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

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

Part II: Plural Norms for a New Law and Economics After the Subprime Mortgage Crisis

Although Oren is not explicit about his normative framework, the frequent references to consumer welfare, maximization, and efficiency hint at a standard utilitarian framework based on revealed preferences. He does mention distributional concerns at certain points, including a reference to the race discrimination evidence.  In the end, I was left wondering what role either welfare maximization or distributional equity were supposed to play; his prescriptions for future legal intervention (better disclosure) ultimately seem motivated mostly by autonomy concerns.

One of the great insights of behavioral economics is that consumer autonomy and wealth-maximizing efficiency are not so neatly aligned as law and economics previously assumed.  The removal in the 1980s of restrictions on mortgage loan terms and prices increased consumer autonomy; it did not maximize consumer (or lender) welfare. Some behavioralists (for example, Michael Barr) advocate choice architecture or “nudging”,  for example by creating favored mortgage products to be offered as the default option. They implicitly favor welfare maximization over autonomy, but obviously give some weight to autonomy as well in preferring “nudges” to legal mandates for contract terms. Oren, on the other hand, recommends disclosure as the legal response to subprime mortgages, and so seems to come out on the autonomy side of the autonomy-welfare dilemma.

These competing values are embedded in present-day policy choices being made for the law of mortgages.  One example can be found in the debate about the “qualified residential mortgage” (QRM) under the Dodd-Frank financial reform law.  Federal regulators have proposed that mortgage borrowers must make a 20% down payment for a loan to be a QRM.  Mortgages that do not qualify as QRM’s are not banned, but lenders cannot package and sell non-QRM loans as securities without retaining some of the risk on their balance sheets.  This nudge favoring high down payments might further the utilitarian goals of limiting risk and hence external costs of default, and might be thought to promote borrower and lender welfare as well, albeit paternalistically.  On the other hand, lower down payments may promote equity for disadvantaged groups, and may also have positive welfare effects, with careful underwriting.  A rule allowing a broader range of product choices would also promote borrower autonomy, perhaps traded off against these competing values.  There is no clear answer, and revealed preferences, i.e. whatever unregulated lenders and borrowers would agree to, are not especially helpful in weighing the value choices.

The new law and economics recognizes that not all markets simultaneously advance consumer autonomy and welfare, to say nothing of equity.  As Nathan Oman points out, markets sometimes are very good at increasing wealth and decentralizing political power, but they can also be pathological, advancing none of our values.  The law in law and economics can benefit from economists’ insights about utilitarian welfare effects, while the economics in L&E can be explicit about its value choices, and seek to measure welfare, equity and autonomy effects of different legal rules for markets. In my final post, I will turn to the specific proposal Oren makes for an improved APR disclosure as the preferred legal response to the subprime mortgage problem.

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