Regulating against bubbles: how mortgage regulation can keep Main Street and Wall Street safe - from themselves.

• Author: Bubb, Ryan
• Position: Introduction through II. Risk Retention C. Risk Retention in a Bubble 3. The Evidence a. Evidence on the Costs and Benefits of Risk Retention in a Bubble, p. 1539-1587

As the Great Recession has painfully demonstrated, housing bubbles pose an enormous threat to economic stability. However, the principal mortgage market reforms in response to the latest boom and bust--the Dodd-Frank Act's provisions on mortgage lending and securitization--are not designed to protect the economy from a housing bubble. Instead, these reforms tinker with the incentives of securitizers and lenders to prevent their exploitation of naive investors and borrowers. In particular, these changes require securitizers to retain credit risk and lenders to assess borrowers' ability to repay.

This approach misses the mark. The sine qua non of a bubble is marketwide overoptimism about future house prices. Irrational exuberance in a bubble leads parties across the entire system of housing finance to make risky bets based on rosy beliefs. It is not just investors who underprice credit risk and borrowers who overextend. Securitizers and lenders are also eager to take on dangerous levels of risk and leverage. The Dodd--Frank Act's incentive-based reforms, by relying on rational behavior by supposedly sophisticated parties, will do little to protect the economy from a bubble. They might even increase systemic risk by concentrating mortgage risk in large financial institutions.

Because indirect incentive-based regulation is ineffective in a bubble, more direct mandates should be employed. We suggest a number of direct regulations to limit mortgage leverage, debt-to-income levels, and other contractual features that enable or induce borrowers to take out larger loans. We show how such limits can curb bubbles, lower defaults, and reduce household exposure to housing risk. While such limits would undoubtedly entail costs, such as restricting access to mortgage credit and homeownership, we suggest straightforward ways to mitigate many of these concerns. Our critique of incentive-based regulation also provides an important new perspective on current legislative efforts to reform the broader architecture of housing finance.

The Dodd-Frank Act's mistargeted approach reflects in part the growing literature in behavioral law and economics that shows how sophisticated firms take advantage of biased consumers. Indeed, much of the debate over the appropriate response to the Great Recession has been about how to keep Main Street safe from Wall Street. We advance this literature by showing that the mistakes of firms have important implications for the design of regulation. Our analysis calls for a fundamental paradigm shift. The central policy challenge is to keep Main Street and Wall Street safe from themselves.

INTRODUCTION I. THE HOUSING BUBBLE AND THE GREAT RECESSION A. The Housing Bubble of 1997-2006 B. The Bubble's Role in the Great Recession 1. The Rise in Risky Lending as the Bubble Inflated 2. The Bursting of the Bubble and the Great Recession II. RISK RETENTION A. Background B. The Market Failure Theory 1. The Asymmetric Information Theory of Risk Retention 2. The Naive-Investors Theory C. Risk Retention in a Bubble 1. The Costs of Risk Retention for Financial Stability 2. The Performance of the Risk Retention Requirement in a Bubble 3. The Evidence a. Evidence on the Costs and Benefits of Risk Retention in a Bubble b. Evidence on the Naive-Investors Theory III. ABILITY TO REPAY A. Background B. The Market Failure Theory C. Ability to Repay in a Bubble 1. The Performance of the Ability-to-Repay Rule in a Bubble 2. The Evidence IV. MORTGAGE REGULATION AGAINST BUBBLES A. Direct Regulation to Protect Banks and Borrowers from Themselves B. Limiting Mortgage Leverage 1. Limiting the Incidence and Magnitude of Housing Bubbles 2. Mitigating the Effect of a Bubble Through the Banking Channel 3. Mitigating the Effect of a Bubble Through the Household Channel 4. The Costs of Limiting Mortgage Leverage 5. Using Corrective Taxes Instead of a Cap C. Limiting Debt-to-Income Ratios D. Limiting "Teaser" Payment Loans E. GSE Reform and the Architecture of Housing Finance CONCLUSION INTRODUCTION

The financial crisis of 2007 to 2008 and its aftermath are a sobering reminder that the main source of systemic risk in the economy is a real estate bubble. Between 1996 and 2006, house prices in the United States soared by over 120%. (1) As the bubble inflated, mortgage lenders made loans with steadily lower down payments and little regard for the creditworthiness of borrowers. Most of these loans were sold to other financial institutions that packaged them into mortgage-backed securities (MBS) and then resold them to investors. The bursting of the bubble in 2006 left in its wake economic ruin. The collapse of house

prices froze consumer spending and left households mired in debt. The resulting wave of mortgage defaults that struck financial institutions triggered a broader breakdown in credit markets. The Great Recession that followed has taken a heavy human toll in lost homes and jobs, and these hardships have fallen disproportionately on low income, working class families.

