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

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

Oren Bar-Gill’s work on contractsin various consumer markets has contributed importantly to the deconstructionof the dominant law and economics paradigm. That paradigm has centered around rational choice theory as adescription of markets generally and consumer contracts in particular, on normsthat are utilitarian, equating aggregate welfare with revealed preferences, andlegal prescriptions that begin with deregulation and noninterference by thestate.  The law and economics paradigmfound expression in the broad deregulation of consumer credit contract terms generally,and mortgage loans particularly, from 1980 until 2008, by Congress, the bankingagencies and the courts.  Oren’s applicationof behavioral economics to consumer credit markets helped pave the way not onlyfor important academic debates but for the change in course for federalregulatory policy that followed the global financial crisis.

In Seduction by Contract, Orenlays out a general behavioral law and economics framework and then applies itin three consumer markets:  credit cards,mortgage loans, and cell phone contracts. I will address the chapter onmortgages, and will consider three aspects, the descriptive, the normative, andthe prescriptive, in separate posts.  In this first part, I focus on Oren’s descriptive model.  In tomorrow’s post, I will suggest three additional points that supplement Oren’s account of the subprime market failure.

The mortgage chapter begins bydescribing the contract design features of subprime mortgages that came todominate the market just before the 2007 foreclosure crisis.  Oren then presents the rational choice model,that would explain whatever mortgage products and pricing that emerged duringthe run-up to the crisis as an expression of homeowner preferences.  The proliferation of home loans with rapidlyescalating payments, negative amortization, and hefty prepayment penalties,would have been a response to consumer choices, so that homeowners and buyersrationally shifted away from fixed-rate amortizing loans in the face of higherhome prices and reduced affordability.  Somemortgage borrowers, especially investors, might rationally have speculated onrising prices by taking out loans with below-interest payments gambling thatthey could resell homes at a profit. 

As Oren points out, the rationalchoice account is difficult to square with the empirical evidence.  There were investors, but rarely more than10% to 20% of mortgage borrowers. Prepayment penalties were contracted for by many borrowers who ended uppaying the penalties to refinance or sell, and would have been better offpaying a slightly higher rate without the penalty.  Most importantly, the massive default rates,as high as 25% or more for some types of mortgages even before home pricescollapsed, reflected the fact that the “affordability” of initial low paymentswas illusory, and unlikely the result of rational borrowing decisions. 

Oren identifies the two essentialcharacteristics of subprime mortgage design as cost deferral and pricingcomplexity.   He then argues that thesefeatures were not the product of rational consumer choice.  Instead, they responded to consumer behavioralbiases, especially myopia, optimism, limited financial literacy and thetendency to focus on salient price elements while ignoring non-salient costs.  

This behavioralist description,while it improves on the rational choice model, to my mind leaves out otherlender and borrower behaviors that contributed critically to the widespreadcontract failure.  The departure fromrational choice and welfare maximization was far worse in the subprime mortgagemarket than in credit card and cell phone contracts.  Welfare losses were not limited, as in thecase of credit card customers, to paying 3% or 4% more than necessary onbalances and a few hundred dollars in excess fees.  Subprime mortgages wiped out families’ entirenet worth, evicted them from their homes, and had global external effects thatwe all know.   A deeper critique of rational choice theory inthis context is essential to getting the prescriptive part right, i.e. toevaluating the welfare effects of various regulatory interventions in thismarket.

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