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Law and Economics of Subprime Lending:

My new article, "The Law and Economics of Subprime Lending" is available for download on SSRN. If the past few months are any indication, I'll have to post an updated version of the article next week (and the week after...). Thanks also to VC Commenters who pointed me to some very useful sources when I posted on the foreclosure issue a few weeks back.

Here's the Abstract:

Abstract:

The collapse of the subprime mortgage market has led to calls for greater regulation to protect homeowners from unwittingly trapping themselves in high-cost loans that lead to foreclosure, bankruptcy, or other financial problems. Weighed against this catastrophe are the benefits that have accrued to millions of American families who have been able to become homeowners who otherwise would not have access to mortgage credit. Although the bust of the subprime mortgage market has resulted in high levels of foreclosures and even problems on Wall Street, the boom generated unprecedented levels of homeownership, especially among young, low-income, and minority borrowers, putting them on a road to economic comfort and stability. Sensible regulation of subprime lending should seek to curb abusive practices while preserving these benefits.

This article reviews the theories and evidence regarding the causes of the turmoil in the subprime market. It then turns to the question of the rising foreclosures in that market in order to understand the causes of rising foreclosures. In particular, we examine the competing models of home foreclosures that have been developed in the economics literature - the "distress" model and the "option" model. Establishing a correct model of the causes of foreclosure in the subprime market is necessary for sensible and effective policy responses to the problem. Finally, we review some of the policy initiatives that have been suggested in response to the crisis in the subprime market. Because new regulatory interventions will have costs as well as benefits, until the causes of the market's problems are better understood it may be that the best policy in the short-term is to do little until well-tailored regulatory approaches are available.

PersonFromPorlock:
I think the notion that present financial problems stem from poor control over who got mortgages misses the point. Writing mortgages at well over the sustainable value of the property and then trading these mortgages at par puts illusory 'dollars' into the financial system that inflate all dollars.

The world is finally catching on to the fact that the dollar is now worth less than they thought it was. This has little to do with the default rate in sub-primes.
3.19.2008 9:58am
Justin (mail):
Wow. A Chicago-style law and economics paper looks at a problem and says do nothing. I'm shocked. ;)
3.19.2008 9:59am
Chris Bell (mail) (www):
I read a surprising statement the other day (I forget where, sorry) from some big company or organization in Europe talking about how they did not want to invest in America because of a "lack of necessary regulation".

Good economic laws do the same thing as good criminal laws, make people feel safe.
3.19.2008 10:07am
Crackmonkeyjr (www):
I'm currently representing a client who bought the house of someone on the verge of foreclosure (literally days away) and leased it back to them for a year with an option to buy it back at the cost of his mortgage on the property so that they would have a year to get their financial act in order and refinance. Because he didn't realize that this would likely be considered a mortgage and therefore didn't comply with truth and lending law, there is a pretty decent chance that the original owner will wind up with both the money paid for the house and clear title for the house. All of this makes the chance of my client ever helping out someone facing foreclosure again about zero. Based on this, I would say that mortgages are already over regulated and to quite a negative result.
3.19.2008 10:58am
ArtEclectic (mail):
Handing people money that they cannot possibly repay is a recipe for disaster. But if the benefits outweigh the common sense, at least make absolutely certain that lenders cannot under any circumstances get taxpayer bailouts when they lose money on these loans - then they will price their risk accordingly and show a bit of restraint rather than handing $500k to anyone who can fog a mirror.
3.19.2008 11:18am
kdonovan:
It strikes me that the main cause of the sub-prime-CDO mess is what did in LTCM - the assumption that the risk of default (or decline) on one item in a bundle is independent of the risk of default of another item in the bundle. Their business model assumed that the risk of default was driven by factors intrinsic to the borrower that would not apply to other borrowers. However when the macro-economy changed (rising interest rates, tightening credit standards preventing refinancing, etc.) risk of default did not turn out to be independent and lenders/holders of CDOs saw more delinquencies than their business model could withstand.

