is true that on paper these professionals are supposed to have certain fiduciary obligations to their clients (and even this is fuzzy for agents representing home buyers), the incentives are completely wrong and do not support such a responsible role. Both real estate agents and mortgage brokers get paid not on the basis of a homeowner’s ultimate ability to pay their mortgage back and live in the house, but on the amount of money spent up front. Indeed, during the height of the housing bubble mortgage brokers were not only paid more for larger loans, they were actually incentivized to put buyers into risky loans.
If we truly want to fix the problem, we need to change the incentives driving the professionals who work with the buyer.
I can imagine a program by which commissions are placed in an escrow account, and if the buyer ends up in foreclosure within 5 years, the commissions would be given to the lending institutions. And the ‘commission’ would no longer be based on the value of the property, but rather on a fixed fee. That fee could be negotiated up front, but it would not vary on the basis of the final price of the house. That would be necessary to avoid having the fee be a much larger share of a low income person’s purchase than of a rich buyer's—which wouldn't be fair.
If such rules were ever proposed the outcry would be enormous. This is change—and no one likes change. And of course, just as buyers should not be exposed to badly incentivized experts, real estate agents and mortgage brokers shouldn’t be forced to accept the bad financial decisions of a borrower post purchase.
There may be no easy answer. But if we aren’t willing to change, then we need to rely on those sharp rules in a fuzzy world. Just remember that when the push back against these new CFPB rules starts up a few years from now.