Regulating Away Housing Bubbles

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Two scholars argue for measures to reduce the incidence and magnitude of housing bubbles.

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Since the Great Recession of 2007-2008, the federal government in the United States has initiated reforms to the nation’s mortgage market. One key measure was the Dodd-Frank Act, which in part seeks to alter the incentives of sophisticated mortgage lenders and securitizers so they stop exploiting less sophisticated mortgage borrowers and investors. The purpose of the law is not to prevent housing bubbles, but to protect less sophisticated participants in the mortgage market by imposing additional regulations on those who would otherwise take advantage of them.

A recent paper, however, calls strongly for a more direct approach that would target housing bubbles themselves. The paper’s authors – Ryan Bubb of New York University and Prasad Krishnamurthy of the University of California, Berkeley – favor imposing limitations to prevent, or mitigate the effect of, housing bubbles.

They argue that the Dodd-Frank Act’s mortgage provisions are “ineffective or even counterproductive” to preventing housing bubbles. According to Bubb and Krishnamurthy, two measures in particular aim to “[protect] naïve investors and borrowers from opportunistic securitizers and predatory lenders.” The law’s risk retention requirement mandates that mortgage securitizers must bear at least five percent of the credit risk of any assets securitized. The law’s ability-to-repay rule requires mortgage lenders to make a “reasonable and good faith determination” on borrowers’ repaying capability.

Bubb and Krishnamurthy cast doubt on the effectiveness of these measures. They question the rationality of participants in the mortgage market during housing bubbles – not just of the naïve borrowers, but of the sophisticated lenders as well. Both the risk-retention requirement and the ability-to-repay rule are premised on lenders and securitizers determining their own risks rationally. The authors, however, assert that bubbles can lead to too-high expectations about future housing, which will prevent mortgage lenders and securitizers from making optimal decisions.

The costs of Dodd-Frank’s risk retention requirement, according to the authors, will only be “increased by the bubble.” They point out an important feature of mortgage securitization: its “tail risk” – the risk that a loan will greatly underperform on its expectations. A tail risk can produce devastating financial crisis if it is concentrated in important financial institutions, such as banks and securities companies, who then must bear the brunt of the losses. Housing bubbles create tail risks, leading Bubb and Krishnamurthy to conclude that imposing greater housing risks on securitizers will be an ineffective and even counterproductive approach to reducing overall “systemic risk” during bubbles.

The authors also argue that Dodd-Frank’s ability-to-repay rule would be insufficient to “prevent predatory mortgage lending from recurring.” They claim that contractual structures of subprime loans in housing bubbles often feature “temporarily” low monthly payments. When loans appear to have superficially favorable rates, low-income home-buyers will underestimate the true loan costs and borrow more than they can afford. Bubb and Krishnamurthy claim that in a bubble, this situation gives lenders strong incentives to offer such “teaser” loans, even under the ability-to-repay rule, because they do not rationally calculate the risk of default.

What are the desirable solutions for inhibiting housing bubbles? Instead of an indirect, incentive-based approach, Bubb and Krishnamurthy favor simply making market participants unable to act on a “bubble mentality.” They propose several possible straightforward solutions using direct regulation to reduce the frequency of housing bubbles.

First, the authors propose simply limiting mortgage leverage. They say this strategy, which would increase the size of the downpayment required in proportion to the mortgage amount, has been successfully used in other countries. They argue that leverage limits would inhibit housing bubbles from forming. Easy credit, which enables households to buy houses with prices far beyond their financial ability, has played an integral role in recent housing bubbles. With leverage limits, home-buyers would be allowed only to make realistic purchases. Although leverage limits might impede access to homeownership to those with more limited means, Bubb and Krishnamurthy stress the importance of reducing this source of the risk of bubbles.

Second, they argue in favor of applying strict debt-to-income ratios (DTIs) on prospective mortgage borrowers. A DTI ratio prevents mortgage borrowers from getting mortgages that would require them to make monthly loan payments greater than a specified portion of their monthly pay.

Finally, Bubb and Krishnamurthy advocate regulation that would limit “teaser” payment loans, which advertise temporarily low rates that will eventually increase substantially. In addition to the concern about lenders’ strong incentives to offer predatory loans, they argue that such “teaser” payment loans have the risk of boosting housing bubbles as they are popular with both borrowers and lenders, who expect housing prices to continue to rise during bubbles. Thus, the authors favor restrictions on temporary reductions of monthly loan payments to promote both consumer protection and financial stability.

Bubb and Krishnamurthy conclude that “it is time for behavioral law and economics to start taking bubbles seriously.” They admit that the direct measures they favor will generate costs, but believe these measures will deliver sufficient benefits to offset those costs.