Kevin
3.19.2008 11:19am
Independent George (mail):
I think we're missing the most important thing here - the names of the co-authors begin with 'Z' and 'A'.

Interestingly, the 'Z' appears first (though I suppose that spares us the pain of titling it "Subprime Mortgages From A to Z").
3.19.2008 11:26am
Mike Gallo (mail):
A good read, thank you. I am one of those many homeowners who would not have been able to buy a house for several years had it not been for the availability of credit at less-than-stellar terms. I bought what I could afford, and then as soon as I built equity into my house through remodeling (done myself) and fixed my credit score by paying my mortgage for over a year, I refinanced to get rid of my ARM second and high rate first, and rolled it all into a 30 year fixed at a much lower rate. I also got rid of the PMI at the same time.

I understand that a lot of the financial liabilities were transferred or hidden by mortgage brokers and underwriters, but I don't see how any of these companies will make the mistake again. What did CitiGroup lose? Like 18 billion? They won't do it again, and I don't see that anyone who got stung by something like this will - including those who are borrowing what they cannot afford to pay back, be it a homebuyer or a lender.
3.19.2008 12:12pm
Mississippi Lawyer (mail):
Crackmonkeyjr,

I recommend resorting to the laws of equity, even if the law would provide the result you suggest is likely, equity would abhor it and impose a constructive trust in your client to avoid the unjust enrichment of the lessors.
3.19.2008 12:28pm
Crackmonkeyjr (www):
Mississippi Lawyer:
If you look at Truth in Lending, it becomes pretty clear that Congress specifically wanted such unjust enrichment.
3.19.2008 12:44pm
J. F. Thomas (mail):
Weighed against this catastrophe are the benefits that have accrued to millions of American families who have been able to become homeowners who otherwise would not have access to mortgage credit.

Nice theory. Too bad it doesn't jive with reality. Home ownership rates have now returned to the level of 2001 and the end of the slide is nowhere near. This PONZI scheme of Mortgage Backed securities where millions of people were duped into believing residential real estate could sustain year to year increases at 15% or more above the rate of inflation (instead of the historic trend of pretty much rising at the same or slightly above) has irreparably damaged the economy.

People like you would have us believe, contrary to common sense and empirical evidence, that this is somehow a good thing.
3.19.2008 1:44pm
Crackmonkeyjr (www):
J.F. Thomas:

I don't think that the sub-prime fiasco is being described by anyone as a good thing, only that steps that might have been taken to avoid it would have been a worse thing.
3.19.2008 1:47pm
J. F. Thomas (mail):
I understand that a lot of the financial liabilities were transferred or hidden by mortgage brokers and underwriters, but I don't see how any of these companies will make the mistake again. What did CitiGroup lose? Like 18 billion?

Oh really? You don't remember the S&L debacle of the '80s. Or the dot.com bubble of the late '90s?

They'll do it again. As long as CEO's and traders can make ungodly sums convincing some sucker to by something on credit and thinks they are smart enough to not get caught holding the bag, it will happen again.
3.19.2008 1:48pm
J. F. Thomas (mail):
I don't think that the sub-prime fiasco is being described by anyone as a good thing, only that steps that might have been taken to avoid it would have been a worse thing.

Todd's thesis is that this debacle at least increased the level of homeownership. That thesis is demonstrably untrue. Therefore, his paper begins with a false premise and any conclusions he draws from it must be complete and utter bullshit. In fact, people are worse off now than they were when they started.
3.19.2008 1:51pm
South Dakota Lawyer (mail):
A simpler explanation may be found at:



Hat tip: Steven Hayward at No Left Turns
3.19.2008 1:54pm
J. F. Thomas (mail):
and even problems on Wall Street

And this has to be the understatement of the month, if not the year.
3.19.2008 2:07pm
karrde (mail) (www):
J.F. Thomas: are we certain that the paper discusses only changes in lending law since 2001?

