Policy-Based Evidence-Making at the Consumer Financial Protection Bureau

New mortgage rules released by the CFPB show why heightened oversight is necessary.

The BadgeThe Consumer Financial Protection Bureau is one of the most powerful and least accountable regulatory agencies in American history.  Immune from budgetary oversight by Congress and headed by a single director who cannot be removed by the President, the agency wields unconstrained, vaguely-defined powers to regulate virtually every consumer and small business credit product in America.  The Bureau has defended its extraordinary independence by claiming that its regulations will be “evidence-based” on unbiased, unimpeachable economic evidence, and thus is above the usual political concerns that justify bipartisan commissions and engaged congressional oversight.

The Rules

Last week’s issuance of its new rules on residential mortgages (summarized here), however, shows why the new regulator can’t be trusted to regulate itself. The rules impose new burdens on lenders to ensure borrowers’ “ability to pay” their loans and create a safe harbor for so-called “qualified mortgages” that are perceived as especially safe by regulators, such as fixed rate mortgages and—don’t laugh—loans issued according to Fannie Mae and Freddie Mac’s underwriting criteria.  The combined effect is to entrench the dominance of the traditional thirty-year fixed-rate mortgage, to effectively limit loans with teaser rates and “exotic” terms such as negative amortization, and to dramatically imperil or even eliminate subprime lending.

All of this is done in the name of consumer protection and “evidence-based policymaking” and is backed by over 800 pages of analysis and justification.  But as Matt Ridley recently observed in a different context, the Bureau’s rules are better characterized as “policy-based evidence making.”  For while the rules may or may not prove a good idea, the Bureau’s inaccurate representation (whether intentional or inadvertent) of much of the underlying evidence is alarming.

Certainly the mortgage lending industry made an extraordinary number of incredibly stupid loans based on the assumption of continued rising housing prices.  But most of these loans were stupid not because consumers didn’t understand them (although some were and a revamp of federal consumer protection laws was needed), but because of the rational incentives created by those loans—incentives that consumers came to understand all too well.  In particular, most of the foreclosures of recent years were not the result of homeowners who couldn’t pay their mortgages but because they wouldn’t pay their mortgages: not because their payments were too high but because their homes have fallen in value below what they owe and they have rationally decided that it is no longer a good investment to continue to pay on an underwater mortgage.  Indeed, to state the obvious—the “affordability” of a particular borrower’s loan only matters if the home is underwater, because if there is equity in the home then the homeowner could always sell the home rather than defaulting on the mortgage.  And while the point is obvious, it is routinely ignored in discussions of the financial crisis and subsequent regulatory responses.

Economists have long modeled mortgage defaults and subsequent foreclosures as a sort of “put option”—each month a consumer faces a choice between making the payment that month and retaining an option to buy the asset (the home) at the end of the thirty-year period of the loan or defaulting on the loan and giving the home back to the lender via foreclosure.  In this model, consumers are not the hapless fools of the CFPB’s imagination, but instead basically rational economic actors responding to the incentives created by the loan and relevant laws, such as the liability they face if they default.  For example, economists predict that when the benefits of exercising the option to default increases or the cost of default falls, consumers will exercise the option more readily.

In fact, this is exactly what is seen in practice.  Thus, when housing prices collapsed, many homeowners rationally recognized that it was no longer worth paying $400,000 for a home that was now worth only $300,000, and chose to walk away.  And in states where personal liability on loans is low, such as states with non-recourse laws (for example, Arizona and California) that limit the lender’s remedy to foreclosing on the home without being able to sue the borrower individually for any remaining amount (or “deficiency”), foreclosure rates are higher when housing prices fall than in states where lenders have greater remedies.  In these states the cost of default is lower than in states that permit deficiency suits; predictably, foreclosure rates are higher.  Even more illustrative of the point that homeowners do in fact respond to incentives is that the incentive effect of state anti-deficiency laws is most pronounced for wealthier homeowners, because they are the ones who are most likely to have other assets that might otherwise be susceptible to seizure to collect on the deficiency claim.  Similarly, studies find that the propensity for “strategic default” on mortgages (where a homeowner is current on other bills and loans and nevertheless defaults on their mortgage) is positively correlated with the borrower’s credit score.  Yet CFPB does nothing about these powerful incentives for default, such as requiring higher down-payments on mortgages.

In short, the fundamental problem underlying the CFPB’s approach in its new mortgage rules is that it has fundamentally mistaken a safety and soundness problem for a consumer protection problem.  What made last decade’s loans so dangerous was the system of incentives that were created by loans with no down-payments, “piggy-back second” mortgages to finance the down-payment, or equity-stripping cash-out refinances and home equity loans.  When housing prices cratered, pushing millions of homeowners into negative equity territory, many of them responded rationally by walking away from a bad investment.  But when consumers rationally respond to incentives, that is not a consumer protection problem.  Instead, the “borrower as victim” mentality appears to be so ingrained at the CFPB that they have erected a structure of rules that will reduce access to credit and stifle innovation—while doing almost nothing to address the incentive problems that lie at the heart of the foreclosure problem.

