Consumer Financial Protection, Vanilla Products

Noam Scheiber has found out that several lobbying efforts are gearing up to do a “Harry and Louise”-style ad campaign against the Consumer Financial Protection Agency. Since I’m currently running a similar thought exercise agency out of this webpage, I’ll take this personally, and sign up to be one of the econ blogosphere point men on arguments against this agency and the good it could accomplish. There’s going to be a few trial runs to figure out the best way to talk about this over the next couple of weeks.

Vanilla Options

Over the weekend, Richard Thaler wrote a piece about Vanilla Options for consumer protection in the New York Times.

As the administration plan describes it, lenders could be required to offer some mortgages they call “plain vanilla,” with uniform terms. There might be one vanilla 30-year, fixed-rate mortgage and one five-year, adjustable-rate mortgage. The features of these plain mortgages would be uniform, much as in a standard lease used in most rental agreements.

Lenders would also be free to offer other exotic mortgages — perhaps called “rocky road” mortgages? — along with the vanilla variety, but these offerings would receive more intense scrutiny from regulators…

First, inexperienced borrowers are steered toward the vanilla mortgages, the terms of which are chosen to be easy to understand…

Second, because the terms of the vanilla mortgages are all the same, they are more easily comparable; just as in the good old days, the A.P.R. will be a good basis for assessing the cost of the mortgage.

This is a pretty smart idea. What are some arguments against it?


John Carney argues that this will throw out all the innovations of the past 25 years in the mortgage industry.

Here’s the problem: Thaler thinks he’s protecting the unsophisticated but his dreamy Golden Era of simple mortgages actually exploited unsophisticated borrowers in a way that enriched banks. You see, under the old mortgage regime, low-income borrowers tended to exhibit what the bankers called “low-prepayment risk.” This was code for the idea that bankers could make more money from the poor because they wouldn’t refinance their home loans, even when interest rates dropped and big savings were available. The poor just kept on paying their old mortgages at the higher rates.

His reforms threaten to bring back this era of exploitation, re-introducing the class division that reigned in the past. The sophisticated people will be able to access mortgages that allow them to take advantage of low rates, while the huddled masses will toil once again as the “low-prepayment risk” engines of profits they once were.

I don’t understand what over the past 25 years in terms of “financial innovation” has lead to prime mortgage holders refinancing more. Prime mortgage holders refinance if the cost of the benefit is greater than the transaction cost plus the hassle. Arguably the transaction cost has gone down, but I believe that has more to do with technology, standardization and perhaps scale rather than something about the mortgage contract itself. More likely consumers became more aware that there was money being left on the table. What would standardizing a base mortgage contract do to change either of those?

Actually, financial innovation went the opposite direction. 75% of subprime loans, the poster child of financial innovation, featured a prepayment penalty. This refinancing has nothing to do with consumers trying to take advantage of interest change movements, and less to do with banks trying to offload negative convexity, and it had a lot more with banks trying to take on direct exposure to the housing market (rather than secondary risk-centered exposures).

I actually think having a large chunk of mortgages be certified government standard vanilla will help with the big innovation of the past 25 years, mortgage bonds. But I’ll flesh that argument out at another time.

Treating Like Adults

Professor Zywicki in the Wall Street Journal:

[1] The idea of a financial product safety commission comes from Elizabeth Warren, a Harvard Law professor and the chairwoman of Congress’s oversight panel for the Troubled Asset Relief Program. She says that such a commission is necessary because consumers cannot buy a toaster that has a one-in-five chance of exploding, but they can get a subprime mortgage that has a one-in-five chance of ending in foreclosure.

But this simple-minded analogy misses the point. An unsafe toaster is a hazard to anyone who buys it. That’s not true for loans…

[2] Consider, for example, prepayment penalties in subprime mortgages. Banks charge such penalties because prepaying a mortgage makes it less profitable and subprime loans are already less profitable than prime loans.

Empirical studies show that there is no link between penalizing borrowers for paying off their loans ahead of schedule and increased foreclosures. Yet, consumer advocates say these penalties are one reason why subprime borrowers find themselves underwater.

If we listened to consumer advocates, prepayment penalties would be banned. But if we did that, lenders would likely charge riskier borrowers higher interest rates. These higher interest rates would, ironically, make it more likely that subprime borrowers would default on their loans.