The comparison of homeownership rates since 2001 is only pertinent if that is the time period in question.
3.19.2008 2:12pm
Curious Passerby (mail):
Crackmonkeyjr, Would the Truth in Lending law apply to a one-time intra-state transaction? I know it applies to banks which are national, but how do they take control of local transactions with no federal connection?

Is it a "pro-bono" attorney on the other side of case for free?
3.19.2008 2:17pm
A. Zarkov (mail):
"It strikes me that the main cause of the sub-prime-CDO mess is what did in LTCM - the assumption that the risk of default (or decline) on one item in a bundle is independent of the risk of default of another item in the bundle."

No that's not what has done. The WSJ had an article on the mathematical model behind CDOs. mathematician Li used an actuarial approach where one default could trigger another.
3.19.2008 2:29pm
Free Trader:
Talk about arrogance. Especially Crackmonkeyjr.

He talks about one situation with less than ideal results, and from that one instance makes enormous global generalization.

I am sorry, but that is definitely arrogant thinking. Its nice that your a know it all. You know that there there does not exist a single policy that could help more than hurt.

Okay... I think that is the typical view of libertarians. That you can arrogantly make huge generalized statements like that from extremely limited evidence. Which is why I am convinced they are all idiots.

Nuance is more intelligent.
3.19.2008 3:18pm
Crackmonkeyjr (www):
Curious Passerby:
I'm trying not to get too into the details, but TIL applies because it was done through a broker that arranges this sort of agreements. There's still an off chance that this agreement doesn't meet the requirements of truth and lending, depending on how much the lessor paid the intermediary, but right now there seems to be a good chance that it will.
3.19.2008 3:26pm
Crackmonkeyjr (www):
Free Trader:

I mentioned a anecdote demonstrating one of the problems with regulating the mortgage industry, that doesn't mean that it is my entire basis for opposing such regulation. I oppose regulation in this area because any such regulation is going to prevent people from deciding for themselves whether a either lending money, or borrowing money under particular circumstances is a good idea in their particular situation.

Pretty much any regulation that would have "fixed" this problem would have probably acted to limit poor people's ability to get loans, either by straight out prohibiting people in certain conditions from getting a loan, or by limiting the terms under which such a loan can be made to terms under which no rational bank would lend to such a person.

This is a bad thing. This means that it becomes that much more difficult for poor people to buy homes, or to borrow against their homes' value. Owning your own home is often a good thing, as it allows you to turn a portion of your housing costs into equity which may be drawn on later, rather than just having it disappear into your landlord's pocket. Being able to borrow against your homes' value is a good thing because it helps people raise money in case of emergency or, as many people do, to attempt to start your own business. Preventing people from taking out such loans will leave poor people frittering their money away on rent, unable to raise money for emergencies and unable to raise capital to start businesses to get out of poverty.

Now there are some dumb people who took out loans that they couldn't afford, and there are those dumb lenders who made loans to people who can't afford them, but them's the breaks. Do you really want to protect dumb people at the expense of letting people who can actually understand their financial situation make those choices that are actually in their best interest? I certainly don't and I certainly don't think that it would be good for the economy in the long run.
3.19.2008 4:19pm
ohwilleke:
The assumption that the subprime market has increased homeownership is suspect. As Alan White explained based upon an examination of the data in an article posted at SSRN:

The U.S. homeownership rate increased somewhat between 1994 and 2007. Subprime mortgages, however, were mostly made to existing homeowners to refinance debt; very few were made to first-time home buyers. The number of homes lost due to subprime foreclosures significantly exceeded the new homeowners added by subprime mortgages. Subprime mortgages also displaced the safer and lower-cost FHA loans that would otherwise have been made. Conventional prime mortgages for purchases fully accounted for the observed increase in homeownership.
3.20.2008 6:28pm