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Everyday Economics
Here’s How Lack of Competition Can Hurt Consumers
Businesses are forever insisting that a little less competition won’t lead to higher prices. What’s one more merger? What’s one more barrier to entry?
A new study of the mortgage market nicely highlights just how little it can take to undermine competition to the point that it starts costing customers.
The paper is both a critique of a specific government initiative — a refinancing program created after the financial crisis — and a clever use of that program to examine what happens when an industry’s rule are suddenly changed.
The Home Affordable Refinancing Program, or HARP, was started in 2009 to enable homeowners to refinance at lower rates even if they didn’t have enough equity in the home to meet the standards of lenders, a common predicament after the nationwide collapse of housing prices. Borrowers with less than 20 percent equity found it all but impossible to refinance — and about 30 percent of people with mortgages were in that boat back in 2010.
HARP is not a foreclosure prevention program. It is open only to those the government called “responsible homeowners” — people who had not missed mortgage payments. The point is to put money into their pockets. (And by the way, the program is still available for one more year.)
The mechanics are fairly simple: The government instructed the mortgage finance companies Fannie Mae and Freddie Mac to guarantee loans that replaced loans they had previously guaranteed, even if the amount of the loan exceeded 80 percent of the value of the home.
But in the new paper, Gene Amromin, an economist at the Federal Reserve Bank of Chicago, and Caitlin Kearns, a graduate student in economics at the University of California at Berkeley, highlight a wrinkle that proved consequential.
Although, in theory, any lender can qualify for these guarantees, the rules of the program give a substantial advantage to the holder of the existing loan. If loans go bad, Fannie and Freddie can seek refunds. The HARP program grants lenders a measure of protection from this risk — but only if the company that refinanced the loan had also been the holder of the previous loan.
In 2012, in an effort to increase participation in the program, the government granted incumbents even greater protection from such refund demands.
Other lenders are still free to compete, but they don’t. The study quotes research finding that 90 percent of loans refinanced under HARP were handled by the original lender, compared with 60 percent of refinances outside HARP.
And here is the key discovery: Not surprisingly, Mr. Amromin and Ms. Kearns find incumbents have taken advantage of this absence of competition to impose above-market interest rates on borrowers — of about 15 to 20 basis points on average.
The toll on each borrower was relatively modest. For every $100,000 borrowed at an interest rate of 4 percent, the borrower would pay an extra $139 in interest each year. But when all those extra payments were totaled, the windfall for the lenders was enormous. The transfer of wealth from borrowers to lenders as a consequence of the government’s rules is at least $1 billion a year, according to the paper.
The research underscores the importance of design. Particularly when costs and benefits are asymmetric — each borrower loses a little, and is unlikely to notice, while the banks are greatly enriched — the government officials who write the rules are not only the first but effectively the only line of defense for the public interest.
It also suggests that the consolidation of the mortgage market since the financial crisis — as many lenders disappeared and others merged — may result in higher costs for borrowers in the future. Less competition, higher rates.
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