targeted subsidies are appropriate for the lowest income groups. As a result of stronger underwriting the U.S. public insurance program FHA has experienced much less deterioration in its performance than have subprime loans. Clear disclosure and suitability rules should be an important part of mortgage lending.

**Consumer protection is particularly important for mortgage lending.** A house purchase is the largest, most highly leveraged, and most complex financial transaction most consumers will ever undertake. A mortgage creates the burden of sizeable payments over extended periods, coupled with the risk of losing the primary residence should the burden prove too great. Housing finance contracts contain many financial options for the consumer (e.g., early repayment) and the lender (e.g., assignment or sale of the loan, rate adjustment), the values of which are extremely sensitive to changing market environment and the outcomes of which may impose additional risk on the consumer.

**Mortgage borrowers often fail to understand the terms of complex mortgages.** In a 2007 study of mortgage borrowers, the Federal Trade Commission (FTC) found that both prime and subprime borrowers failed to understand the costs and terms of their loans using existing disclosure forms (Lacko, Pappalardo, 2007). The behavioral finance literature shows that individuals often make irrational choices in the face of complexity.<sup>62</sup> When they read loan documentation, many borrowers lack the financial training to understand the risks of complex adjustable loans. Some part of weak subprime underwriting resulted from inaccurate or incomplete disclosures to borrowers.

**Consumer protection rules should contribute to improved efficiency of the mortgage market,** especially by addressing the market failures that lead to reduced levels of competition, high costs of loans, or the exclusion of consumers. The most important failures arise from information asymmetries between lenders and consumers; the heterogeneity of consumers with respect to their financial education, gender, race, and other factors; and transaction-cost asymmetries, which limit the ability of consumers to react to lender action; e.g., to an interest rate increase.

# **Consumer protection rules should contribute to market stability and social**

**protection:** stability in the sense of avoiding over-indebtedness of borrowers, with its consequences for the solvency of lenders and systemic risk for the financial sector. Social protection is relevant in the sense of mitigating individual hardship caused by mortgage market outcomes.

**Consumer protection rules should provide for clear disclosures and fair competition, and should prohibit abusive charges.** Predatory lending can have a much broader reach than the individual borrower. In the U.S., risky subprime lending practices could have been restricted much earlier by tightening existing rules on non-bank lenders. Arguably, this would have reduced the scale of the crisis. As they work to increase access to finance, authorities in emerging markets should establish clear and workable rules for disclosing the complete costs and risks of mortgage borrowing, and to protect consumers

> 62 For an overview of behavioral economics, see Camerer, 2003.

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