This just in: markets fail

The Fed today unveiled a set of proposed amendments to Regulation Z, the collection of rules intended to ensure "truth in lending." Why is this big news? Mainly because it is the Fed's long-awaited response to the unfolding subprime debacle. Many have been highly critical of the Fed for failing to take proactive steps to curtail abuses in subprime lending. (See this article in today's New York Times.) And many will surely be critical of the Fed's proposed amendments as "too little, too late."

Still, the Fed's document is groundbreaking in at least one respect: it explicitly acknowledges the problem of market failure in the business of loan origination, and it even uses that term repeatedly in giving the background for the proposed changes. Manifestations of these market failures include the "yield spread premiums" paid to mortgage brokers, the failure to escrow tax and insurance payments--and even the coercion of appraisers. This represents a real shift from the Fed's more laissez-faire policy of recent years. Even more remarkable is that the person leading the effort to overhaul Reg Z was governor Randy Kroszner--a University of Chicago professor with ties to the American Enterprise Institute. Economists with Kroszner's background tend to emphasize the power of markets, rather than their limitations. So give the Fed, and Kroszner, credit for recognizing that markets can, and do fail. That's cold comfort to those who have already been burned in the subprime debacle, of course. Let's just hope that, by making markets work better, tinkering with the obscure provisions of Reg Z will help avert the next catastrophe.

Update: another five seconds of fame! Check out my sound bite on this evening's edition of Marketplace.