Regulation Week: Consumer Protection

Sigh. So much for a Justice League of financial regulators. It looks far more like the Articles Of Confederation. Felix Salmon has the scoop: ” FOSC = NBS + FDIC + NCUA + SEC + CFTC + FHFA + FOMC + CFPA + Treasury.” Can we just go ahead and add The Coast Guard and The League of Women Voters to the mix?

Let’s think positive thoughts. At least the CFPA is official! Obama is proposing a Consumer Financial Protection Agency (CFPA). I think this is a great move – I don’t know how much opposition there was to the CFPA, but it appears to be there and will have some teeth on it.

“Consumer Protection” is a vague notion; a lot of people want it though what it will do is often left blank. In the document it appears one big part of it will be consolidating the interpretation and carrying out of several mortgage related regulatory acts (HMDA, TILA, CRA, etc. see page 53).

It may rely a lot on “Nudges.” I am of two minds towards the “Nudging” effect. On one hand it is very important; people do over-and-under estimate certain types of risk. Information can be presented, and indeed is, in a way that is sub-optimal for people to understand their rights and obligations. This amounts to a transfer from those writing the contracts to those signing off on them.

On the other hand, people do not need to be “nudged” into understanding that a core basket of health care and education is being priced out of the range of working-class people or that ‘income volatility’ is making their lives more unpredictable and unstable. The thugs at the collection agencies calling them at 8 in the morning saying threatening things to their kids are nudging them plenty. Nudging can look like a neoliberal band-aid on a gushing wound to me when I am being cynical. As I might get today.

Again though, positive thoughts. I want to suggest 3 things, ranging from a simple bill to broader ideas behind it, that consumers could use protection from in the financial markets. Let’s start by using a particular punching bag around these parts: let’s look at what is wrong with prepayment penalties.

Ban Prepayment Penalties at the Federal Level

Daniel Indiviglio at the Atlantic:

In continuing with the regulation theme, I wanted to consider one way in which regulation advocates might believe the crisis could have been prevented: a more highly regulated mortgage industry. What if those evil/negligent/stupid mortgage brokers hadn’t been allowed to originate wacky subprime mortgages? What if a regulation had been there to stop it? If you believe that regulation should be put in place to prevent a subprime housing bubble in the future, then this idea probably seems attractive.

But how would the government go about telling mortgage originators how to write mortgages? They’ve already got truth-in-lending disclosures, so borrowers know what they’re getting into. You’d have to go further and have specific requirements about the basic underwriting standards.

Nope. One way to do it would be to ban prepayment penalties at the federal level. In that entry, we worked out a model where banks were able to bet on house prices rising by using prepayment penalties to capture part of the rises and by making sure the loans were bad enough, with deseperate enough people with terrible enough 2-year resets, to force refinancing. Let’s peek at one of my favorite charts of the subprime market, the percent of mortgages not alive by time after origination:

30 months out 80% of subprime loans aren’t active, most having refinanced. Of those subprime loans, 80%+ had a prepayment penalty. We work the numbers in that model; on average prepayment penalties reflected 6 months interest, so around 3% of the houses values. So if the house appreciates 10% in two years, the bank gets to exercise an option that transfers 3% of that equity straight over.

Because remember, banks do not normally have a delta (exposure) on housing values. If house prices rise on a prime mortgage the only value they get are secondary (less default, higher recovery); subprime mortgages were a way for them to tap that equity. Betting on house prices directly is not what we want banks to be doing. This is a direct law that could be passed by this agency. Let’s go one level higher.

Calling Fees Transaction Costs

What’s wrong with prepayment penalties at a higher level? In general, our banking system has moved to a system of fees. What would be good is correctly identifying what is a genuine fee from what is a transaction cost, as well as making financial agents less incentivized to making a profit through collecting fees and instead through providing a good/service. Making your profit off of fees and transaction costs takes attention away from the actual underlying, the service we want to encourage.

We need to be clear on terminology, and this agency can help. In many cases, these aren’t fees. The burrito maker charges me a fee for my burrito (It is not from the benevolence of the burrito maker…), and I love him for it. In the case of a prepayment penalty, it’s a transaction cost. The proper “fee” is the interest rate on the loan. This penalty is a transaction cost – it prevents money from going to where it needs to go, and gummy ups the market. Markets hate transaction costs.

It also creates incentives for volume over quality. And it also creates incentives for origination instead of holding. The mortgage part of the financial crisis is full of stories where it is clear the banksters in questions were less concerned with a loan getting paid off and instead with it getting paid off enough. This business model is part of the reason why. This was clearly a problem in the previous crisis, and will likely be a problem in some other way in the next. But isn’t this transaction cost really just a hidden option?

Properly identifying embedded options

Let’s go higher. When I was discussing this prepayment penalty theory with a very smart person from a hedge fund, he told me that selling people embedded options is always deviously clever because people don’t understand that they are buying them, and often don’t understand their value. I think this is key.

Take a mortgage. It is simply a risk-free rate, with an option to default (put option) and an option to prepay (call option). Most consumers, if they had 50%+ equity in their homes, probably wouldn’t realize that the bank is more concerned about them exercising the prepayment option (exposing them to nasty negative convexity) than defaulting. If the consumer has that much equity, chances are he rationally won’t mail in his keys. But most consumers expect the opposite, that banks are freaked out about them defaulting and rooting for them to make extra payments more often.

We should emphasize options that smooth risk and smooth consumption. Prime mortgage buyers have less than 2% prepayment penalties. Lord knows that they could get them in exchange for some extra money, but they rationally choose to pay a little extra to avoid having to pay a lot extra under adverse conditions. Most options, from option ARMs to Prepayment Penalties, make payments more volatile and de facto encourage gambling. Hidden embedded options that make payments more volatile, harder to predict and more of a shock should be discouraged in exchange for options that, if anything, make payments smoother, easier to predict, and are less conditioned to be most adverse when things in the economy are worst.

So that’s taking one penalty and looking at it from several different levels. What are some other things I think they could look at?

Insurance

People consistently overestimate the amount of insurance they have on their house. Surveys and studies find that they aren’t rationally optimizing marginal costs but instead simply not comfortable with properly estimating tail risks and not updating contracts in their head based on changes that occur in the world. Coming up with some better contracts that nudge with people’s expectations are good for consumers.

Underbanked Communities

I do not know enough about this subject, but I have heard enough smart finance people I trust talk about it for me to believe that there could be an effort here.

Private Student Loans

This is a terrible, nasty, crony-infested industry that needs some disinfectant. Is the CFPA up for the challenge?

I’m missing a ton of obvious ones. What are some other ideas for this CFPA to tackle?