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Subprime Mortgage Contracts

Subprime Mortgage Contracts

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Published by ohweill
Subprime Mortgage Contracts
Subprime Mortgage Contracts

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categoriesBusiness/Law
Published by: ohweill on Oct 28, 2010
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THE LAW, ECONOMICS AND PSYCHOLOGY OFSUBPRIME MORTGAGE CONTRACTS
Oren Bar-Gill 
Almost three million subprime loans were originated in 2006, bringing the total value of outstanding subprime loans 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, lend- ers, neighborhoods, and cities, not to mention broader effects on the U.S. and world economies. In this Article, I focus on the subprime mortgage contract and its central design features. I argue that these contractual design features can be explained as a rational market response to the imperfect rationality of borrowers. Accordingly, for many subprime borrowers, loan contracts were not welfare maximizing. And to the extent that the design of subprime mort- gage contracts contributed to the subprime crisis, the welfare loss to borrow- ers—substantial in itself—is compounded by much broader social costs. Finally, I argue that a better understanding of the market failure that pro- duced these inefficient contracts should inform the ongoing efforts to reform the regulations governing the subprime market.
I
NTRODUCTION
.................................................1074
I.T
HE
S
UBPRIME
M
ORTGAGE
M
 ARKET
......................1087 A.Defining Subprime.................................1087B.Subprime Mortgage Loans: The Numbers..........1088C.Market Structure...................................10891.
Participants 
......................................10892.
Competition 
......................................1091D.Regulatory Scheme.................................1093E.Summary...........................................1095
II.T
HE
S
UBPRIME
M
ORTGAGE
C
ONTRACT
....................1096 A.Deferred Costs.....................................10961.
Small Down Payments and High LTVs 
.............10972.
 Escalating Payments 
..............................10983.
Prepayment Penalties 
..............................1101
Professor of Law, New York University School of Law. I wish to thank Barry Adler, Jennifer Arlen, Lily Batchelder, Lucian Bebchuk, Vicki Been, Omri Ben-Shahar, PaulCalem, Clay Gillette, Solomon Greene, Louis Kaplow, Kevin Kordana, Lewis Kornhauser, Adam Levitin, Elizabeth Renuart, Alan Schwartz, Diane Thompson, Elizabeth Warren,Lauren Willis, and workshop and conference participants at the University of Pennsylvania,NYU, Seton Hall, UVA, and the 2008 Meetings of the American Law and Economics Associ-ation for helpful comments and discussions. Margot Pollans and Michael Schachter pro- vided excellent research assistance.
1073
 
1074
CORNELLLAWREVIEW 
[Vol.94:1073B.Complexity.........................................11021.
Interest Rates 
....................................11032.
 Fees 
.............................................11033.
Prepayment and Default 
...........................11054.
A Complex Array of Complex Products 
..............1106C.Summary...........................................1107
III.
 ATIONAL
-C
HOICE
T
HEORIES AND
T
HEIR 
L
IMITS
..........1107 A.Deferred Costs.....................................11081.
Affordability 
.....................................11082.
Speculation 
......................................1112B.Complexity.........................................11161.
Interest Rates 
....................................11162.
 Fees 
.............................................11163.
Prepayment and Default 
...........................11174.
A Complex Array of Complex Products 
..............1117C.Summary...........................................1118
IV.A B
EHAVIORAL
-E
CONOMICS
T
HEORY 
......................1118 A.Deferred Costs.....................................1119B.Complexity.........................................1121C.Heterogeneity in Cognitive Ability..................1123D.Market Correction..................................11271.
On the Demand Side: Learning by Borrowers 
........11282.
On the Supply Side: Mistake Correction by Sellers and Reputation Effects 
................................1129
 V.W
ELFARE
I
MPLICATIONS
..................................1130 A.Hindered Competition.............................1130B.Distorted Competition..............................1132C.Delinquency and Foreclosure.......................1133D.Distributional Concerns............................1138
 VI.P
OLICY 
I
MPLICATIONS
....................................1139 A.The Great Promise of the APR Disclosure..........1140B.The Failure of the APR Disclosure..................1143C.Fixing the APR Disclosure..........................1147
C
ONCLUSION
...................................................1150
I
NTRODUCTION
 Almost three million subprime loans were originated in 2006,bringing the total value of outstanding subprime loans over a trilliondollars.
1
A few months later the subprime crisis began, with soaring
1
See 
Yuliya Demyanyk & Otto Van Hemert,
Understanding the Subprime Mortgage Crisis 
,22 R 
EV 
. F
IN
. S
TUD
. (forthcoming 2009) (manuscript at 6 & n.6, 7 tbl.1, on file with authors)(analyzing data covering approximately 85 percent of securitized subprime loans. In 2006,75 percent of subprime loans were securitized, and the authors’ data set included1,772,000 subprime loans originated in 2006, implying a total of 1,772,000 / (0.85 * 0.75) =
 
