• 27 July 2009

The Law, Economics and Psychology of Subprime Mortgage Contracts

Oren Bar-Gill - New York University School of Law

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Over 4 million subprime loans were originated in 2006, bringing the total value of outstanding subprime loans to over a trillion dollars.  A few months later the subprime crisis began, with soaring foreclosure rates and hundreds of billions, perhaps trillions, of dollars in losses to borrowers, lenders, neighborhoods, and cities, not to mention broader effects on the U.S. and world economy.  In this Editorial, I focus on the subprime mortgage contract and its central design features.  I argue that for many borrowers, these contractual design features were not welfare-maximizing.  And to the extent that the design of subprime mortgage contracts contributed to the subprime crisis and to the ensuing recession, the welfare loss to borrowers, substantial in itself, is compounded by much broader social costs.  Finally, I argue that a better understanding of the market failure that produced these inefficient contracts should inform the ongoing efforts to reform the regulations governing the subprime market.

During the five years preceding the crisis, the subprime market experienced staggering growth as riskier loans were made to riskier borrowers.  Not surprisingly, these riskier loans came at the price of higher interest rates, which compensated lenders for the increased risk that they undertook.  But high prices themselves are not the central problem; the problem is that these high prices were hidden by lenders and underappreciated by borrowers.  In the prime market, the traditional loan is a standardized 30-year fixed-rate mortgage (FRM).  Lenders could have accounted for the increased risk of subprime loans by simply raising the interest rate on the traditional FRM.  Yet the typical subprime loan is a far cry from an FRM.  The subprime market boasted a broad variety of complex loans with multidimensional pricing structures.  Hybrid loans—combining fixed and variable rates, interest-only loans, and option-payment adjustable-rate mortgages (ARMs), each product type with its own multidimensional design—were all common in the expanding subprime market.  Many of these contractual designs were not new; they were known in the prime market since the early 1980s.  But it was in the subprime market where they first took center stage.

Common subprime mortgage contracts share two suspect features.  The first is cost deferral.  (Of course, any loan contract involves deferred costs; I am referring to deferral of costs beyond what is necessarily implied by the very nature of a loan.)  The traditional prime mortgage required a 20% down payment, which implies a loan-to-value (LTV) ratio of no more than 80%.  In the subprime market, in 2006, over 40% of loans had LTVs exceeding 90%.  Focusing on purchase-money loans, in 2005, 2006, and the first half of 2007, the median subprime borrower put no money down, borrowing 100% of the purchase price of the house.  The schedule of payments on the loan itself exhibits the same deferred-cost characteristic.  Under the standard prime FRM, the borrower pays the same dollar amount each month—a flat payment schedule.  Under a conventional ARM, where the monthly payment is calculated by adding a fixed number of percentage points to a fluctuating index, the dollar amount paid varies from month to month, but without any systemic trajectory.  The majority of subprime loans, on the other hand, exhibited an increasing payment schedule: they set a low interest rate for an introductory period, commonly two years, and a higher interest rate for the remaining term of the loan.  Other subprime loans exhibited an even steeper payment schedule.  Interest-only loans and payment-option ARMs allowed for zero or negative amortization during the introductory period, further increasing the step-up in the monthly payment after the introductory period ended.  A direct implication of an escalating-payments contract is the “payment shock,” which occurs when a rate reset leads to a significant, up to 100%, increase in the monthly payment.

The second suspect feature of subprime contracts is their level of complexity.  While the traditional FRM sets a single, constant interest rate, the typical subprime mortgage includes multiple interest rates, some of which are defined implicitly by non-trivial formulas that adjust rates from one period to the next.  The typical subprime loan also features a host of fees, some applicable at different periods during the loan term, some contingent on various exogenous changes or on borrower behavior.  The numerous fees associated with a subprime loan fall under two categories: (1) origination fees, including a credit check fee, an appraisal fee, a flood certification fee, a tax certification fee, an escrow analysis fee, an underwriting analysis fee, a document preparation fee, and separate fees for sending emails, faxes, and courier mail; and (2) post-origination fees, including late fees, foreclosure fees, prepayment penalties, and dispute-resolution or arbitration fees.  These fees can add up to thousands of dollars, or up to 20% of the loan amount.  The prepayment option, which is of special importance in the subprime market, further complicates the valuation of these contracts,  and so does the (implicit) default option.  Finally, since a borrower must choose among many different complex products, each with a different set of multidimensional prices and features, the complexity of the borrower’s decision is exponentially greater than the already high level of complexity of a single contract.

