Thaler vs Posner on Consumer Financial Protections

This is excellent.

If you have been following the controversy about consumer Financial Protection at all you probably know that the administration has asked for simpler and safer products. This has angered many on each side.

For instance (From NPR) Fed Chair Bernanke and US treasury Secretary Geithner have taken different sides in the issue:

"The White House wants to create a new Consumer Financial Protection Agency to oversee a vast range of financial products, stripping the Federal Reserve and other banking regulators of their current authority for policing them.

"I think it's very hard to look at that system and say that it did anything close to an adequate job of what it was designed to do," Geithner told the House Financial Services Committee. He cited the collapse of the housing and credit markets because of high-risk subprime mortgages made to borrowers who didn't understand and couldn't afford them.

Bernanke, appearing before the same committee after Geithner, argued that the Fed should retain its consumer protection powers regarding consumer products.

I have been sort of on the fence: worried that regulation would strangle innovation, but admitting that many, myself included, get so bogged down with the paperwork and number of choices that accompanies some deals that there in the end it is far from an optimization problem and closer to a "can I just be done" solution.

In his Nudge Book (which by the way is well worth reading and even if you only read the interview on the Amzon page you will learn much.) Thaler and Sunstein suggest that by should take human behavior (i.e. behavioral finance/economics) into account when considering "choice architecture".

Seemingly this idea has taken root and large parts of it are being adopted and as such has more or less been in the news weekly for the past few months.

Not all are happy with this and recently Richard Posner took issue with the proposed changes in a WSJ opinion piece:

"...the agency might [emphasis is Jim's] outlaw adjustable-rate mortgages on the theory that consumers don’t give adequate weight to a future increase in interest rates. But such mortgages are cheaper than fixed-rate mortgages, because they shift the risk of interest-rate fluctuations from lender to borrower. Do borrowers not understand they are trading a lower interest rate for greater risk?

The agency might also outlaw prepayment penalties on mortgages. They do make refinancing more costly, but mortgages that include such penalties compensate by charging a lower interest rate. Is the choice among such alternatives really beyond the cognitive competence of the average home buyer? Is three minutes the limit of his attention span?"

Thaler responded on Paul Solman's blog over at PBS The Business Desk with Paul Solman | Online NewsHour | PBS. Thaler begins by talking about crib deaths and then brings that story back to the case of protecting lenders and borrowers. (Indeed I actually caught myself looking back in the article to make sure I had not opened a new tab!) Specifically, he tells of a sad death of one of his friend's baby in a crib that never should have been allowed to remain on the market.

"How should we go about preventing deaths such as Danny's? Three factors should be kept in mind. First, most parents have little knowledge about the properties of a crib (or toy) that makes it dangerous. Second, many do not read the instructions before using the crib. Third, cribs tend to be passed on from one family to another, often without the instructions that have long since been tossed. The crib Danny died in had been donated to the day-care center, almost certainly without the assembly instructions. What these three facts tell us is that cribs should be designed to be fail-safe in the sense that they should not be dangerous even if the user has not read the instructions.

Which brings me to the proposed Consumer Financial Protection Agency that is the subject of Judge Posner's essay."

Without going into details (he links to his own NY Times piece for interested readers), Thaler writes:

"The proposal that particularly draws Posner's ire is the idea that the Agency would designate a few types of "plain vanilla" mortgages and suggest that unsophisticated shoppers concentrate their search on those. The idea is very similar to the standard leases used in most rental agreements. The landlord can change the terms of the standard lease, but those changes are done in a way that makes them quite salient to prospective tenants, and the tenants are alerted to the fact that these terms are not the usual ones...."

And takes pain to stress that plans do not rule out adjustable rate mortgages.

"The administration has not stipulated how many types of plain vanilla mortgages there would be, but the research on which this proposal is based makes it clear that it is reasonable to assume that there would be at least a fixed-rate and some type of adjustable-rate mortgage in the mix."

Stay tuned. This one is not done yet.