Rob Goodspeed has a long post today on how we might want to alter regulatory policies in the wake of the sub-prime crisis. It’s an interesting read, but I have some fundamental disagreements with the post.

One is generally economic in nature. Most good economists recognize that there are market failures requiring regulatory solutions, making such solutions in some sense “good.” They’ll also quickly tell you that they’re nonetheless to be avoided when possible. Partially, that’s because regulations bring with them costly compliance costs and bureaucracy, and partially it’s because regulations frequently have unintended consequences. So when in no doubt, regulate, but when in doubt, don’t.

My other disagreements center on what I feel is that actual nature of the problem, and what are other seemingly bothersome things that just happened to happen at the same time as the problem or that were symptomatic of the problem but not actually the problem. I think it’s important to understand two key things about the housing bubble and collapse before thinking about regulatory solutions. First, changes in the homeownership rate are closely related to changes in required downpayments. As the latter fell, the former rose. Now that credit’s tight, the latter has soared, and the former is dropping below pre-bubble levels. And second, foreclosure rates are more a symptom of falling prices than of resetting mortgages.

Taken together, it seems like the real source of the housing crisis was the growth of lending outfits operating on the assumption that rising prices were a given. If the market is rising, there is no need to worry about borrower incentives or financial wherewithal, because the house will be sold or refinanced within two years.

The problem, in other words, was that banks suddenly thought it was a good idea to give amateur investors a ton of money without really worrying about what buyers were investing in or whether they had any skin in the game. And the solution should address this.

There’s certainly no harm in increasing disclosure requirements, but I’d suggest that all the regulation that’s really needed in mortgage markets is a minimum down-payment requirement and better appraisal rules. Fiddling around with maximum interest rates and similar is likely to be more costly and less effective. In the end, you want the lenders and borrowers to do as much of the oversight as possible, and getting the buyer to bear more risk is a good way to start. That might have a natural bubble cooling effect, as well, since rapidly increasing prices would mean rapidly increasing required down payments.

Ultimately, financial technologies are going to change rapidly and evolve to try and find the best return. Ban some loan products or transactions now, and other vehicles will arise to take their place. But rule that homeowners must be financially invested in their own properties, and you’ll need to do a lot less work regulating every new financial innovation that comes along, because buyers will be a lot more careful purchasing homes with their own savings than they will with other peoples’.

PS - And obviously it would also be worthwhile to scrap all the silly rules encouraging homeownership. I’d miss the mortgage deduction, but it’s still bad policy.