What explains these contractual design features?  I first consider possible rational choice explanations.  I show that rational choice theories, while explaining some of the observed contractual designs in some contexts, do not provide a complete account: the prevalence of cost-deferral and the exceedingly high level of complexity cannot be fully explained within a rational choice framework.  To fill this explanatory gap, I develop a behavioral economics theory of the subprime mortgage contract.  I argue that one can explain the design of these contracts as a rational market response to the imperfect rationality of borrowers.  Myopic borrowers unduly focus on the short-term dimensions of the loan contract and pay insufficient attention to the long-term dimensions.  Optimistic borrowers underestimate the future cost of a deferred-cost contract.  They overestimate their future income.  They expect to have unrealistically attractive refinance options.  Or they overestimate the expected value of a bet placed on the real estate market, perhaps because they irrationally expect that a 10% price increase last year will be replicated next year.  If myopic and optimistic borrowers focus on the short term and discount the long term, then lenders will offer deferred-cost contracts with low short-term prices and high long-term prices.

A similar argument explains the complexity of subprime mortgage contracts.  Imperfectly rational borrowers will not be able to effectively aggregate multiple price and non-price dimensions and discern from them the true total cost of the mortgage product.  Inevitably, these borrowers will focus on a few salient dimensions.  If borrowers cannot process complex, multidimensional contracts and thus ignore less salient price dimensions, then lenders will offer complex, multidimensional contracts, shifting much of the loan’s cost to the less salient dimensions.

While focusing on only one part of the subprime picture—the design of subprime loan contracts—this Editorial develops an alternative account of the dynamics that led to the subprime crisis.  One common account focuses on the unscrupulous lenders, who pushed risky credit onto borrowers who were incapable of repaying.  Another common account focuses on the irresponsible borrowers who took out loans they could not repay.  Both accounts capture some of what was going on during the subprime boom, but both accounts are incomplete.  In many cases, borrowers were not reckless; they were imperfectly rational.  And in many cases lenders were not evil; they were simply responding to a demand for financing that was driven by borrowers’ imperfect rationality.

This Editorial highlights a demand-side market failure: imperfectly rational borrowers “demanded” complex deferred-cost loan contracts, and lenders met this demand.  But the failures in the subprime mortgage market were not limited to the demand side.  In fact, a supply-side market failure explains why lenders willingly catered to borrowers’ imperfectly rational demand, even when the demanded product designs increased the default risk born by lenders.  The main culprit is securitization—the process of issuing securities backed by large pools of mortgage obligations.  Securitization created a host of agency problems, as a series of agents (intermediaries tasked with originating loans, pooling and packaging them into mortgage-backed securities and assessing the risk associated with the different securities) stood between the principles (the investors who ultimately funded the mortgage loans) and the borrowers.  The compensation of these agents-intermediaries was not designed to align their interests with those of the principles-investors: Their fees were based on the quantity, not quality, of processed loans.  As a result, the agents-intermediaries had strong incentives to increase the volume of originations, even at the expense of originating low-quality, high-risk loans, by promoting mortgage products that, with high levels of complexity and cost-deferral, created the appearance of affordability.  Moreover, even the sophisticated investors and financial intermediaries were likely caught up in the frenzy of the real estate boom and underestimated the risks associated with the mortgage products that they were peddling.  The multibillion dollar losses incurred by these sophisticated players provide (at least suggestive) evidence that imperfect rationality was not confined to the demand-side of the subprime market.

The proposed behavioral economics theory offers a more complete account of the dynamics in the subprime market and of how these dynamics shaped the design of subprime loan contracts.  These contractual design features have substantial welfare implications, especially when understood as a market response to the imperfect rationality of borrowers.  First, excessive complexity prevents effective comparison-shopping and thus hinders competition in the subprime mortgage market.  Second, deferred-costs features are correlated with increased levels of delinquency and foreclosure, which impose significant costs not only on borrowers, but also on surrounding communities, lenders, and loan-purchasers, and the economy at large.  Third, excessively complex, deferred-costs contracts have adverse distributive consequences, disproportionally burdening financially weaker, often minority, borrowers.  Finally, backloading a loan’s cost onto less salient or underappreciated price dimensions artificially inflates the demand for mortgage financing and, indirectly, for residential real estate.  The proposed theory thus establishes a causal link between contractual design, on the one hand, and the subprime expansion and the real estate boom, on the other hand.  Accordingly, one can attribute the subprime meltdown that followed this expansion, at least in part, to the identified contractual design features.

Importantly, the identified contractual design features and the welfare costs associated with them are not the result of the less-than-vigorous competition in the subprime market.  In fact, enhanced competition would likely make these design features even more pervasive.  If borrowers focus on the short term and discount the long term, then competition will force lenders to offer deferred-cost contracts.  And if borrowers, faced with complex, multidimensional contracts, ignore less salient price dimensions, then competition will force lenders to offer complex, multidimensional contracts and to shift much of the loan’s cost to the less salient price dimensions.  Accordingly, ensuring robust competition in the subprime mortgage market would not solve the problem.

