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’sbook chapter on subprime mortgages: the behavioral economics insights thatdescribe how these disastrous contracts came to be, and the norms and valuesthat the law should promote in regulating the mortgage market in light of thesubprime fiasco.  I now turn to theconclusion of the chapter, and its policy recommendations.  In brief, Oren proposes two steps, an all-inloan 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 tostart . . . A disclosure mandate seems to provide . . . an effective responseto the behavioral market failure in the subprime and Alt-A mortgage markets.”

Given the range of regulatory tools already adopted byCongress, the Federal Reserve and the CFPB, and the extensive damage done bythe subprime mortgage market, this prescription is surprisingly timid.  Oren acknowledges that Dodd-Frank includessubstantive regulation of contract terms, but nevertheless adheres to a verytraditional economist’s solution – fix information problems and the market willmaximize welfare.

But the whole point of behavioral economics, in the contextof mortgage loans, is that information isn’t enough. Even borrowers whounderstand risky and expensive loan terms will still choose them, and sufferwelfare harms as a result.  Subprimebrokers were also very adept at using mandatory disclosures to mislead consumersand reframe choices. Moreover, Oren nicely summarizes the evidence thatliteracy and math skills of most adults are not up to the task of assessingmortgage risk and making complex price trade-offs, for example with adjustablerates 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 formortgage regulation.  To my mind thisevades some more difficult choices for the law of mortgage contracts, whereserious attention to welfare maximization and economic equity would call forstronger legal intervention, but where we can recognize that autonomy is avalue as well. 

On the question of foreclosure risk, for example, theDodd-Frank act is paternalistic. It requires lenders to make a reasonabledetermination of the borrower’s repayment ability, i.e. it prohibits excessiveforeclosure risk.  The new law’sregulatory approach is an interesting balance between consumer autonomy andwelfare maximization.  The CFPB ischarged with prescribing contract terms that are deemed safe, and loans withthose terms are immune from legal attack. Loans outside the safe harbor contract design are legal, but may beattacked under the broad affordability standard in the statute.  This is a form of nudging or choicearchitecture advocated by other behavioral economists.

There are also important value trade-offs in current debatesaround fair lending laws, such as how to apply the disparate impact test tomortgage lending, that directly confront the normative conflicts betweenautonomy, welfare maximization and racial justice.   Aprescription to begin with disclosure seems ill-suited to addressing the hugeimpact subprime mortgage lending had on racial wealth distribution in ourcountry, and ill-suited to preventing future systemic mortgage contractfailures and their disastrous consequences for homeowners and the economygenerally. 

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