Aftershocks from the subprime mortgage crisis continue to be felt by families and the financial markets alike. Despite regulatory measures to increase disclosures and access to information around home buying, individuals continue to make poor financial decisions; moreover, some newly established standards may diminish innovation and access to credit while seeking to address inherently harmful practices in the housing market.
An opt-out mortgage system would make traditional mortgage products—such as thirty-year mortgages with fixed interest rates—the default offered to most borrowers. The default would have protections to offset strong incentives offered by lenders to encourage use of alternative products. When alternative products are offered, they would require heightened disclosures and include greater legal exposure for lenders.
The current housing and financial crisis has led to significant congressional and executive action to manage the crisis and stem the harms from it, but the fundamental problems that caused the crisis remain largely unaddressed. The central features of the industrial organization of the mortgage market with its misaligned incentives, and the core psychological and behavioral phenomena that drive household financial decisionmaking remain. While the causes of the mortgage meltdown are myriad and the solutions likely to be multifaceted, a central problem that led to the crisis was that brokers and lenders offered loans that looked much less expensive and much less risky than they really were — and borrowers took them. It is time for common-sense reform to the mortgage market. This paper develops a new framework for understanding the mortgage markets as the interaction between individuals with specific psychological biases and firms that respond to those psychologies within specific markets. We argue that regulation needs to take account of that interaction. Our new framework leads us to propose a sticky opt-out mortgage system, under which lenders would be required to offer borrowers loans with standard terms. Borrowers could opt out for other loans, but only after heightened disclosure requirements, and lenders would face increased exposure to liability or other sanctions.