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

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

Part III: Prescriptions for Future Mortgage Regulation When Information Is Not Enough

In my prior posts, I discussed two aspects of Oren Bar-Gill’s book chapter on subprime mortgages: the behavioral economics insights that describe how these disastrous contracts came to be, and the norms and values that the law should promote in regulating the mortgage market in light of the subprime fiasco.  I now turn to the conclusion of the chapter, and its policy recommendations.  In brief, Oren proposes two steps, an all-in loan price disclosure by means of an improved annual percentage rate (APR) formula, and requiring disclosures earlier in the mortgage shopping process.  “Disclosure regulation is the right place to start . . . A disclosure mandate seems to provide . . . an effective response to the behavioral market failure in the subprime and Alt-A mortgage markets.”

Given the range of regulatory tools already adopted by Congress, the Federal Reserve and the CFPB, and the extensive damage done by the subprime mortgage market, this prescription is surprisingly timid.  Oren acknowledges that Dodd-Frank includes substantive regulation of contract terms, but nevertheless adheres to a very traditional economist’s solution – fix information problems and the market will maximize welfare.

But the whole point of behavioral economics, in the context of mortgage loans, is that information isn’t enough. Even borrowers who understand risky and expensive loan terms will still choose them, and suffer welfare harms as a result.  Subprime brokers were also very adept at using mandatory disclosures to mislead consumers and reframe choices. Moreover, Oren nicely summarizes the evidence that literacy and math skills of most adults are not up to the task of assessing mortgage risk and making complex price trade-offs, for example with adjustable rates and prepayment penalties, even with perfect disclosures.

Although the recommendations are not presented as exclusive, Oren implicitly comes out favoring consumer autonomy as the primary norm for mortgage regulation.  To my mind this evades some more difficult choices for the law of mortgage contracts, where serious attention to welfare maximization and economic equity would call for stronger legal intervention, but where we can recognize that autonomy is a value as well. 

On the question of foreclosure risk, for example, the Dodd-Frank act is paternalistic. It requires lenders to make a reasonable determination of the borrower’s repayment ability, i.e. it prohibits excessive foreclosure risk.  The new law’s regulatory approach is an interesting balance between consumer autonomy and welfare maximization.  The CFPB is charged with prescribing contract terms that are deemed safe, and loans with those terms are immune from legal attack.  Loans outside the safe harbor contract design are legal, but may be attacked under the broad affordability standard in the statute.  This is a form of nudging or choice architecture advocated by other behavioral economists.

There are also important value trade-offs in current debates around fair lending laws, such as how to apply the disparate impact test to mortgage lending, that directly confront the normative conflicts between autonomy, welfare maximization and racial justice.   A prescription to begin with disclosure seems ill-suited to addressing the huge impact subprime mortgage lending had on racial wealth distribution in our country, and ill-suited to preventing future systemic mortgage contract failures and their disastrous consequences for homeowners and the economy generally. 

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