Point 1: I’m assuming that if I was a degenerate crackhead who snuck into your neighborhood and mugged you for $50, the Wall Street Journal Opinion Page would want me thrown in jail. Now imagine that I’m a degenerate crackhead who took out a subprime loan to move next door to you, in an arrangement that I’m likely not going to pay off. I might not even make one payment. If I default you’ll lose 10% of the value of your home from the externality effect. Assuming your home is worth $300,000, there’s a 20% chance I default in 2 years (realistic numbers), and you lose 10%; 300,000*.2*.1 = I’ve just robbed you for $6,000 while the Wall Street Journal Opinion Page cheered me on. And that’s one house – I’ll have a dozen neighbors. Now mind you, the product was great for me – I got to smoke crack indoors, in a house I could never realistically afford, which was a big plus. The subprime lender sold my loan to a pension fund in Denmark for a nice fee. It goes in the win column for us.

So out the door financial instruments can cause harm to others. I’ll think through and write more about these questions, but the libertarian argument is only going to hold so much water with me.

Point 2: “But if we did that, lenders would likely charge riskier borrowers higher interest rates. These higher interest rates would, ironically, make it more likely that subprime borrowers would default on their loans.” Why? Assuming markets works, the NPV of the loan will be the same in either case; there is no free lunch in arranging a fee in one place versus smoothing it out. I can always find an interest rate that makes a person indifferent between two series of cash flows, and assuming markets work they’ll converge to that one. Mind you the uncertainty is with short-term cash flows, and prepayment penalties particularly hurt there.

Now I think it is better to smooth payments rather than cluster them (to pay a little extra in every period rather than taking a chance you have to have a big payment in one period) when we are otherwise indifferent to hedge against income volatility. I think there is a strong obligation to “nudge” people there – and anyone who wouldn’t should explain clearly why having people concentrate short term risks in one period is smarter than smoothing them out across all periods.

So why be up in arms? Because prepayment penalties were moved to create a situation where the banks wanted to exercise them not to hedge negative convexity on their loans (good financial use) but to get a piece of rising house prices (bad financial use – we don’t want banks doing this through embedded options). Where the initial rate on an ARM was already too high to be manageable, thus forcing prepayments inside the penalty zone. I’ve covered that elsewhere, and I believe it is where the elite research is going to end up.


I may try to take this Consumer Financial Protection show on the road (on the internet that is); please tell me in comments what arguments are and are not working for you. What are the strong suits and what are the weak points? I imagine I’ll need the advice as the months go on.

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21 Responses to Consumer Financial Protection, Vanilla Products

  1. financeguy says:

    Good idea for a series of blog entries! I think the conservative objections to cfp will fall mainly along the lines of “we’ll lose all these great financial innovations” theme. Which is kind of dumb really, if cfp takes the right form. For one: standardized mortgage products. Why not mandate that a couple of plain Jane varieties be offered, along with the weird exotic flavors? Keep it simple: a basic fixed rate, floating rate. Then, as noted, a consumer can compare between several banks, forcing banks to be more competitive to win business, the best banks grow bigger honestly (as opposed to getting bigger bcz they’re better at dreaming up weird loophole-infested mortgage products and snookering unsuspecting customers), it’s a win-win-win for consumers and capitalism. That shouldn’t be an onerous requirement for a bank, to offer two types of simple products. This system needs a lot more transparency.

  2. racerx says:

    The first step of a consumer financial protection agency is to define predatory behaviour. In order to be predatory there needs to be 1) an assymetry of information 2) a zero sum game (your loss is my gain). Traditional predatory subprime mortgage lending involved the transfer of equity from a borrower to lender. Prior to around 2005, most suprime loans were refinances with low LTVs, adj rates and Baloons (2/28 or 3/27). The subprime mortgage lending of post 2005 were purchases with high LTVs adj rates and baloons (and a substantial amount of Home equity piggyback loans). There was virtually no equity in the transactions for the borrowers to lose. The real loser in these transactions were the lenders. These were colossally bad loans but are they really predatory?

  3. Chris says:

    Banks charge such penalties because prepaying a mortgage makes it less profitable and subprime loans are already less profitable than prime loans.

    Sure. So unprofitable that they were aggressively pushed on anyone who could possibly be persuaded to accept one.

    Don’t piss on my leg and tell me it’s raining, Wall Street Journal. Some of this stuff hardly even needs refuting.

    The whole point of the CFP is to shut down profitable bad-faith dealings. This is highly likely to be opposed by people profitably dealing in bad faith, but they generally can’t just come out and say so.

    An unsafe toaster is a hazard to anyone who buys it. That’s not true for loans
    Was there actual evidence presented for this distinction? I’m sure there are several ways for a toaster to be unsafe for the average person that would permit a knowledgeable electrician taking the correct precautions to use it safely. The average person isn’t a knowledgeable electrician – but they aren’t a financial products expert, either. Working at the Wall Street Journal might make you more likely to forget the second fact, but you’ll probably remember the first.

    Consumer product safety should be viewed with the average consumer in mind, not the atypically expert consumer. That’s why we have professionals examine toasters for safety.