2009]
SUBPRIME MORTGAGE CONTRACTS 
1075foreclosure rates and hundreds of billions—perhaps trillions—of dol-lars in losses to borrowers, lenders, neighborhoods, and cities, not tomention broader effects on the U.S. and world economies.
2
In this Article, I focus on the subprime mortgage contract and its central de-sign features. I argue that for many borrowers these contractual de-sign features were not welfare maximizing. And to the extent that thedesign of subprime mortgage contracts contributed to the subprimecrisis, the welfare loss to borrowers—substantial in itself—is com-pounded by much broader social costs. Finally, I argue that a betterunderstanding of the market failure that produced these inefficient contracts should inform the ongoing efforts to reform the regulationsgoverning the subprime market.During the five years preceding the crisis, the subprime market experienced staggering growth as riskier loans were made to riskierborrowers.
3
Not surprisingly, these riskier loans came at the price of higher interest rates that compensated lenders for the increased riskthat they undertook.
4
But high prices themselves are not the centralproblem; the problem is that lenders hid these high prices and bor-rowers underappreciated them. In the prime market, the traditionalloan is a standardized thirty-year fixed-rate mortgage (FRM). Lenderscould have accounted for the increased risk of subprime loans by sim-ply raising the interest rate on the traditional FRM. Yet the typicalsubprime loan is a far cry from an FRM. The subprime market 
2,779,608);
see also State of the U.S. Economy and Implications for the Federal Budget 
:
Hearing Before the H. Comm. on the Budget,
110th Cong. 10(2007) [hereinafter
Hearing 
] (preparedstatement of Peter Orszag, Director, Congressional Budget Office) (“By the end of 2006,the outstanding value of subprime mortgages totaled more than $1 trillion and accountedfor about 13 percent of all home mortgages.”). The Center for Responsible Lending esti-mates that as of November 27, 2007, there were 7.2 million outstanding subprime loans with an estimated total value of $1.3 trillion. A Snapshot of the Subprime Market, Centerfor Responsible Lending, http://www.responsiblelending.org/issues/mortgage/quick-ref-erences/a-snapshot-of-the-subprime.html (last visited Mar. 1, 2009) [hereinafter CRLSnapshot].
2
See 
C
ONG
. B
UDGET
O
FFICE
, T
HE
B
UDGET AND
E
CONOMIC
O
UTLOOK 
: F
ISCAL
EARS
2008
TO
2018, 23 (2008) [hereinafter CBO O
UTLOOK 
],
available at 
http://www.cbo.gov/ftpdoc.cfm?index=8917&type=1 (noting estimates of between $200 billion and $500 billionfor total subprime-related losses and noting the additional—and potentially substantial—indirect adverse effects of the subprime crisis on the economy);
see also 
Henry M. Paulson, Jr., U.S. Sec’y of the Treasury, Remarks on Current Housing and Mortgage Market Devel-opments at the Georgetown University Law Center (Oct. 16, 2007),
available at 
http:// www.treasury.gov/press/releases/hp612.htm (noting that foreclosures on subprime loansincreased more than 200 percent between 2000 and 2006 and discussing the broad impact of these foreclosures on the economy).
3
See 
Demyanyk & Van Hemert,
supra 
note 1 (manuscript at 5, 7 tbl.1); Center forResponsible Lending, Mortgage Lending Overview, http://www.responsiblelending.org/issues/mortgage/ (last visited Mar. 1, 2009).
4
See 
Lauren E. Willis,
 Decisionmaking and the Limits of Disclosure: The Problem of Preda- tory Lending: Price 
, 65 M
D
. L. R 
EV 
. 707, 720–21 (2006) (describing the development of risk-based pricing in the mortgage market).

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