The subprime crisis has spurred a plethora of reform proposals.  One of these proposals has recently matured into law, as the Federal Reserve Board (FRB) issued a new set of regulations governing mortgage lending in July 2008.  The behavioral economics theory, developed in my full-length article, can be used to evaluate the existing and proposed regulatory solutions and to devise potentially superior solutions.  In the full article, I focus on disclosure regulation.  I argue that the centerpiece of the current disclosure regime, the Annual Percentage Rate (APR) disclosure, has the potential to undo the adverse effects of imperfect rationality, including the identified contractual design features and the welfare costs they impose.

The APR disclosure was the most important innovation of the Truth-in-Lending Act (TILA) of 1968.  A normalized total-cost-of-credit measure, the APR was designed to assist borrowers in comparing different loan products.  In theory, the APR should solve, or at least mitigate, both the complexity problem and the cost-deferral problem.  Complexity and multidimensionality pose a problem if they hide the true cost of the loan.  The APR responds to this concern by folding the multiple price dimensions into a single measure.  The APR should similarly help short-sighted borrowers grasp the full cost of deferred-cost loans, since the APR calculation assigns proper weight to the long-term price dimensions.  Moreover, since the APR, in theory, strips away any competitive advantage of excessive complexity and cost-deferral, lenders will have no reason to offer loan contracts with these design features.

The APR can solve these problems, but only if it lives up to Congress’s expectations, namely, if it provides a timely, true measure of the total cost of credit, and borrowers rely on it in choosing among different loan products.  The current APR disclosure does not live up to these expectations.  First, the APR disclosure often comes too late to be useful for comparison-shopping.  Second, the APR does not measure the total cost of credit.  Numerous fees paid by mortgage borrowers are excluded from the regulatory definition of a “finance charge” and are thus ignored in the APR calculation.  Moreover, the current APR calculation assumes that the borrower will hold the loan for the nominal loan period, commonly 30 years.  The actual duration of a mortgage loan is, however, much shorter than 30 years—closer to 5 years in the subprime market.  Most borrowers refinance and prepay (or default) long before the 30-year mark.  By ignoring the possibility of prepayment (and default), the current APR disclosure fails to reflect the true total cost of the loan.  The distortion was especially large during the recent subprime expansion, when for many loans the prepayment option constituted a substantial value component.  When a borrower expects to prepay a deferred-cost loan by the end of the low-rate introductory period, it makes little sense for this borrower to rely on an APR that presumes continued payments at the high post-introductory rate.

Since the APR disclosure often came too late and did not reflect the true cost of credit, borrowers stopped relying on the APR as the main tool for comparison-shopping among loan products.  And as the APR lost the trust of borrowers, it also lost the ability to serve as an effective antidote to imperfect rationality.  Recent reforms and existing reform proposals address some of the shortcomings of the APR disclosure.  The FRB’s new mortgage regulations—as well as the recently enacted Housing and Recovery Act—addressed and partially solved the timing-of-disclosure problem.  I commend these reforms, but argue that more should be done.  The underinclusiveness problem was recently addressed by Elizabeth Renuart and Diane Thompson, who propose a broader definition of a “finance charge”—one that that would cover all, or most, of the costs paid by borrowers.  The analysis in this Editorial supports the spirit of the Renuart-Thompson proposal, while simultaneously recognizing that a comprehensive cost-benefit analysis may justify keeping certain price dimensions outside the scope of the “finance charge” definition.

Recent reforms and existing reform proposals do not address the exclusion of the prepayment option (and the default option) from the APR definition.  I explain how the APR calculation would have to be adjusted to incorporate the prepayment option.  I acknowledge the costs of making these adjustments, and I urge policymakers to carefully weigh these costs against the potentially substantial benefits of an APR that accounts for the prepayment option.  If borrowers ignored the traditional APR figure because it ignored the prepayment option, they should embrace an APR that incorporates that option.  And, as the APR reclaims its rightful position at the forefront of the mortgage disclosure regime, borrowers, and society, will again benefit from the APR’s unique ability to undo the adverse effects of imperfect rationality.dingbat



Copyright © 2009 Cornell Law Review.

Oren Bar-Gill is Professor of Law at New York University Law Review.

This Editorial is based on the following full-length Article: Oren Bar-Gill, The Law, Economics and Psychology of Subprime Mortgage Contracts, 94 CORNELL L. REV. 1073 (2009).

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