Why the CFPB’s Qualified Mortgage Rule Misses the Mark

This post grows out of two working papers (downloadable here and here) I’ve written with Joshua Mitts, a former student of mine who is now working at Sullivan & Cromwell.

Why the CFPB’s Qualified Mortgage Rule Misses the Mark
Ian Ayres & Joshua Mitts

Last Friday, the Consumer Financial Protection Bureau’s “qualified mortgage” rule went into effect.  This rule is designed to put an end to the risky lending practices that led to the financial crisis.  But a simpler rule could better assure borrowers’ ability to repay and simultaneously create greater repayment flexibility.

The purpose of the QM rule is to help assure that borrowers have sufficient monthly income to make their required mortgage payments, lessening the risk of large-scale defaults like those experienced after 2008. The rule creates a lender safe harbor for qualifying mortgages.  Lenders can still make non-qualifying loans, but must instead meet more onerous multi-factored underwriting standards. Qualifying loans reduce the risk that lenders will be held liable under Dodd-Frank for failing to make a “reasonable, good faith determination of a consumer’s ability to repay.” 

How High Gas Prices Triggered the Housing Crisis

Republican presidential candidate Rick Santorum made headlines last week when he suggested that high gas prices made mortgages unaffordable, causing the recent housing bubble to burst and sending the economy into recession. It may sound far-fetched, but it is precisely the theory that I and a pair of coauthors presented in a working paper released five days before Santorum’s remarks.

We are actually a bit more nuanced, arguing that unexpectedly high gas prices triggered the collapse of the housing market -- igniting a fire fueled by easy credit, lax lending practices, and speculation. It is a provocative claim and one with broad implications, but it is also a claim supported by economic theory and empirical evidence.

The federal government’s Financial Crisis Inquiry Commission asserted in its 2010 report that “it was the collapse of the housing bubble . . .that was the spark that ignited a string of events that led to a full-blown crisis in the fall of 2008.” And a broad, if not unanimous, consensus among economists suggests that the ongoing economic malaise was induced by a financial crisis caused by the housing crisis. Relatively less well-understood is what caused the housing crisis in the first place.

Circling the Drain: Can the Euro Be Saved, Or Is It Doomed? A Freakonomics Quorum

On Jan. 1, 1999, the euro was launched in electronic form. A few years later, amidst much fanfare, 12 European countries began replacing beloved national currencies with the euro, and the currency rapidly became the tender of choice across Europe. Wim Duisenberg, the then-president of the European Central Bank applauded the new currency: "By using the euro notes and coins we give a clear signal of the confidence and hope we have in tomorrow's Europe."

Almost ten years later, things look a little different. The financial crisis that has brought much of the developed world to its knees looks poised to bring down Europe's single currency as well. The cover of this week's Economist reads "Is this really the end?" Inside, the magazine offers the following observation:

The chances of the euro zone being smashed apart have risen alarmingly, thanks to financial panic, a rapidly weakening economic outlook and pigheaded brinkmanship. The odds of a safe landing are dwindling fast.

Why Does the Worldwide Financial Crisis Fester So?

In today's Journal, David Wessel nails it. (If you ask me, Wessel nails it consistently.) First, he asks the question that needs to be asked:

It has been two years since the flames were first spotted in Greece, yet the blaze still hasn't been put out. Now it has spread to Italy.

It's been five years since the U.S. housing bubble burst. Housing remains among the biggest reasons the U.S. economy is doing so poorly.

On both continents, there is no longer any doubt about the severity of the threat or the urgent need for better policies. Yet the players seem spectacularly unable to act.

What's taking so long?

Dear Occupy Wall Street: Are You Sure You're in the Right Place?

I get it - people are angry. Very, very angry. I'm angry too. And Wall Street sure makes a great scapegoat, hence the Occupy Wall Street protest. Wall Street is a symbol of the "greed and corruption" that took over America and caused this whole mess.

But let's take a minute to examine the facts and see if we can't find some better scapegoats:

In 1997 Andrew Cuomo, the Secretary of Housing and Urban Development under Bill Clinton, allowed Fannie Mae to reduce the standards by which they would secure loans. This helped create the entire subprime category. Was this a bad thing? Of course not - it allowed more people to leave the ghetto, move to the suburbs, and achieve the American Dream of owning a home. Who knew that "Dream" would turn into a nightmare in a mere decade. Andrew Cuomo is not Nostradamus. We can blame him of course, but he had good intentions despite the negative results.

What if We Paid Bank Regulators for Performance?

Well then they probably wouldn't make much money would they? Zing! No but seriously. A new paper by two law professors, Frederick Tung of Boston University and M. Todd Henderson of Chicago, proposes just that. Here's the abstract (with a link to the full paper):

The authors are essentially proposing giving regulators stakes in the banks they oversee, by tying their bonuses to the changing value of the banks' securities, theoretically giving them a motive to intervene when things look dicey. If the incentives are well designed, the authors argue, regulators would capture the benefits that accrue from making banks more valuable, and suffer the negative consequences when banks fail.

Why the Market Meltdown is Crazy

After Thursday's massive stock market sell-off, a lot of people are talking about how we may be experiencing another year like 2008. I’m going to get right to the point: that’s impossible. Here’s what was happening in 2008:

A) Housing bust: housing prices were already down 20-40% off of their highs.
B) Financial crisis: two major banks had gone bankrupt and every other bank was at risk.
C) Mark-to-market accounting was ruining bank balance sheets.
D) The uptick rule had been abolished on short-selling.
E) We were already in a recession.

Let’s fast forward to right now and walk through those items plus a few more. But first, a reminder to follow me on Twitter.

Did Rating Agencies Give Preference to Big Banks?

At the heart of the financial crisis was the market for mortgage-backed securities (MBS). These are the "toxic assets" that larded up bank balance sheets and all but froze the credit markets in the fall of 2008. Turns out a lot of those assets are still sitting there. Though they've mostly been downgraded to junk status, many of them began life as gold-plated investment products thanks to the AAA ratings they received from the rating agencies Moody's, S&P, and Fitch. These firms that allowed so much junk to be passed off as gold were essentially the enablers of the financial crisis.

The relationship between the rating agencies and banks is a perfect case study of flawed incentives. With banks paying them to rate their investment products, and so much money pouring in at the height of the mortgage-boom (driving record profits for the highly competitive rating agencies), Moody's, S&P, and Fitch had a strong incentive to play along.

A new study adds more fodder to the argument that these agencies were unduly influenced by the institutions whose products they were grading. It basically posits that the more MBS an institution issued, the better rating their stuff received.

How Is This Economic Recovery Unlike the Rest?

A recent study by a team of economists at Northeastern University's Center for Labor Market Studies argues that the current economic recovery is the worst since World War II for worker pay and job growth -- but the best for corporate profits. The headline:

Over this six-quarter period [from Q2 of 2009 to Q4 of 2010], corporate profits captured 88% of the growth in real national income while aggregate wages and salaries accounted for only slightly more than 1% of the growth in real national income.

That's right. Of the $528 billion in real national income gained between the second quarter of 2009 and the fourth quarter of 2010, pre-tax corporate profits accounted for $464 billion, while wages rose by just $7 billion.

Stimulus Package Analysis: Which Type of Spending Created The Most Jobs?

Bruce Sacerdote and James Feyrer, both of Dartmouth, have produced a paper that looks at how the stimulus package (American Recovery and Reinvestment Act) affected employment, and which type of spending had the most (and least) amount of impact. It's among the first detailed analyses of employment and earnings effects from the stimulus that uses actual employment outcomes. Here's the abstract (full version here):