    If the free marketeers want to create a separate category of less-regulated instruments that can only be offered to borrowers with CPAs, MBAs, or similar expertise, maybe that would be OK (possibly even including borrowers who hire an expert to review the terms, as long as the transaction is structured to give the expert a sufficiently strong incentive to actually serve the borrower’s interests). But they know perfectly well that most knowledgeable borrowers would reject those toxic loan terms anyway. Innovative loans were generally created to be misunderstood, a business model that only works if you offer them to consumers likely to misunderstand them.

    P.S. @racerx: Weren’t the real losers in those cases the MBS buyers, who are now facing large writedowns on their “AAA” securities? I think those transactions were equally predatory, but with different prey. Although, of course, if the loans were recourse, there’s no reason you couldn’t prey in both directions at once.

  4. racerx says:

    @racerx: Weren’t the real losers in those cases the MBS buyers, who are now facing large writedowns on their “AAA” securities? I think those transactions were equally predatory, but with different prey. Although, of course, if the loans were recourse, there’s no reason you couldn’t prey in both directions at once.

    It would have been the MBS buyers if the banks had unloaded them fast enough. A lot of stuff that was held for sale had to be changed to held for investment (bank still stuck with them). In other cases the “buyer” of the securities were off balance sheet vehicles that ended up going right back to the bank (suprise, bank still stuck with them).

    As far as the borrower is concerned whether or not the loans are recourse depends on the state and the type of loan. For instance, a first lien primary residence in CA is non recourse (these borrowers can walk away and stick the bank with the home). Refinances, home equity loans, investment homes and 2nd homes are all subject to recourse.

  5. Another Mike says:

    I love this part:

    “Today credit cards are more complex, but they are also better. They offer no annual fees for no-frills cards, flexible interest rates, and more benefits. Competition is fierce and consumers have a wide range of choices.”

    Coincidentally, these innovations coincided with higher fees and other traps, making the market a conduit for transferring wealth from poorer (and less financially sophisticated) to richer customers–and moving more customers from the latter to the former category.

  6. Another Mike says:

    Zywicki makes a better argument in the comments section:

    “That was my point–a lot of these crazy loans present major safety and soundness issues, such as making nothing-down loans in states with anti-deficiency laws. If a borrower rationally responds to the incentives presented by that sort of loan and walks away, that presents a safety and soundness problem. It is not, however, a consumer protection problem. That’s the point I am making: many of the problems we have seen resulted from lenders making unsafe loans in light of the incentives that they provided for borrowers. But that is a safety and soundness issue, not a consumer protection issue. And treating it as a consumer protection issue could end up being counterproductive.”

    I agree with him on the idea that the major problem in these arrangements is that the intermediary is taking advantage of both the borrower and/or the investor to line his own pocket (and that holds, too, if the “investor” is his employer, given how little input shareholders have had into compensation structures that have favored short-term profits over risk management). However, the article doesn’t read as if this is his “point”–he does start to make this argument early on, but abandons it at the end for the less interesting claim about regulation killing financial innovation.

  7. Mike says:

    A couple points.

    For accuracy points. 1.5% is probably more accurate for the externality per foreclosure, not 10%. So picture 6 houses within a mile to get to 10%.

    Another Mike – thanks for pointing out that comment of his. I also didn’t get that that was the point of the article.

    FinanceGuy and others – I also like the idea of the vanilla option with these multiple contracts. I’m curious how much good it will do, but I don’t honestly see the bad side. It’ll make innovations have to be clearer and more transparent. Will the fight be over credit cards? “Remember how great they used to be….” as cc companies begin to slash parts of their cards to deal with projected 20% losses and blame congress for it.

  8. Taunter says:

    I think the safety commission is a good idea for retail products, and I particularly like Chris’ point that what may be safe for an expert to use could nonetheless be too dangerous for general distribution. We regularly close roads in bad weather despite the obvious fact that professionals with the right gear are able to navigate them (how else would the roads get repaired/inspected/reopened).

    However, my concern with the safety commission is that it is somewhat anticompetitive.

    Any attempt to fix the definitions of a product is going to benefit the incumbents. When the government bans cigarette advertising, it’s doing Altria a favor – people already know about Marlboro, it’s the new guy who can’t get his message out.

    When the government says “this is the vanilla contract, everyone will use it” it prevents people from competing on anything other than APR and distribution network. That’s great for the giant banks, who have the lowest cost of capital and the broadest distribution network, but it’s an impediment for anyone who is trying to break into the game. Given the consolidation in the industry, it’s not hard to see a return to the sort of soft collusion that defined the good old days of 3-6-3.