New Rules on Teaser Rates and Exotic Mortgages

The new rule also imposes stiff new rules on mortgages with “teaser” rates and other “exotic” mortgage terms, such as negative amortization loans.  The CFPB’s rule parrots the conventional wisdom that attributes the financial crisis to the steering of low-income, uneducated consumers into loans with unaffordable terms like “exploding” teaser rates or other “exotic” mortgage terms. However, actual economic analysis debunks this theory as well.  In fact, the studies purportedly relied on by the CFPB to regulate teaser loans actually found that most defaults on loans with teaser rates occurred during the first year of the loan—well before rate reset—and that most others resulted in a refinance not foreclosure (I summarize the findings of several studies here).  In short, they were loans that never should have been made in the first place, and teaser rates had little to do with their eventual failure.  Indeed, the CFPB acknowledges that “The evidence is mixed on whether payment shock at the initial interest rate adjustment causes default”—but then proceeds to adopt rules that heavily deter loans with those terms.

The CFPB rulemaking also relies on a recent Chicago Fed analysis of “complex mortgages” to justify limits on negative amortization and other similar terms.  Yet that study unsurprisingly finds that complex mortgages were almost uniformly pitched to only the most sophisticated and highest-income borrowers who, far from being ignorant dupes, have aggressively walked away when their houses collapsed in value.  As the article abstract summarizes the point

Homeowner defaultWe find that complex mortgages are used by households with high income levels and prime credit scores, in contrast to the low income population targeted by sub-prime mortgages.  Complex mortgage borrowers have significantly higher delinquency rates than traditional mortgage borrowers even after controlling for leverage, payment resets, and other household and loan characteristics. Our analysis of dynamic default patterns, bankruptcy filings, and household characteristics suggests that complex mortgage contracts attract sophisticated borrowers who are more strategic in their default decisions.

Compare the conclusions of that study with the characterization attributed to the study in the CFPB Rule, which treats the study as demonstrating that these loans created a problem of affordability, rather than because of their propensity for strategic default by sophisticated borrowers (pages 563-64):

In their later incarnations, interest-only and negatively amortizing loans (along with loans with terms greater than 30 years) were often sold on the basis of the consumer’s ability to afford the initial payments and without regard to the consumer’s ability to afford subsequent payments once the rate was recast.  At the peak of the market, between 2004 and 2006, the percentage of loans that were interest-only, option ARMs or 40-year mortgages rose from just 7 percent of originations to 29 percent.  The lower payment possibility for these loans allows borrowers to qualify for loans that they otherwise may not have been able to afford; but this comes with the same risks just described.  The performance of many of these loans was also very poor, and worse than expected, with the onset of the downturn. [Footnote 196 in rulemaking reference to “Complex Mortgages” study.]  The final rule does not ban such products outright, but rather requires that lenders that make such loans have a “reasonable and good faith” belief in the borrower’s ability to repay and that in formulating such a belief the lender must calculate the monthly payment based on the fully indexed rate and fully amortizing payments, and does not allow these loans to enjoy the presumption of compliance associated with qualified mortgage status. The new underwriting requirements, coupled with the liability for violating these rules, should deter improper loans and ensure proper underwriting and diligence when making such loans; again limiting cases of personal or social harm.

In short, the sole study relied upon by the CFPB fails to support the proposition for which it is cited; indeed, it is more accurate to state that it squarely contradicts the CFPB’s purported interpretation.

Economic studies have concluded that the cause of most foreclosures was not the myth of consumer exploitation by exploding teaser rates and exotic mortgages, but instead the deterioration of down-payment requirements and the rise of equity-stripping cash-out refinancing transactions that eliminated the buffer against a subsequent drop in housing prices, thereby putting more homeowners into an underwater position and providing incentives to default.  Yet, as noted, the CFPB’s new rules do nothing to require higher down-payments.  Still further, the new rule actually guarantees the right to strip out equity by erecting new limits on prepayment penalties, even though economists have found no link between the presence of prepayment penalties and higher foreclosure rates (primarily because interest rates and other costs are lower on mortgages with prepayment penalties, especially subprime mortgages).

The Rules Demonstrate the CFPB’s Fatal Institutional Flaws

Despite its chest-thumping claims to the contrary, the mortgage rules demonstrate that the CFPB’s rulemakings are no more “scientific” and no more immune to political judgments than any other agency.  Even if the CFPB is not deliberately misrepresenting the findings of the studies on which it purports to rely, studies, data, and other “evidence” do not speak for themselves, but must be interpreted, a task on which reasonable minds often will disagree.  This is precisely the reason why most independent agencies are established as multi-member bipartisan commissions that generate an internal deliberative and often adversarial process in order to air competing views of the facts, law, and policy.  The decisions rendered by the CFPB as a consumer protection agency, for example, are no different from those of the Federal Trade Commission, which formulates policy in the realm of not only consumer protection but also the highly technical and economically sophisticated analysis of antitrust law, or the Securities Exchange Commission, both of which are bipartisan commissions.  Or, on the other hand, the Department of Justice, which engages in any number of wide-ranging evidence-based investigations of corporate fraud and antitrust policy-making, and is subject to the standard political controls of the President.

