The New York Times

December 26, 2007


A One-Size-Fits-All Solution


WHILE the causes of the mortgage crisis are myriad, a central problem was that many borrowers took out loans that they did not understand and could not afford. Brokers and lenders offered loans that looked much less expensive than they really were, because of low initial monthly payments and hidden, costly features.

Families commonly make mistakes in taking out home mortgages because they are misled by broker sales tactics, misunderstand the complicated terms and financial tradeoffs in mortgages, wrongly forecast their own behavior and misperceive their risks of borrowing. How many homeowners really understand how the teaser rate, introductory rate and reset rate relate to the London interbank offered rate plus some specified margin, or can judge whether the prepayment penalty will offset the gains from the teaser rate?

While disclosure alone is unlikely to help, there’s another option.

In retirement policy, behavioral research has led Congress to promote “opt out” plans under which employers sign workers up for retirement benefits unless the worker chooses not to participate. This policy has significantly improved people’s retirement savings.

Why not have an opt-out home mortgage plan, based, for example, on a 30-year, fixed-rate loan, with sound underwriting and straightforward terms?

Eligible borrowers would be offered a standard mortgage (or set of mortgages) and that’s the mortgage they would get — unless they choose to opt out in favor of another option, after honest and comprehensible disclosures from brokers or lenders about the risks of the alternative mortgages. An opt-out mortgage system would mean borrowers would be more likely to get straightforward loans they could understand.

But given lender incentives to hide true costs from borrowers, we need to give the opt-out plan some bite. Under our plan, lenders would have stronger incentives to provide meaningful disclosures to those whom they convince to opt out, because if default occurs when a borrower opts out, the borrower could raise the lack of reasonable disclosure as a defense to bankruptcy or foreclosure. If the court determined that the disclosure would not effectively communicate the key terms and risks of the mortgage to the typical borrower, the court could modify or rescind the loan contract.

This approach would allow lenders to continue to develop new kinds of mortgages, but only when they can explain them clearly to borrowers. To avoid the next mortgage crisis, we should use behavioral insights to make it harder for lenders to put borrowers where they will make predictable and consequential mistakes.

Michael S. Barr is a professor of law at the University of Michigan. Sendhil Mullainathan is a professor of economics at Harvard. Eldar Shafir is a professor of psychology at Princeton.