Demand-Side Gatekeepers in the Market for Home Loans

Abstract

The market for home loans has changed dramatically over the past thirty years, due, in large part, to the development of a market for asset-backed securities. Encouraged through the creation of Fannie Mae and Freddie Mac - government-sponsored entities created to purchase and package small-to-medium-sized “conforming” mortgages - that effort had appeared until recently to be a success. A robust market for real estate mortgage-backed securities (“RMBS”) developed and then expanded well beyond the market for “prime” “conforming” mortgages that could be handled by Fannie and Freddie. The development of a secondary market for both conforming and nonconforming home loans increased the availability of mortgage credit to consumers with lower income levels and with worse credit histories than ever before. But, as recent events have demonstrated, this increased liquidity came at a high price.

In this article, we identify market failures both on the supply side and the demand side of the home mortgage market. On the supply side, the problem lies in imperfect incentive structures for the various supply-side gatekeepers. On the demand side, our concerns lie principally in the cognitive biases of consumer borrowers and the absence of demand-side institutions to either constrain or debias consumer choice. We then explain why shifts in the nature of mortgage finance led to a greater need for consumer protection. We examine various demand-side gatekeeping institutions, exploring their interrelationships, as well as their relative strengths and weaknesses. As noted above, supply-side gatekeepers face, as of yet, unchecked incentives to maximize the amount of lending without also looking to minimize consumers’ risk of default. Gatekeepers on the demand side generally do not face the same conflicts. However, we identify a different set of institutional impediments and conclude that none of the existing institutions are well equipped to debias consumers’ decision-making processes. Finally, we conclude by emphasizing the need to explore the contours of institutional structure and regulatory options. While it suggests a framework for evaluating legislative reforms, we leave the development of this topic for future research.