Saturday, 2 October 2010

The William Cohan fallacy

William Cohan the other day complained that Elizabeth Warren fallaciously claimed borrowers did not know what they were getting themselves into when they took out exotic loans. Cohan suggests instead that the vast majority of borrowers knew what they were signing up for when they took out exotic mortgages.

This was certainly the case for some borrowers (particularly speculators), but I am not sure "vast majority" is correct. Understanding the intricacies of, say, a pay-option ARM requires a degree of mathematical sophistication that I would guess is beyond the capabilities of many borrowers. My former GW colleague Vanessa Perry has found that many borrowers do not understand anything about credit beyond their next monthly payment. In the case of pay-option ARMS, this payment was often low relative to income and stayed low for some time, so a potential borrower/homebuyer could be "advised" by a mortgage broker lender and/or real estate broker that an expensive house was indeed "affordable."

Should such borrowers have known better? I don't know. I do know that even though I really wanted to dunk a basketball, it was never going to happen, because I am short and can't jump. Similarly, no matter how much they try, there will be potential borrowers with generally good life skills who will never be able to understand an amortization schedule, and who are susceptible to a good sales pitch. To suggest such people are "responsible" for their plight is akin to suggesting that I am "responsible" for never being able to dunk a basketball.

Might Elizabeth Warren's idea of sufficient consumer protection go too far? Sure. But the events of the past eight years or so strongly suggest to me that consumer protection was insufficient.

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