Financial Markets and Institutions (2-downloads)

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Part 6 The Financial Institutions Industry

M I N I - C A S E

The 2007–2009 Financial Crisis and Consumer

Protection Regulation

Because of the principal–agent problem inherent in the

originate-to-distribute model for subprime mortgages

discussed in Chapter 8, there were weak incentives for

mortgage originators, typically mortgage brokers who

were virtually unregulated, to ensure that subprime

borrowers had an ability to pay back their loans. After

all, mortgage brokers keep their large fees from mort-

gage originations even if sometime down the road the

borrowers default on their loans and lose their houses.

With these incentives, mortgage brokers weakened

their underwriting standards, leading to subprime

mortgage products such as “no-doc loans,” more pejo-

ratively referred to as “liar loans,” in which borrowers

did not have to produce documentation about their

assets or income. A particular infamous variant of the

no-doc loan was dubbed the NINJA loan because it

was issued to borrowers with No Income, No Job,

and No Assets. Mortgage brokers also had incentives

to put households into very complicated mortgage

products borrowers could not understand and which

they couldn’t afford to pay. In some cases, mortgage

brokers even engaged in fraud by falsifying informa-

tion on borrowers’ mortgage applications in order to

qualify them for mortgage loans.

Lax consumer protection regulation was an impor-

tant factor in producing the subprime mortgage crisis.

Mortgage originators were not required to disclose

information to borrowers that would have helped them

better understand complicated mortgage products and

whether they could afford to repay them. Outrage

over the surge of foreclosures has been an important

stimulus for new regulation to provide better informa-

tion to mortgage borrowers and to ban so-called

unfair and deceptive practices. Under Regulation Z of

the Truth in Lending Act, in July of 2008, the Federal

Reserve issued a final rule for subprime mortgage

loans with the following four elements: (1) a ban on

lenders making loans without regard to borrowers’

ability to repay the loan from income and assets other

than the home’s value, (2) a ban on no-doc loans, 

(3) a ban on prepayment penalties (i.e., a penalty for

paying back the loan early) if the interest payment can

change in the first four years of the loan, and (4) a

requirement that lenders establish an escrow account

for property taxes and homeowner’s insurance to be

paid into on a monthly basis. In addition, the rule stip-

ulated the following new regulations for all mortgage

loans, not just subprime mortgages: (1) a prohibition

on mortgage brokers coercing a real estate appraiser

to misstate a home’s value, (2) a prohibition on putting

one late fee on top of another and a requirement to

credit consumers’ loan payments as of the date of

receipt, (3) a requirement for lenders to provide a

good-faith estimate of the loan costs within three days

after a household applies for a loan, and (4) a ban on

a number of misleading advertising practices, includ-

ing representing that a rate or payment is “fixed”

when the payment can change.

Because there was a view that more needed to be

done, the Obama administration and the Congress

have stepped in by creating a new consumer protec-

tion agency as part of the financial reform legislation

of 2010 which is discussed later in the chapter. The

mandate of this agency is to further strengthen con-

sumer protection regulation on subprime mortgages

and other financial products.

as vigorously. Thus, although the existence of asymmetric information provided a ratio-

nale for anticompetitive regulations, it did not mean that they would be beneficial.

Indeed, in recent years, the impulse of governments in industrialized countries to restrict

competition has been waning. Electronic banking has raised a new set of concerns for

regulators to deal with. See the E-Finance box for a discussion of this challenge.

Summary

Asymmetric information analysis explains what types of financial regulations are

needed to reduce moral hazard and adverse selection problems in the financial

system. However, understanding the theory behind regulation does not mean that

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Chapter 18 Financial Regulation