The Truth about Plain Vanilla

The Wall Street Journal has a story today that is meant to provide some insight about the Obama plan to create a “plain vanilla” home mortgage product (s).  The Journal infers that these products represent some kind of constraint upon lenders – like a taking of real property, except this is not real estate.

The plain vanilla concept is borne out of behavioral economics.  In the case of home mortgages, it says that consumers forego making fully rational decisions because they do not want to pay the search costs of fully understanding the details in their mortgage.  They forego getting the perfect information that is an assumption of classical economics.

A lot has been made about the preference in the Obama administration for behavioral economics.

That in and of itself is sort of exciting.  After all, some of the most interesting academic conversations in economics have been with this subfield for recent years.  Have you read some of things that Kahneman and Tversky have said? My favorite is the prospect theory – which says that people put more weight on avoiding losses than they do on making gains.  It reveals something very true.  We prefer to avoid failure.  Investors often refuse to sell a stock that has suffered a loss, for example.  There’s also their comments about the illogical search cost function: people will drive five miles to save $1 dollar on a tank of gas, but they won’t drive five miles to save $1 dollar on an expensive  color television.  The time cost and the monetary gain are the same, but the proportional savings are lower with the latter, and people make a different choice as a result.

These kinds of errors govern many decisions.  It appears that the behavioral perspective will also manifest itself in Obama’s plan in employee benefits policy.  It is possible that employers will no longer use an opt-in default program for 401 (k) sign up, and instead switch to a default opt-out approach.  That should result in more people taking their 401 (k) benefit, and enhance the stability of our retirement finances.

Anyway, back to mortgages.  The plain vanilla approach is valuable in part because it eliminates search costs.  It creates a standard, much like a Good Housekeeping Seal of Approval or an Oregon Tilth Certification.  Granted, the plain vanilla plan probably won’t offer a “refund or replacement if defective”, but it does a lot to protect consumers.

The Journal’s complaint is that such a plan would curb profits for banks.

That in and of itself demonstrates the problem with the lack of transparency in our mortgage products.  The boiler plate language in a mortgage is complicated, highly heterogeneous, and often non-negotiable.  The profits that it produces represent a valuable profit stream, and one that is secured not through the exchange for some kind of value proposition with the consumer, but only through opaque bait-and-switch.

“Plain vanilla” also fits with the relatively “granular” elements of home purchasing.  Home buyers put down earnest money on a few contigent factors – fixed or adjustable, interest rate, term – but rarely upon the presence of pre-payment penalty or a reset window.  The essence of such an offer is to make sure that legitimate financing can be secured.  If the financing is not there – as would be relatively often right now – then the deal is off.  That’s not rocket science – it is just a system borne of a realistic assumption (s) about how people evaluate a financial product.

The fact this is problematic for lenders suggests an expectation for a system that does not serve the needs of consumers.  That’s out of synch with the political and financial reality today.  Our politicians are less wedded to the banks today, because consumers are on to their machinations.  Moreover, consumers are essentially stockholders of many banks.