Editor: David Reiss
Brooklyn Law School

February 25, 2013

Regulating the Distribution of Home Equity

By David Reiss

Ian Ayres and Joshua Mitts have posted Three Proposals for Regulating the Distribution of Home Equity which brings welcomed attention to the systemic risk implications of consumer protection regimes.  In particular, they argue that the proposed Qualfied Residential Mortgage “rules do not effectively address the systemic consequences of mortgage terms which in aggregate can exacerbate market volatility.” (4) They also argue that the new and proposed regulations governing residential mortgages are too static and that they have too many bright line rules that could needlessly reduce variation and innovation for mortgage products.

The authors apply cap and trade to the residential mortgage market in a novel way — one that is is worthy of exploration.  They propose that the government sell mortgage lenders licenses to originate a range of low downpayment mortgages, with the total number capped so as not to pose a systemic risk to the mortgage market.

This is not to say that the paper is flawless.  I find the modeling of the mortgage market overly simplistic.  For instance, its discussion of circuit breaker gaps (an empty range “of equity levels  that can absorb small decreases in prices by keeping homeowners above the range in positive equity”) assumes that LTV ratios at origination will somehow be carried over even when a mortgage is seasoned. (14) That would not be the case.

Its proposal to require that debt-to-income ratios be increased from the 5 years in the proposed regulation to the life of the loan does not seem to take into account the fact that it would kill just about the entire market for ARMs. (32) Given that many ARM products (5/1s ,7/1s, 10/1s) are legitimate and important products, this proposal seems off. (32)

Finally, there is something a bit “turtles all the way down” about the cap and trade proposal. (see 34) The proposal does not let us know how regulators would come up with the optimal (from a systemic risk perspective) distribution of licenses.  Until we know how to answer that question, it will be hard to determine the value of this proposal.


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