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 andEconomics After the Subprime Mortgage Crisis

Although Oren is not explicitabout his normative framework, the frequent references to consumer welfare,maximization, and efficiency hint at a standard utilitarian framework based onrevealed preferences. He does mention distributional concerns at certainpoints, including a reference to the race discrimination evidence.  In the end, I was left wondering what roleeither welfare maximization or distributional equity were supposed to play; hisprescriptions for future legal intervention (better disclosure) ultimately seemmotivated mostly by autonomy concerns.

One of the great insights ofbehavioral economics is that consumer autonomy and wealth-maximizing efficiencyare not so neatly aligned as law and economics previously assumed.  The removal in the 1980s of restrictions onmortgage loan terms and prices increased consumer autonomy; it did not maximizeconsumer (or lender) welfare. Some behavioralists (for example, Michael Barr) advocate choice architectureor “nudging”, for example by creating favored mortgage products to be offered as the defaultoption. They implicitly favor welfare maximization over autonomy, but obviouslygive some weight to autonomy as well in preferring “nudges” to legal mandatesfor contract terms. Oren, on the other hand, recommends disclosure as the legalresponse to subprime mortgages, and so seems to come out on the autonomy sideof the autonomy-welfare dilemma.

These competing values areembedded in present-day policy choices being made for the law ofmortgages.  One example can be found inthe debate about the “qualified residential mortgage” (QRM) under theDodd-Frank financial reform law.  Federalregulators have proposed that mortgage borrowers must make a 20% down paymentfor a loan to be a QRM.  Mortgages thatdo not qualify as QRM’s are not banned, but lenders cannot package and sellnon-QRM loans as securities without retaining some of the risk on their balancesheets.  This nudge favoring high downpayments might further the utilitarian goals of limiting risk and henceexternal costs of default, and might be thought to promote borrower and lender welfare as well, albeitpaternalistically.  On the other hand,lower down payments may promote equity for disadvantaged groups, and may alsohave positive welfare effects, with careful underwriting.  A rule allowing a broader range of productchoices would also promote borrower autonomy, perhaps traded off against thesecompeting values.  There is no clearanswer, and revealed preferences, i.e. whatever unregulated lenders andborrowers would agree to, are not especially helpful in weighing the valuechoices.

The new lawand economics recognizes that not all markets simultaneously advance consumerautonomy and welfare, to say nothing of equity. As Nathan Oman points out,markets sometimes are very good at increasing wealth and decentralizingpolitical power, but they can also be pathological, advancing none of ourvalues.  The law in law and economics canbenefit from economists’ insights about utilitarian welfare effects, while theeconomics in L&E can be explicit about its value choices, and seek tomeasure welfare, equity and autonomy effects of different legal rules formarkets. In my final post, I will turn to the specific proposal Oren makes foran improved APR disclosure as the preferred legal response to the subprimemortgage problem.

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