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Thursday, March 21, 2013

Online Symposium on Oren Bar-Gill's Seduction By Contract, Part IIB: Alan White, The New Law and Economics and the Subprime Mortgage Crisis

AlanThis is the third 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 second of a series within the series contributed by Professor Alan White of the CUNY School of Law (pictured at right).

At least three important points should be added to Oren’s account of the subprime market failure. First, the range of consumer and lender biases, abbreviated reasoning, and situational influences that cause mortgage products to depart systematically from rational welfare maximizing is considerably wider than the territory he surveys. Second, his account focuses on pricing, but much of the harm done by subprime mortgages was due to product features that needlessly increased the risk of default, quite apart from whether prices were excessive or misunderstood. Third, subprime mortgage originators and their funders did more than simply respond to consumer behavior. They deliberately framed the choices and exploited consumer behaviors to maximize yield spread. In other words, lenders had agency, and the product offerings were not merely a response to consumer demand.

Lauren Willis’ 2006 paper, for example, described subprime mortgage borrowers’ “assent” to harmful contracts as a result not only of the cognitive limitations mentioned by Oren, but also to the ego threat presented by the possibility a loan application will be denied, and the emotional distress attendant to the home purchase and financing context. She points out as well that abbreviated reasoning brought on by both cognitive limitations and emotional factors led subprime mortgage borrowers to focus almost exclusively on the initial monthly payment as a proxy for the loan price. Indeed, minority mortgage applicants may not attend to price terms at all, if their focus is primarily on finding a lender willing to approve a loan in the first place. These emotional factors are not readily addressed by better information disclosure.

SeductionSellers, of course, are not perfectly rational either. Apart from the exploitation issue, any account of the subprime mortgage market that does not acknowledge overt and implicit racial bias is necessarily incomplete. The empirical evidence is clear that price discrimination, i.e. charging higher rates and fees to equally qualified borrowers, was rampant and had a disparate effect on minority borrowers. While price discrimination can be seen as rational rent seeking, it is difficult to explain the systematic practice of steering minority mortgage borrowers to unnecessarily expensive loan products when market share might have been gained by competing on price for these borrowers. It bears emphasizing that minority homeowners did not just face more expensive and risky loans because of lower credit scores and home values. The credible research tells us that homeowners of color paid higher rates and were more likely to get subprime mortgages than comparably qualified white homeowners. Homeowners lost homes, and much of their accumulated wealth, not just because they were financially weaker, but also because they were black or brown. The role of race in the descriptive story of the subprime mortgage market distinguishes it from the market failures in credit card, cell phone, and other consumer markets, and has important implications for regulation of mortgage contracts.

Even when loan prices reasonably reflect lender costs, subprime loans imposed welfare losses via excess risk of default and foreclosure. By increasing the loan amount, dispensing with income verification, adding prepayment penalties and deferring payment of interest and principal, lenders dramatically increased the risks of default, in ways that borrowers either misunderstood or predictably ignored. Often the same borrowers would have qualified for safer mortgages at similar cost, or in the case of income documentation, at lower cost. Consumers’ inability to judge loan risk or avoid needlessly risky mortgages is the topic of another paper by Professor Willis. While rational choice adherents would say borrowers who knowingly took on a 25% risk of default might have reasonably weighed the benefits of the loan and the risk, and therefore they were not harmed by taking such a risky loan, that account of welfare and utility is thin indeed. The excessive default risk of subprime mortgages is not easily fixed with disclosure-based solutions.

Behavioral economists tend to minimize the agency of sellers in framing and manipulating consumer biases and mental short cuts. The emphasis on consumer errors is significant. Oren repeatedly refers to lenders “responding” to consumer misperception and bias. A different characterization ascribes more responsibility to lenders: faced with consumer biases and heuristics, some mortgage originators deliberately manipulate consumer behavior. As he points out, lenders could respond to consumer optimism bias by marketing fixed payment loans and selling their safety compared to teaser-rate or teaser-payment loans. Instead, they chose to push payment deferral and to obfuscate prices, electing the profit-maximizing strategy of exploiting rather than correcting consumer bias. Whether we describe mortgage lenders as responding to consumer errors, on the one hand, or exploiting behaviors, emotional states and cognitive limitations of consumers on the other, will matter considerably when we turn to the normative and prescriptive conclusions to be reached from our better understanding of how the subprime market worked (or didn’t).

[Posted, on Alan White's behalf, by JT]

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