Thus, although the CFPB sees its mortgage rules as a triumph of evidence-based policymaking, in fact its tendentious use of existing studies to rationalize its political decisions actually demonstrate why it CFPB should not be spared the same internal and external checks of other agencies, such as a bipartisan commission structure that can air differences of opinion in a deliberative context.  Indeed, I am likely one of only a handful of people outside the Bureau who has actually read and is familiar with the studies the CFPB cites and dragoons into supporting its policies.

And Demonstrate the Need for Active Congressional Oversight

But while the primary lesson of the CFPB’s mortgages rulemaking is in illustrating the need to provide new internal checks on the Bureau’s decisions, the rule further justifies the case for more engaged congressional oversight as well.  One of the most controversial elements of the initial proposal for a consumer financial protection agency was the proposal that lenders would be required to offer so-called “plain vanilla products” as a preferred offering, which consumers would have to affirmatively reject in order to enter into a different loan.  Congress quickly, and wisely stripped that proposal out of the final Dodd-Frank legislation.  The qualified mortgages rule essentially reinstitutes the logic of “plain vanilla.”  But rather than requiring the lender to offer plain vanilla and forcing the consumer to opt-out, the structure of the rule ostensibly allows the lender to offer and the borrower to accept any type of mortgage, but it provides a safe harbor to certain types of loans (such as simple fixed-rate loans) that does not apply to others (such as those with teaser rates).  The overall effect will be identical to the original proposal—to advantage certain products and certain terms in the consumer marketplace over others—simply by using a set of incentives rather than mandates.  The overall effect, however, will be to stifle innovation in the marketplace and prefer traditional products, especially the traditional thirty-year fixed rate mortgage over others.  Regardless of whether that is a good idea or not Congress should be concerned that the new agency is imposing through the back door the policy that Congress prohibited.

Moreover, preferring the thirty-year fixed-rate mortgage is unlikely to have the CFPB’s intended effect of staving off foreclosures.  Although countries in Europe experienced housing price bubbles similar to ours, their foreclosure rate is a fraction of ours.  In part this is because Europe has very strict foreclosure rules that provide much stronger disincentives for default than in the United States.  In large part this difference is because most European countries also prohibit mortgage prepayment, which in practice acts as a check against equity-stripping cash-out refinancing.  Thus homeowners were required to retain their equity cushion at the height of the bubble, leaving far fewer in a negative equity position when the bubble burst.

But, importantly, another key reason is that most European mortgages have adjustable, rather than fixed rates.  This means that when the central bank reduces interest rates in order to make mortgages more affordable (for those who want to keep their homes), interest rate resets on mortgages automatically produced lower payment obligations for homeowners.  In the United States, by contrast, the dominance of the fixed-rate mortgage has meant that the Fed’s efforts to prompt a housing market recovery through record-low interest rates has been much less effective.  A homeowner with a fixed-rate mortgage can refinance at a lower rate only if he goes through the expense and time of a formal refinance, which can cost upwards of $5,000 and involved substantial time, paperwork, and good credit.  In addition, in order to refinance the homeowner must have equity in the home itself—it is unrealistic for those who are tens of thousands of dollars underwater to come to the refinance closing table with enough cash to make up the shortfall, not to mention a sufficient equity cushion that the lender will be willing to refinance.  As a result, there are many homeowners in the United States that could benefit from refinancing but are unable to do so because they lack sufficient liquid funds to pay the closing costs or because they are underwater, leaving them locked into higher interest rates.  The naïve preference for fixed-rate mortgages implicitly embodied in the CFPB’s Ability to Pay and Qualified Mortgages rules fails to appreciate the systemic risk to the economy from waves of simultaneous refinancings on one hand and the barriers that fixed-rate mortgages erect to effective monetary policy on the other.

Congress should be worried about CFPB’s effort to end-run its legislative decision on plain vanilla by imposing it instead through regulation.  Moreover, given the potentially economy-wide effects of this particular consumer protection rule, it simply reinforces the obvious importance of the CFPB as a major financial regulator and the need for effective congressional or executive oversight.  The political insulation of the CFPB Director—appointed for a five-year term, removable for cause, and insulated from the appropriations process—is impossible to justify in light of the broad policy impact of the Bureau’s rules.  As with the bipartisan commission structure, the mortgage rules demonstrate again the need for effective oversight of the CFPB.

Todd Zywicki

Todd J. Zywicki is George Mason University Foundation Professor of Law at George Mason University School of Law and Senior Fellow of the Mercatus Center. He is the co-author of “Consumer Credit and the American Economy” with Thomas A. Durkin, Gregory Elliehausen, and Michael E. Staten (Oxford University Press, 2014).

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  1. Richard Relph says

    Prof. Zywicki, you write “In particular, most of the foreclosures of recent years were not the result of homeowners who couldn’t pay their mortgages but because they wouldn’t pay their mortgages…”

    That there were many ‘strategic defaults’ I do not doubt, but the “most” claim surprised me.
    Can you point me at accessible (to the average 1L dropout ;-) evidence to back that up? Thank you.


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