In the Great Recession’s morality play, unscrupulous financiers on the inside of the mortgage industry exploited ordinary folk on the outside. Predatory lenders pushed unsuspecting homebuyers into teaser rate mortgages that seemed affordable but were in fact ticking time bombs. Wall Street’s financial alchemists then packaged these mortgages into impenetrably complex securities, which the credit rating agencies dutifully declared to be triple AAA gold. Everyone on the inside of this chain—the brokers, lenders, securitizers, and rating agencies—took their cut. But when the mortgage bomb finally exploded, the unsuspecting borrowers and investors on the ends of the chain were left in ruin.

This tale of exploitation of Main Street by Wall Street motivated the Dodd-Frank Act’s reforms to the mortgage industry. The Act tries to force mortgage market insiders to keep some skin in this otherwise rigged game. It penalizes lenders if unaffordable home loans default and requires securitizers to retain an interest in the mortgages they package and sell. The prospect of losses, so the Act’s drafters thought, will prevent insiders from making and selling bad loans. There is plenty of truth to this tale. One can scarcely pick up the business section of a newspaper without seeing a story of naked fraud somewhere in the mortgage market.

But as a guide to systemic reform, this narrative is deeply wrong.

In our new Article “Regulating Against Bubbles,” we argue that the roots of the recent crisis lie more in mass mania than in exploitation. Mortgage market insiders themselves made huge bets on the housing market as they were swept up in the irrational exuberance of the bubble. The same Wall Street banks that manufactured and sold these mortgage securities suffered debilitating losses when the housing bubble burst.

The real challenge for reform is not to keep Main Street safe from Wall Street. It is to keep Main Street and Wall Street safe from themselves.

The overarching goal of reforms to the mortgage market should be to make the economy more robust to a housing bubble. The sine qua non of a bubble is market-wide over-optimism about future asset prices. Such over-optimism makes the Dodd-Frank Act’s indirect incentive-based approach ineffective or even counterproductive. To address the risks of housing bubbles, mortgage regulation should instead directly regulate mortgage leverage, borrower debt relative to income, and other contractual features that induce borrowers to take out larger and riskier loans.

The Dodd-Frank Act’s approach to mortgage regulation reflects in part the influence of an important new academic literature applying insights from behavioral economics to legal policy. A recurring theme in behavioral law and economics is that sophisticated firms can take advantage of biased consumers through contract design. This asymmetric view of behavioral biases leads naturally to the borrower-and-investor-protection approach taken in the Dodd-Frank Act. We advance this literature by also considering mistakes by firms. We show that market-wide over-optimism about house prices has important implications for the design of regulation.

We begin our analysis with what many consider a centerpiece of the Dodd-Frank Act: the risk-retention requirement. The Act requires securitizers to retain credit risk to give them better incentives to monitor the quality of the mortgages they buy and thereby protect investors.

This risk-retention requirement, however, will not effectively mitigate the risks posed by a housing bubble and might in fact exacerbate them. Risk retention imposes additional costs on securitizers when mortgages default. But in a bubble over-optimism about future house prices leads market participants to underweight the probability of default and blunts the incentive benefits of risk retention. Moreover, a binding risk-retention requirement would further concentrate mortgage risk on the balance sheet of large, financial institutions and increase systemic risk.

Our analysis of the evidence from the recent housing boom and bust confirms that the risk-retention requirement will be ineffective in a housing bubble. The market-determined level of risk retention by securitizers during the recent boom was in fact too high, not too low. There is also little evidence that selling MBS to naïve investors caused the decline in underwriting standards preceding the crisis, and there are good reasons to think it did not. Contrary to the naïve investors story, sophisticated contractual arrangements, put in place over decades of experience with securitizing mortgages, were employed to mitigate the incentive problems posed by securitization.

The second pillar of the Dodd-Frank Act’s reforms to mortgage underwriting—the ability-to-repay rule—requires mortgage originators to make a reasonable determination that borrowers can repay their loans. We show that the ability-to-repay rule has an analytic structure that parallels the risk-retention requirement; it relies on changing the incentives of more sophisticated market participants to control mortgage underwriting and protect the less sophisticated. Because in practice the ability-to-repay rule imposes costs on the originator only in the event of a default, it functions as a liability rule for negligent mortgage underwriting.

A housing bubble undermines the ability-to-repay rule in much the same way it undermines the risk-retention requirement. In a bubble, originators underweight the prospect of default, blunting the incentives created by the rule. Moreover, the ability-to-repay rule focuses on a narrow aspect of underwriting—the affordability of the loan—and does nothing to prevent the deterioration of other aspects of underwriting in a bubble, such as credit histories and down payments. The widespread failures among mortgage originators in the wake of the crisis confirm that the ability-to-repay rule will be ineffective in a bubble.

We conclude by considering how mortgage regulation can be better designed to protect the economy from housing bubbles. Because over-optimism about house prices in a bubble will defeat indirect, incentive-based regulation, direct regulatory mandates will be more effective in protecting both banks and borrowers.

One simple but powerful tool for combating bubbles is a limit on mortgage leverage. Forbidding zero-down-payment loans would limit the incidence and magnitude of debt-fueled housing bubbles. It would also provide a buffer that protects mortgages from a fall in house prices and reduce the exposure of households to undiversified, highly leveraged investments in housing. While a leverage limit would restrict access to mortgage credit and therefore potentially to homeownership, we propose straightforward ways to mitigate these costs through public grants and guarantees.

Our analysis also suggests other direct regulatory tools to further mitigate bubbles, such as a cap on the debt-to-income ratios of mortgages and restrictions on contractual features like teaser rates that encourage borrowers to take out unsustainable loans in a bubble. Finally, our critique of incentive-based regulation provides an important new perspective on current legislative efforts to reform the Government Sponsored Enterprises (GSEs) and the broader architecture of housing finance.

The preceding post comes to us from Ryan Bubb, Professor of Law at New York University School of Law, and Prasad Krishnamurthy, Assistant Professor of Law at Berkeley Law.  It is based on their article entitled “Regulating Against Bubbles: How Mortgage Regulation Can Keep Main Street and Wall Street Safe – from Themselves”, which is available here.