Many of the reforms to the financial system following the crisis should, in principle, make it more robust to a future housing bubble. The landmark Dodd-Frank Act (2) imposes higher capital requirements on banks, (3) creates a new resolution regime to safely wind down insolvent financial institutions, (4) and tasks a new Financial Stability Oversight Council with identifying and addressing emerging systemic risks. (5)

The Dodd-Frank Act, however, takes a different tack in its reforms to the mortgage market. Rather than addressing the risks to the economy posed by a future housing bubble, the Act focuses on protecting naive investors and borrowers from opportunistic securitizers and predatory lenders. First, the Act directs banking regulators to require securitizers to retain at least 5% of the credit risk of any assets that they securitize. (6) Second, it requires mortgage originators to "make[] a reasonable and good faith determination" that each borrower has "a reasonable ability to repay" the loan. (7) The Act thus relies on changing the incentives of sophisticated market participants to end their exploitation of the less sophisticated.

In this Article, we identify the costs of the Dodd-Frank Act's borrower and investor protection paradigm in terms of economic and financial stability and chart a better way forward. The mortgage market should be reformed to make the economy more robust to a housing bubble. The sine qua non of a bubble is marketwide overoptimism about future asset prices. Such overoptimism makes the Act's indirect, incentive-based approach ineffective or even counterproductive. The Act's approach will produce little benefit in terms of improved incentives and will likely increase, rather than reduce, systemic risk by concentrating mortgage risk in systemically important financial institutions. A better approach to addressing the risks of housing bubbles would be to regulate directly mortgage leverage and other contractual features that induce borrowers to take out larger and riskier loans.

The Dodd-Frank Act's approach to mortgage regulation reflects in part the influence of an important new academic literature applying insights from behavioral economics to legal policy. (8) A recurring theme in the initial wave of scholarly work in behavioral law and economics is how sophisticated firms can take advantage of biased consumers through contract design. (9) This asymmetric view of behavioral biases leads naturally to the borrower and investor-protection approach taken in the Dodd-Frank Act. (10) Similarly, the leading treatment of the recent housing bubble in existing legal scholarship considers "irrational exuberance" exclusively on the part of borrowers, which the authors conclude cannot explain the increase in the supply of mortgage credit during the boom. (11) We advance this literature by also considering mistakes by firms. We show that the marketwide overoptimism about house prices in a housing bubble--among sophisticated lenders and securitizers in addition to investors and borrowers--has important implications for the design of regulation. Mortgage regulation should not just seek to prevent lenders and securitizers from exploiting the mistakes of naive borrowers and investors; rather, it should also protect the economy from the mistakes of lenders and securitizers. Our analysis implies that the mistakes of firms (and consumers) undermine indirect incentive-based regulatory approaches and points toward more direct regulatory mandates. (12)

To motivate our analysis, we begin in Part I with an overview of the essential role of the housing bubble in the Great Recession. The bursting of a housing bubble produces a severe economic downturn through two main channels: (1) losses to financial institutions that result in a financial crisis (the "banking channel") and (2) a fall in household wealth that reduces consumption (the "household channel"). The main source of systemic risk is the threat of a future housing bubble, and the mortgage market plays a key role both in fueling housing bubbles and in linking them to the broader economy. Mortgage regulation should therefore be designed to perform well in the face of a bubble and to mitigate its macroeconomic effects through these channels.

We then analyze the Dodd-Frank Act's reforms to the mortgage market and show that they fail this test. We start in Part II with what many consider a centerpiece of the legislation: the risk retention requirement. Barney Frank himself recently declared that "to me ... the single most important part of the bill was risk retention." (13) But to what market failure is a mandatory risk retention requirement a useful regulatory response?

The standard answer is moral hazard. It is now conventional wisdom that lenders made loans to riskier borrowers in the run-up to the crisis because they lacked "skin in the game." Lenders sold the loans to securitizers that in turn...