Monday, June 11, 2007

Exploding Toasters and Mortgages

In an article entitled "Unsafe at Any Rate," Elizabeth Warren suggests that financial products should be regulated in a similar manner to consumer products. She writes:
It is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house. But it is possible to refinance an existing home with a mortgage that has the same one-in-five chance of putting the family out on the street–and the mortgage won’t even carry a disclosure of that fact to the homeowner. Similarly, it’s impossible to change the price on a toaster once it has been purchased. But long after the papers have been signed, it is possible to triple the price of the credit used to finance the purchase of that appliance, even if the customer meets all the credit terms, in full and on time. Why are consumers safe when they purchase tangible consumer products with cash, but when they sign up for routine financial products like mortgages and credit cards they are left at the mercy of their creditors?

...Consumers can enter the market to buy physical products confident that they won’t be tricked into buying exploding toasters and other unreasonably dangerous products. They can concentrate their shopping efforts in other directions, helping to drive a competitive market that keeps costs low and encourages innovation in convenience, durability, and style. Consumers entering the market to buy financial products should enjoy the same protection. Just as the Consumer Product Safety Commission (CPSC) protects buyers of goods and supports a competitive market, we need the same for consumers of financial products – a new regulatory regime, and even a new regulatory body, to protect consumers who use credit cards, home mortgages, car loans, and a host of other products. The time has come to put scaremongering to rest and to recognize that regulation can often support and advance efficient and more dynamic markets.

But doesn't regulation interfere with an efficient market outcome? Only when there are no externalities, perfect competition and perfect information. In this particular case, the relevant market failure is imperfect information. As Warren discusses, the "disclosure" associated with financial products is deliberately obfuscatory and makes it very costly for consumers (even those of us with PhDs in Economics) to fully learn what they are getting themselves into.

Warren's article came to my attention due to Gretchen Morgenson's NY Times column (only free for TimesSelect subscribers), on the issue of "exploding mortgages":

Anyone who believes that the worst is over in the subprime mortgage fiasco need merely wait awhile. A tsunami of interest rate increases on these loans is headed your way.

Adjustable-rate mortgages, with interest rates that recalibrate according to market fluctuations, have been among the more questionable “innovations” sweeping through the staid world of home lending in recent years. Especially ingenious — for lenders, at least — were so-called exploding A.R.M.’s that lured borrowers with unusually low teaser rates that then reset skyward two or three years later (typically pegged to the London Interbank Offered Rate, plus six percentage points).

During the next five years, some $1 trillion in adjustable-rate mortgages will reset. But in the here and now — from just June to October this year — more than $100 billion of that amount is scheduled to reset, and all of it is in loans that are in the riskier subprime category. Given the recent interest rate spike, many of those loans that once carried low teaser rates are on track to reset to at least 11 percent — or more than four percentage points higher than the current rate on a conventional, 30-year home loan.

Very scary indeed - even more frightening than exploding toasters!


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