New Magna Carta for Ordinary Folks

Here's an article in the NY Times discussing theinitiative to make mortgages simpler: the Obama Administration has proposed a regulatory requirement that lenders offer consumers "plain vanilla" mortgages.

This article by Richard Thayer, a University of Chicago economist who specializes in "behavioural economics" discusses the situation. I especially enjoy his proposed Homer economicus to go up against the traditional Homo economicus:

THIS column is in praise of warning labels. So let’s begin with one: I am not your usual sort of economist.

I practice what has come to be called behavioral economics. We behavioralists differ from our more traditional brethren in the way we characterize agents in the economy. Traditional economics is based on imaginary creatures sometimes referred to as “Homo economicus.” I call them Econs for short. Econs are amazingly smart and are free of emotion, distraction or self-control problems. Think Mr. Spock from “Star Trek.”

Real people are not Econs. Real people have trouble balancing their checkbooks, much less calculating how much they need to save for retirement; they sometimes binge on food, drink or high-definition televisions. They are more like Homer Simpson than Mr. Spock. Call them Homer economicus if you like, or just Humans. Behavioral economics is the study of Humans in markets.

Designing policies for Econs is pretty straightforward. Because they are smart consumers and make good choices, the best policies give them as many choices as possible and simply assure that they have access to all the relevant information.

Humans, however, can use a bit more help, especially when the options are hard to understand. Often, it is possible to help people make better choices without restricting their options at all. So shouldn’t it be a no-brainer to try? Some of the financial regulations recently proposed by the Obama administration provide a good example.

Consider mortgages, the source of so many problems in the financial crisis. Once upon a time, choosing a mortgage was easy. Nearly all mortgages were of the 30-year, fixed-rate variety, required a 20-percent down payment and were devoid of tricky features like balloon payments, teaser rates and prepayment penalties.

Sensible regulation was easy in this environment. Congress passed what’s known as the Truth in Lending Act, which required lenders to report interest rates in a uniform way, using the now-ubiquitous annual percentage rate. Picking the best mortgage was no more complicated that finding the lowest A.P.R.

Fast forward to 2008, and the world of mortgage shopping had become a much more complicated place. Borrowers were quoted low initial “teaser” rates that would jump later to some higher level, depending on market interest rates at the time, and there were prepayment penalties for paying off the loans early. For such mortgages, an A.P.R. was no longer an adequate measure of the loan’s cost.

How can we help people make sense of all this?

Go read the article, it discusses the proposal.

Sitting north of the US border, it seems to me that most fundamental problem is not legalese, but the idea of buying something without any "skin in the game". Here's a graph from a NY Federal Reserve report on mortgage borrowing:



In Canada, conventional mortgages require a 25% down payment and the cost of carrying the mortgage (plus all shelter-related costs) has to be less than 32% of your gross income. In the US they've gone crazy with mortgages which require 0% down payment and with NINJA loans they simply ignored whether you had income to carry the mortgage. Surprise! The housing market blew up, took down Wall Street, and spred a terrible recession around the world.