Today at ABS East, the mortgage investor conference I am attending in Miami, the topic du jour is regulation. The opening panel discussed the regulatory environment and whether it is helping or hindering the asset-backed securities market.
This conversation has made me ask the fundamental question—why do we regulate in the first place? The economist’s answer to this question is that the government deploys regulation to correct market failures. Classic examples include environmental regulations that correct market externalities that cause air and water pollution.
Externalities are the consequences of economic activity experienced by individuals that are not directly involved in the activity. It’s not clear to me that there are any externalities in the mortgage industry that need correcting. So what is the market failure that we are regulating to correct today in the mortgage industry?
One can argue that the regulatory framework being implemented in the mortgage industry today is attempting to protect the consumer with an array of regulations that make the consumer more informed and protected from unfair business practices and inappropriate products.
Additionally, the mortgage market participants are likely, through regulation, to be required to retain more risk because it is believed that it will incent more prudent and careful behavior. I am not sure that these regulations actually address the root cause of the crisis.
While borrowers may have been insufficiently informed and mortgage industry participants may have retained insufficient amounts of risk these are not the market failures that caused the crisis.
The collective belief that home prices always rise explains why borrowers leveraged their homes and chose the loan products that kept payments low. The belief that home prices always rise explains why mortgage investors bought those loan products and were not concerned about documentation of income or the creditworthiness of the borrower.
The belief that home prices always rise explains why all of the market participants made the decisions that were so fatefully detrimental in the last decade.
The regulations that have been developed in response can’t fix that market failure—a collective expectation of ever increasing house prices. So fire burn and caldron bubble as house prices rise again, but remember that there is no regulation that protects us from our own irrational exuberance.