The Optimal Mortgage For The Rational Borrower

Two professors have released a paper branding adjustable rate mortgages, which are responsible for the subprime meltdown, as the optimal mortgage type for rational borrowers. As we know all too well, few borrowers are antiseptically rational. According to Columbia professor Tomasz Piskorski and NYU professor Alexei Tchistyi, ARMs hold several unrivaled advantages:

•The option to pay less than the minimum monthly interest owed on the loan is valuable for people with good self-control whose income fluctuates a lot. They can pay just a little in lean months and catch up in fat months. It’s good for lenders, too, because they don’t have to foreclose on people who fall behind, which is an expensive process. People with steady incomes don’t need this feature, but having it doesn’t hurt them.

•The fact that the loan is an ARM–namely, its rate fluctuates with market interest rates–is especially valuable to lenders. This is a subtler notion, but the idea is that if there are going to be a certain number of defaults in a pool of mortgages because of random bits of bad luck like a job loss or a divorce, the lender would prefer that they be concentrated during periods of high interest rates. Why? Because when market interest rates are high, the lender that forecloses and gets back (most of) its money can redeploy the cash in high-yielding alternatives. The lender would prefer not to foreclose and get its money back when rates are low and other options are unattractive. An ARM loan achieves what the lender wants. Borrowers, meanwhile, are neutral about whether they default in periods of high or low market interest rates.

•Finally, the economists say the optimal loan contract would outright ban getting a new loan from a different lender. There are no such bans. But they say that the prepayment penalties that are common in subprime loans are a good second best. How could that be? Because lenders will offer more favorable terms if they know that they’ll be able to hang onto the loan long enough for it to be profitable. If they fear that the borrower will refinance at the drop of a hat, they’ll give less favorable terms.

The difference between conventional mortgages and ARMs can be worth half a percentage point of interest, or $50 billion in savings for the nation as a whole – but only if everyone acts rationally.

BusinessWeek cutely suggests that if the research is right:

…maybe it makes sense to get people to behave rationally through extensive, even expensive, consumer education.

Surprise: ‘Toxic’ Mortgages Are the Best [BusinessWeek]
(AP Photo/Denis Poroy)