Regulating Against Bubbles: How Mortgage Regulation Can Keep Main Street and Wall Street Safe - from Themselves

Abstract

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 naïve investors and borrowers. In particular, they 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 market-wide 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.

Keywords: Bubbles, Mortgage Regulation, Financial Crises, Financial Regulation