Wednesday, March 20, 2013
Online Symposium on Oren Bar-Gill's Seduction By Contract, Part IIA: Alan White, The New Law and Economics and the Subprime Mortgage Crisis
This is the second in a series of posts on Oren Bar-Gill's recent book, Seduction by Contract: Law Economics, and Psychology in Consumer Markets. The contributions on the blog are written versions of presentations that were given last month at the Eighth International Conference on Contracts held in Fort Worth, Texas. This post is the first of a series within the series contributed by Professor Alan White of the CUNY School of Law (pictured at right).
Oren Bar-Gill’s work on contracts in various consumer markets has contributed importantly to the deconstruction of the dominant law and economics paradigm. That paradigm has centered around rational choice theory as a description of markets generally and consumer contracts in particular, on norms that are utilitarian, equating aggregate welfare with revealed preferences, and legal prescriptions that begin with deregulation and noninterference by the state. The law and economics paradigm found expression in the broad deregulation of consumer credit contract terms generally, and mortgage loans particularly, from 1980 until 2008, by Congress, the banking agencies and the courts. Oren’s application of behavioral economics to consumer credit markets helped pave the way not only for important academic debates but for the change in course for federal regulatory policy that followed the global financial crisis.
In Seduction by Contract, Oren lays out a general behavioral law and economics framework and then applies it in three consumer markets: credit cards, mortgage loans, and cell phone contracts. I will address the chapter on mortgages, and will consider three aspects, the descriptive, the normative, and the prescriptive, in separate posts. In this first part, I focus on Oren's descriptive model. In tomorrow's post, I will suggest three additional points that supplement Oren's account of the subprime market failure.
The mortgage chapter begins by describing the contract design features of subprime mortgages that came to dominate the market just before the 2007 foreclosure crisis. Oren then presents the rational choice model, that would explain whatever mortgage products and pricing that emerged during the run-up to the crisis as an expression of homeowner preferences. The proliferation of home loans with rapidly escalating payments, negative amortization, and hefty prepayment penalties, would have been a response to consumer choices, so that homeowners and buyers rationally shifted away from fixed-rate amortizing loans in the face of higher home prices and reduced affordability. Some mortgage borrowers, especially investors, might rationally have speculated on rising prices by taking out loans with below-interest payments gambling that they could resell homes at a profit.
As Oren points out, the rational choice account is difficult to square with the empirical evidence. There were investors, but rarely more than 10% to 20% of mortgage borrowers. Prepayment penalties were contracted for by many borrowers who ended up paying the penalties to refinance or sell, and would have been better off paying a slightly higher rate without the penalty. Most importantly, the massive default rates, as high as 25% or more for some types of mortgages even before home prices collapsed, reflected the fact that the “affordability” of initial low payments was illusory, and unlikely the result of rational borrowing decisions.
Oren identifies the two essential characteristics of subprime mortgage design as cost deferral and pricing complexity. He then argues that these features were not the product of rational consumer choice. Instead, they responded to consumer behavioral biases, especially myopia, optimism, limited financial literacy and the tendency to focus on salient price elements while ignoring non-salient costs.
This behavioralist description, while it improves on the rational choice model, to my mind leaves out other lender and borrower behaviors that contributed critically to the widespread contract failure. The departure from rational choice and welfare maximization was far worse in the subprime mortgage market than in credit card and cell phone contracts. Welfare losses were not limited, as in the case of credit card customers, to paying 3% or 4% more than necessary on balances and a few hundred dollars in excess fees. Subprime mortgages wiped out families’ entire net worth, evicted them from their homes, and had global external effects that we all know. A deeper critique of rational choice theory in this context is essential to getting the prescriptive part right, i.e. to evaluating the welfare effects of various regulatory interventions in this market.
[Posted, on Alan White's behalf, by JT]