Interfluidity is back (and stay back!) with a post about the vanilla option, which is highly recommended. I want to expand on two points he brings up.
Vanilla products would turn basic financial services into a commodity business, and force providers to compete on price…. Since vanilla financial products would be commodities, banks would have to universally collude to offer them at inflated prices in order to bilk consumers. Competing vanilla project offerings would (at least they should) vary only on a single dimension (e.g. an interest rate). Points, fees, penalties, etc. would be homogeneous or uniformly pegged to the core price.
This is actually very important to one of the earlier financial engineering innovation – the futures commodities market. I’ll write about this in a geekier fashion tomorrow, but if you are buying a commodity to be delivered in the future, one that hasn’t even been made yet – cattle, apples, corn, etc. – it’s incredibly important to have it clear what the quality is of the product at the time of the bidding. Since I imagine the producer of those commodities will try and cheat me – he’s locking in a price on the future commodity years in advance from me but the commodity isn’t even created yet, we quickly hit a market for lemons style problem. The only way to cut this is to ruthlessly enforce a standardized quality measure that is the same for all contracts.
This is the point Eakes was getting at in his 2000 testimony: “Because what I hear from lenders directly is that I can’t eliminate prepayment penalties for my loans unless all the other lenders in my marketplace are eliminated at the same time; if everyone is constrained then we can compete on the same playing field and we will be competing on interest rate.” By locking down one clear dimension across products, competition can actually do its job in the single dimension, with additional products also being subject to these comparable comparison forces.
Market For Lemons
Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing. Status quo financial services should be a classic “lemons” problem, a no-trade equilibrium. Unfortunately, those models of no-trade equilibria don’t take into account that people sometimes really need the products they cannot intelligently buy, and so tolerate large rent extractions if they must in order to transact.
The microeconomics is even more fascinating. I want to draw everyone’s attention to a paper by Gabaix and Laibson, “Shrouded Attributes and Information Suppression in Competitive Markets” (MR has a copy of a layman’s overview). If you speak Micro, it’s just a fascinating paper about how markets clear with naive investors and fees. It’s a look at markets where there are low cost, high hidden fee firms, and how competition from medium cost, no fee firms will lose. What’s interesting about this is it is generalizable to a wide variety of favorable market conditions (zero-cost advertising, for instance). And luring sophisticated consumers away won’t work as they are cross-subsidized by the naive consumers paying fees.
I saw this cross-subsidized problem first hand talking about the credit card bill earlier in the year. People were upset their “free” points were going to take a hit as a result of banning high interest rate jumps off those who miss a payment and letting credit card markets reset along those lines. If they were “free” because they were subsidized in part by mislead consumers is that a just and/or fair arrangement? I suppose it depends on what you think about mislead consumers – if they are struggling as a result of increased income volatility or health care cost shocks, piling on them strikes me as unjust. But explain that to someone who is flying for free off them!
As a last point, thinking a lot about the vanilla option makes me strongly reconsider Steve Waldman’s post on a government vanilla credit card.
Also check out Alyssa Katz on the subject.
Losing the plain vanilla mandate sucks deeply, but the really important battle regardless is what will happen to the secondary market. Fannie and Freddie and their regulators made plain vanilla the standard for decades – CRA activists in the 1980s actually used “plain vanilla” as an epithet, describing how the GSEs’ strict underwriting standards for this mortgages excluded minority/urban borrowers. It was only with the entry of essentially unregulated secondary market actors following 1980s deregulation that subprime and other gotcha mortgages came on the scene…
There’s still ample opportunity for the feds to push plain vanilla, if they choose to seize it. Bankers don’t necessarily mind, either – after all, they did very well for themselves selling plain vanilla backed by the GSEs. The Mortgage Bankers’ Association’s proposal for GSE reform contemplates explicit government guarantees on mortgage pools that meet regulators’ specified standards. With the right standards and incentives, a mechanism like that can promote plain vanilla as once again a dominant market presence. Think of it as the “public option” for mortgage credit, and perhaps other forms of credit too.
There’s a secondary financial crisis problem out there, and that is related to the capital markets banking system. Without going into that further, the system’s ability to generate “informationally insensitive” debt, or risk-free debt, is incredibly important. One solution is for the Fed to write CDS contracts on pools of debt away from market prices in order to provide a liquidity backstop. I think this is highly unlikely to happen. Another solution will be the Fed helping to create pools of mortgages that can be stapled AAA (and made so by de facto CDS writing with guarantees by the Fed). This is actually one reason I thought vanilla contracts might be popular – it would help with the informational problem in securitized mortgage debt, and since I don’t think the capital market banking system is likely to go away, this would help with assuming a government backstop.
I get the impression that insuring pools of high quality debt, similar to a CDS window in a sense, is the approach the Fed will take; if they decide to do it with the lending market as it stands, they deserve everything that is going to happen to them. First time as tragedy – second as farce.
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BTW, who really gets any benefits from “innovative financial products”? Isn’t it just the traders who know more (and have more influence) than everyone else? There is no point for the rest of us in pretending that “innovation” (often a cover for “lack of transparency”) is a net gain for most consumers, if it isn’t.
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“Consumers know they are at a disadvantage when transacting with banks,…” and many other businesses; the plethora of offerings is designed to confuse consumers and make rational cost comparisons impossible, be it in the banking sector (teaser rates, hidden and open fees on accounts, which are waved at changing levels of deposits for depositors, similar for consumer and mortgage credit, as this post reminds us), in car buying (confusing numbers of ‘add-ons’, models…[now getting better with info available on the web]), cell phone service (How many ‘free’ minutes do you get? What is the penalty to leave the service early? What is the real cost of the new phone model you get for another 2 year’s commitment? ). Consumer ‘choice’ – my @55. (Sorry.)
It would be indeed good, if ‘vanilla offerings’ would be legally required, and in a way which is not undercut by the companies (as in the phone service market, where the regulated tariff rates are always much higher than any ‘plan’ they offer, making them useless for comparisons.) Fannie Mae and Freddy Mac could ensure reasonable offerings in the mortgage market by buying only certain ‘vanilla ‘ mortgages (in a way telephone regulators apparently cannot; there a law is required that allows consumers to leave any plan without penalty in a short time. For mortgages, a law forbidding prepayment penalties would also be good.)
The informational problems with plain vanilla mortgages are amazingly high, from the point of view of the secondary market, if not the consumers. Prepay risk . . .
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It’s hard to imagine a non-tricky credit card because the very concept is tricky. Checking account debit cards could be a non-tricky product and loans could be non-tricky. The only purpose I see in tying them together (a payment card that can be used to borrow money) is to make it possible for someone to end up in debt by accident.
Nothing stops someone wanting to go into debt from going to their bank and asking for a vanilla loan. It’s consumers’ job to work out which products are vanilla.
I appreciate the theory behind a vanilla option. Vanilla financial instruments might be helpful to some people. Nothing will save people from this emotional feeling of being “at a disadvantage” when entering contracts with certain organizations.
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