A simple approach to preventing the next housing crisis - why we need one, what one would look like, and why Dodd-Frank isn't it.

• Author: Dana, David A.

Introduction I. The Move to Complexity and its Consequences II. The Simplicity Approach (or Why Not Follow Denmark?) III. The Choice-Is-Always-Good/Innovation-Is-Always-Good Objection IV. The Ownership Society Objection V. The Hard Reality of Politics and the Need for Campaign Finance Reform INTRODUCTION

The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") (1) was, ostensibly, a response to the crisis in the U.S. housing market and the inter-related crisis in the market for mortgage-backed securities ("MBS"). One of the goals of the legislation, presumably, was to prevent another crisis in housing and mortgage finance. After what we have seen in recent years, certainly no one could question the importance of that goal. The housing crisis has deprived thousands upon thousands of Americans of not just wealth, but of their homes; it has helped drive municipalities to the brink of fiscal collapse; and it has impeded the recovery of the U.S. job market. The MBS crisis took down major financial institutions in the United States and almost caused a complete collapse of the financial sector. We cannot afford a repeat experience.

But Dodd-Frank, even if it is implemented in the far-reaching way that some hope and think it can be, will not address a problem at the heart of the housing and MBS crisis: excessive complexity. The years running up to the implosion of the housing and MBS markets were marked by ever-increasing complexity. This complexity caused confusion and poor judgments on the part of unsophisticated home buyers and owners, as well as supposedly sophisticated securities investors. (2) This complexity also allowed some people and institutions to make an astonishing amount of money originating mortgages that never should have been originated and selling MBS that never should have been sold, at least at the prices at which they were sold. (3) Dodd-Frank does not do the structural simplification work we need to prevent this from recurring once the memories of the current crisis fade.

Instead of Dodd-Frank, we need clear statutory reform that limits residential mortgages to a few sensible products, all girded by strict underwriting standards, and that correspondingly produces a well-ordered, transparent market in bonds or securities based on these mortgages. Other countries, most notably Denmark, have maintained a simplified, and hence much more stable, regime of residential lending and finance with reasonable costs of capital for borrowers. Moreover, it would probably be a good thing if reforms brought about lower rates of household investments in home ownership in the United States. From a basic economics perspective, Americans have long been overinvested in where they live. The approach I advocate--the simplicity approach, if you will--is admittedly politically unfeasible at present, but if what is politically feasible is only Dodd-Frank, then perhaps our attention needs to focus most immediately on changing our politics and thereby expanding the domain of the politically feasible.

1. THE MOVE TO COMPLEXITY AND ITS CONSEQUENCES

   At one point in time, residential lending in the United States was fairly simple, involving few parties per transaction and few instruments. Thirty-year fixed rate, fully-amortized mortgages were overwhelmingly the mortgage of choice, a significant down payment deposit was required, and second and third mortgages were relatively uncommon, at least as part of the initial purchase transaction. In the last twenty years or so, we saw the utilization of a dizzying array of nontraditional alternatives in which rates were not fixed or were only fixed for a time, principal was only partially amortized or not amortized at all, and by means of second mortgages or simply through relaxed underwriting standards, purchases often meant little or no upfront, unborrowed cash deposit. (4) At the same time, the number of parties involved in a single loan proliferated. (5) Whereas once mortgages were solicited, originated, and held by lenders, (6) now those functions are typically performed by different parties. Mortgage brokers often originate mortgages, and usually sell them as fast as possible to lenders, who in turn often sell them again and again. Lenders very often retain servicing on loans they sold long ago. (7) As the big servicers, such as Bank of America, have recently been forced to admit, (8) the fabric of transactions surrounding a given ordinary residential mortgage can now be so complex that it is no mean feat to determine at a given point in time who exactly "owns" the mortgage. (9)

   There has been a corresponding move to complexity in the MBS arena. (10) Mortgages have been securitized for quite a long time in the United States, (11) but until recently, almost all of the securitized mortgages were fixed rate mortgages that were originated using relatively strict Federal Housing Administration (FHA) or Freddie Mac underwriting requirements and that enjoyed an implicit repayment guarantee of the United States. (12) In the years immediately leading up to the implosion of the housing and mortgage finance market, we witnessed an array of new private label MBS that were much more complex than traditional MBS. The new types of MBS had so many tranches and permutations that you needed flow charts and advanced engineering degrees just to map them out. FHA and Freddie Mac sought to compete with private label MBS by loosening their underwriting standards and producing increasingly varied MBS products. (13) The greater complexity in the market for mortgage instruments and in the MBS market were intertwined and reinforcing. As Adam Levitin and Susan Wachter have recently detailed: "The greater and more complex array of MBS fed demand for more borrowers, which was achieved in part by means of new, more complex loan arrangements that targeted households that could not have afforded traditional mortgages." (14)

   That the housing and MBS crises were preceded by a move from simplicity to great complexity does not, by itself, mean that the complexity per se was a cause of the two crises. But complexity can operate to lead to suboptimal decisions, as the behavioral psychology literature illustrates. Faced with a confusing array of choices, people tend to fall back on heuristic biases that do not necessarily result in decisions that maximize their welfare. (15) In particular, the complexity of mortgage arrangements and instruments likely made it easier for potential home owners and refinancing home owners to fall prey to the "myopia bias" and the "the optimism bias." (16) The myopia bias leads to excessive discounting of future costs compared to near-term or immediate ones. (17) With the optimism bias, it was too easy for many borrowers to believe that housing prices always rise (and certainly never fall) and hence that a...