    Furthermore, vanilla contracts encourage brainless origination. In a vanilla world, perhaps all fixed rate deals will be 80/20. But what was needed this past cycle was precisely for someone to say no, I will not pay 80% of the price of your Inland Empire house – I might pay 60%, but that’s it. By contrast, someone else’s North Dakota house that could be scrapped for 70% recovery on the wood alone might well justify a 90/10 deal.

    On the whole, of course, a good idea. I would just like to see it accompanied by some sort of more effective clearinghouse to ensure that there are robust bids to provide the mortgages. Hell, I’d rather the government got out of the Fannie/Freddie business of supplying capital to the mortgage industry and got into the business of mediating the mortgage industry.

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  11. racerx says:

    Consumer protection should be constructed so that risks can’t be transferred to parties that are incapable of handling the risk. I don’t think a prepayment penalty is predatory in the sense that there’s no upside for the borrower (they should benefit from a lower interest rate) but for the most part the borrower can’t properly value or handled the downside risk. If the borrower needs to refi due job loss, divorce, illness etc they’re stuck with the penalty.

    *All prepayment penalties on mortgages are not the same (Hard vs soft Prepay). A hard prepayment penalty (used in most subprime loans) does not allow prepayment under any circumstance, a soft prepay allows for prepayment in the case of the sale of the home.

  12. D R says:

    It’s the bubble, silly!

    Everyone could “afford” houses at any ridiculous price so long as prices kept going up 5 percent every year. The bank could care less if you make payments if they can foreclose on you and sell the home at a profit. You care less because you could always sell the house before the bank forecloses.

    Subprime, schmubprime. The lending standards have naught to do with it. The pension fund in Denmark wouldn’t buy the loan if they’d realized the obvious– that prices were going to fall. And why care about the 10% loss due to the foreclosure when the home was 80 percent overvalued to start?

    The real crime was pretending there was no housing bubble.

    • Dan says:

      The two interact. In many metros, foreclosures were increasing long before any significant price declines. Chicago, Atlanta, Cleveland, etc. Of course, the bubble markets saw large declines as prices drop.

      Subprime foreclosure rates were 10-20 times as high as prime in the late 1990s. It was just a smaller market.

      Finally, what led to the bubble; maybe the fact that loan-to-income ratios were 50% or more higher with subprime.

      Things are a bit less linear than you portray…

  13. pebird says:

    What vanilla contracts do is establish a standard of information transparency that those who want to offer non-vanilla contracts need to meet.

    People won’t be brainless if the product they are offered explains what it does and doesn’t do. You shouldn’t have to hire a quant to figure out what debt product to buy.

    Credit cards are a great example – for most banks if you want more information security than their standard policy you need to WRITE AND MAIL A LETTER. Funny, they haven’t figured out how to use the internet for something other than marketing or collecting money faster. Any bank who uses the interest for customer transactions should be required to allow consumers to opt-out on-line. The banks love to bitch about information security unless its their own database they want to sell.

    The argument that clarity and transparency is going to stifle innovation is almost laughable except it isn’t funny. “Take your innovation out of my back pocket”.

  14. Zack says:

    Pretty cool post. I just came by your blog and wanted to say that I have really enjoyed browsing your posts.

    Any way I’ll be subscribing to your feed and I hope you post again soon!

  15. winstongator says:

    Loans had interest rates that did not accurately reflect default risk – arms, 2/28’s with teaser rates, option-arms. Poor loan underwriting contributed heavily to inflated home prices. What is better, a 12% loan on a 50k townhouse, or a 4% 2/28 teaser on a 200k townhouse? (fyi – the 4% loan is 2x as expensive as the 12%) Why are subprime defaults (and defaults in general) geographically concentrated?

    The most ‘creative’ lenders have the highest rates of default, why? Their ‘creations’ were not positive for anyone, and limiting those would have been positive for everyone.

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  17. Patrick says:

    “Degenerate Crackhead” really gets the point across. If you ask me, that argument is a silver bullet. If enough people can understand this stuff in such concrete terms, financial regulation will become a political slam-dunk.(….or to stick with the silver bullet metaphor, it will be a dead werewolf….)

  18. Mike says:

    Heh. Well, I was trying to parody the Wall Street Journal editorial page a bit with that line – it’s worth noting that, in a study conducted in Mass., 60% of subprime defaulters started off as prime mortgages. And I think there are some decent reasons why desperate people would go after subprime loans, besides the fact that their downside is limited but their upside is large. That said, the responsibility part, and the dangerous part remains.

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  20. Ron Stone says:

    Simple is better. While in the mortgage business (recently exited), I found most of my customers really didn’t understand the various types of mortgages and particularly all the forms they had to sign. So while I like the idea of simpler mortgages, no matter how simple the mortgage is we need simpler loan documentation to go with it otherwise the benefit will not be there. Unfortunately, the government regulators are racing in the opposite direction.

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