Can Government Make Markets Work Better?

October 18, 2010

 “Joseph Stiglitz argues that markets in which information is less than perfect can work better with government intervention. You continually emphasize the information problem faced by borrowers in the home loan markets. Hence, if you agree with Stiglitz, you should be a strong interventionist, yet most of what you write is critical of Government intervention. How do you explain that?”


It is very simple. The Stiglitz argument is that when information is imperfect government might improve the market, not that it necessarily will. To argue that Government will always improve a market when information is imperfect assumes that Governments are perfect, which is perhaps even less tenable a view than that markets are perfect. Imperfect governments can make imperfect markets even worse. When that happens in the home loan market, I rant about it. Unfortunately, it is more the rule than the exception.

 Good Disclosures Versus Bad Disclosures

The most direct way for Government to deal with the disparity between the information available to borrowers and the information possessed by lenders is for government to mandate that lenders disclose the information borrowers need. That should be a slam-dunk case for government intervention, but it isn’t. There are good disclosures and bad disclosures, and all too often the disclosures mandated by government are bad.

A good disclosure is one that is relevant to the borrower’s decisions, that is provided early enough in the process to be useful, that is consistent with and complementary to other required disclosures, and that is uncontaminated by garbage disclosures that are useless to the borrower but absorb his time and deflect his attention. Alas, there are all too few good disclosures.

The Federal Government has been in the mortgage disclosure business for the last 30 years, with terrible results: garbage disclosures that are useless to borrowers, conflicting disclosures by multiple agencies involved in the process, disclosures so voluminous in total that borrowers cannot absorb them, and disclosures made too late to do borrowers any good. Maybe the new consumer protection agency created by the Dodd/Frank bill will do it better – maybe.

 Good Rules Versus Bad Rules

Government intervention can also take the form of rules regarding what lenders and perhaps others cannot do, or must do, to resolve a particular problem that borrowers have. There are good rules and there are bad rules. A good rule is one that accomplishes its objective at minimal cost. Bad rules don’t, for a variety of possible reasons: they don’t deal with the underlying cause of the problem, they are enforceable only by deploying an army of regulators, or they stimulate legal forms of evasion. One bad rule often leads to another bad rule.

A useful illustration of good versus bad rules is dealing with the problem of excessive charges to borrowers for third party services required by lenders, including title insurance, mortgage insurance, property appraisal, and closing services. These services have always been over-priced because borrowers paid for them while lenders selected the service providers. Competition by third party service providers took the form of services provided to the lenders who made the referrals, which raised the costs of the service providers, which costs were passed on to borrowers in the price of the service.

A good rule for dealing with this problem is to require that all third party services required by lenders be purchased by lenders, who would embed the cost in the price of the mortgage. Since lenders are knowledgeable purchasers and can purchase in bulk, the price of third party services would drop like a rock.

A useful way to think about this is to reverse the scenario: consider what would happen to the price of automobile tires paid by car buyers if, instead of being included in the price of the car, the tires had to be purchased separately from firms selected by the car dealer. Can there be any doubt that car buyers would pay more for the tires than they do now when the cost is included in the car price?

The proposed rule would accomplish the objective because it confronts the problem head-on by eliminating the referral power of lenders, and would require no costly enforcement system. Borrowers who were charged separately for third party services would be unpaid enforcement agents.

But this rule has never been adopted. Instead, law-makers fashioned a bad rule: they prohibited the payment of referral fees. Instead of eliminating the referral power of lenders, this rule attempts to police how that power is used, which is impossible without an army of enforcement agents.

Small players often ignore the rule against payment of referral fees, and large ones have fashioned legal mechanisms that get around it. Reinsurance affiliates that share the mortgage insurance premiums paid by the lender’s customers, and joint ventures with title companies who get their title business, are legal methods of paying referral fees. Needless to say, prices paid by borrowers have not been reduced by the law prohibiting payment of referral fees that have not been legalized.

Why do we have such a bad rule when there is an obvious good rule available? Stay tuned.

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