What ever caused the sub-prime mortgage crisis to become a full-blown credit freeze, it's clear that at its core were bad mortgage loans made to borrowers who didn't understand the long-term implications of the loan by lenders acting in their own self-interest. Meanwhile, credit card balances and delinquencies, caused in part by confusing terms and ineffective disclosures, are skyrocketing. And, without easy and automatic ways to save, the personal savings rate is mired at or below 1%.

A new approach to the way we write the rules for buying homes, getting credit cards and managing our finances is needed, one based on real-world human behavior, not just economic theory. Regulations governing these transactions can play an extremely constructive role if they are better attuned to both consumers' and producers' behavior, incentives and self-interest.

On October 17, the Asset Building Program of the New America Foundation held a lively discussion on these topics and released a seminal paper on this timely topic by Professors Michael Barr of the University of Michigan Law School, Sendhil Mullainathan of Harvard University, and Eldar Shafir of Princeton University entitled Behaviorally Informed Financial Services Regulation. Using the tools of behavioral economics, Professors Barr, Mullainathan and Shafir-three of the nation's leaders in this field -- propose that regulators should pay attention to both the "rules of the game" -- what a provider must do or say, and the "scoring" -- the reward or penalty arising from obeying or ignoring the rules. Based on this novel framework, the authors propose ten innovative ideas for regulating mortgages, credit cards and bank accounts for saving.

Professor Shafir began the event by giving an overview of behavioral economics, and stressed the importance of “framing” when options are presented to borrowers and consumers. He argued that people are often “context dependent” and will often make decisions that adversely affect their health or financial well-being if options are presented in an overly complicated or convoluted way, even in circumstances when they may know the beneficial behavior. The solution, Shafir argued, is to frame choices such that consumers are nudged into the right decisions.

Professor Barr continued the discussion by offering a number of innovative ideas that are informed by behavioral economics. In particular, Professor Barr promoted ideas ranging from an opt-out payment plan for credit cards (where a credit card holder with a balance would be automatically enrolled into a certain payment level, and they could opt-out at anytime) to a “sticky” opt-out mortgage plan, where potential homebuyers would be automatically enrolled into a certain mortgage (say, 30-year fixed-rate) unless they otherwise noted. The “sticky” part of the mortgage would involve increased liability exposure for deviations from the original choice, as they may harm consumers.

Alex Pollock of the American Enterprise Institute followed with an enlightening critique of the new paper. He argued that applying patterns in human decision-making to financial services is both an obvious idea and an idea that has been around for many years, and that simplicity in choice is entirely consistent with the behaviorally-informed policy laid out by Professors Barr and Shafir. Mr. Pollack also advocated for a single-page mortgage form that would give potential homeowners a simple document with which they could make an informed decision on a mortgage.

Finally, Travis Plunkett of the Consumer Federation of America discussed these topics in the context of the credit market, and concurred with the idea of an “opt-out” payment plan for credit cards. Mr. Plunkett stated that the current business model has very little cost on the front end for the credit-card holder, and lower minimum payments have been instituted, people have run up unsustainable amounts of debt.

A dynamic Q&A session followed, moderated by David Wessel of The Wall Street Journal that touched on issues of paternalism, applying these behavioral principles to current regulators, and the current financial crisis.

 --Event summary by Mark Huelsman, Program Associate, Asset Building Program