The market for home loans has changed dramatically over the past thirty years, due, in large part, to the development of a market for asset-backed securities. Encouraged through the creation of Fannie Mae and Freddie Mac—government-sponsored entities created to purchase and package small-to-medium-sized “conforming” mortgages—that effort had appeared until recently to be a success. A robust market for real estate mortgage-backed securities (“RMBS”) formed and then expanded well beyond the market for “prime” “conforming” mortgages that could be handled by Fannie and Freddie. The development of a secondary market for both conforming and nonconforming home loans increased the availability of mortgage credit to consumers with lower income levels and with worse credit histories than ever before. But, as recent events have demonstrated, this increased liquidity came at a high price.
The current crisis in the financial services sector demonstrates that this development of a secondary market for home loans produced unintended consequences for banks, consumers, and the real estate market.
The story of the development of this market appears to be a story of clever transactional innovations taken two steps too far. Conflicts of interest and gatekeeper failures on the supply side led to overlending. But errors in consumer decision making and the absence of demand-side institutions to protect consumers also led to overborrowing. Together they multiplied the level of risk in the banking system and helped provoke the subprime mortgage crisis.
In this Article we retell the story of how agency problems in the market for securitized home loans pumped up the level of risk in the financial system, and the related story of how these innovations encouraged overleverage. The shift to capital markets financing for home mortgages turned lenders into aggressive marketers of home loans and created a need for both consumer protection and consumer education—not just to protect consumers, but also to protect the integrity of the capital markets themselves.
The flourishing of the RMBS market coincided with, and spurred, a shift from relationship lending to capital markets financing of home mortgages. This shift from a “face-to-face” model of mortgage underwriting to a “capital markets” model interposed a functional distance between the investor and the investment. Instead of particularized investment decisions, capital markets investors came to rely on a series of “gatekeepers,” such as credit reporting agencies, appraisers, and rating agencies, to protect the integrity of the market for mortgage-backed securities. These gatekeepers were not new. Mortgage lenders had relied on appraisers long before anybody ever thought of securitizing mortgages. The mortgage-backed securities market, however, changed the roles of these familiar gatekeepers in two crucial respects: (1) gatekeepers in the market for mortgage-backed securities are relied upon to provide assurances about assets backed by consumer rather than corporate debt; and (2) because these debt securities are backed by mortgage transactions, there are two “gates” to watch—the underwriting of the underlying mortgage itself and the later underwriting of the securities to the capital markets.
This shift disturbed the historic identity of interests between mortgage originator and mortgage investor. Historically, the originator and the investor were, in fact, one and the same. When mortgages are securitized, however, the originating bank does not hold the mortgage as an investment for its own portfolio, but instead sells it. As a result, profit maximization strategies shift. Instead of investing, mortgage brokers sell a product. Appraisers and rating agencies have little stake in the outcome of the transactions they rate. They face only the risk of reputational sanctions if securitized loans go bad. But, since their customer is the broker, not the ultimate investor, the effect of reputational sanctions is further attenuated. At least in theory, the market should have picked up on these inherent agency problems and refused to purchase at least some mortgage-backed securities. Apparently, however, the market participants continued to rely on the rating agencies’ risk assessments. What followed should not have been surprising. If the riskiness of a mortgage-backed security is not fully disclosed, investors will pay too much and consumer credit will be too cheap and too plentiful.
If borrowers were perfectly rational, one would have expected a consumer’s own concerns about unsustainable debt to buffer the effect of supply-side gatekeeper failures, and the consequences of these failures would have been tolerable. Behavioral decision research generally suggests, however, that consumers have a predisposition to borrow more and pay more for credit than perfectly rational individuals. As a result, problems on the supply side of the market for mortgage-backed securities also created problems on the demand side of the market for home loans. In a world of strict mortgage underwriting and risk-averse lenders, originators would not let consumers borrow more than they could be expected to repay. In a world that separates the decision to originate a mortgage from the decision to hold a mortgage as an investment, demand-side irrationality exacerbated the risks created by an imperfect system of supply-side gatekeepers. And this synergy of gatekeeper failure and consumer irrationality had systemic consequences. Systemic risk increased because of the greater risk of default. Enhanced default risk also added risk to collateral values. Not only did consumers find themselves with too much debt, but their exuberance pumped up a housing bubble.
In short, with twenty-twenty hindsight, consumer protection might have served to increase the safety and soundness of the financial system by preventing consumer overleverage. If lenders face incentives to overlend, and borrowers are hard-wired to overborrow, there is a need for both consumer protection law and regulation of the capital markets. Indeed, as we will discuss later, even if all of the irrationality could be squeezed out of the supply side, consumer irrationality would still create policy-relevant social welfare costs. In our view, these demand-side institutions need to be strengthened in order to enhance social welfare, but also to enhance the safety and soundness of the financial system.
In Part II of this Article, we identify market failures both on the supply side and the demand side of the home mortgage market. On the supply side, the problem lies in imperfect incentive structures for the various supply-side gatekeepers. On the demand side, our concerns lie principally in the cognitive biases of consumer borrowers and the absence of demand-side institutions to either constrain or debias consumer choice.
In Part III, we explain why shifts in the nature of mortgage finance led to a greater need for consumer protection. We examine various demand-side gatekeeping institutions, exploring their interrelationships, as well as their relative strengths and weaknesses. As noted above, supply-side gatekeepers face, as of yet, unchecked incentives to maximize the amount of lending without also looking to minimize consumers’ risk of default. Gatekeepers on the demand side generally do not face the same conflicts. However, we identify a different set of institutional impediments and conclude that none of the existing institutions are well equipped to debias consumers’ decision-making processes.
Part IV concludes by emphasizing the need to explore the contours of institutional structure and regulatory options. While it suggests a framework for evaluating legislative reforms, we leave the development of this topic for future research.