Here is my perspective on the sub-prime mortgage crisis: When the housing market was hot, all the bankers that gave out loans assumed that their customers didn’t want their house to go into foreclosure, and that they would act accordingly. The first assumption was correct—no one wanted their house to go into foreclosure. But the second assumption, that consumers knew what to do in order to make sure they didn’t lose their house, was wrong, very wrong. The basic problem is that it is extremely difficult to calculate the optimal amount that any of us should borrow on a mortgage. Think about it: If you had to get a new house right now, what is the ideal amount to spend and how much of it should you take as a mortgage?
On top of that, the smart bankers introduced interest-only mortgages. From a standard economics perspective these mortgages are wonderful because they allow for extra flexibility. At the time when these mortgages became popular, I was working on research at the Federal Reserve Bank in Boston and I got into a debate with a local economist. He maintained that interest-only mortgages were a great idea because they provided much flexibility; people could pay only the interest and use the rest of the money to pay other expenses such as credit card debt, or health-related expenses. Of course they could always use the money to pay down the principal on the loan. But from my perspective these loans would be ideal only if people were purely rational. But we’re not.
