Subprime Lending & Financial Services Reform

Online Debate

In recent months, there has been a lot of discussion about the “sub-prime mortgage crisis”, its causes, and what should be done about it.  One response has been calls from a number of quarters for financial services reform.  George Mason University Professor of Law Todd Zywicki, University of North Carolina Law Professor Melissa Jacoby, and Cleveland-Marshall College of Law Professor Kathleen Engel discuss these issues.

Questions and Answers:

Todd Zywicki: There is plenty of blame to go around in identifying the culprits of the subprime mess.  Lenders and mortgage brokers who misled and defrauded borrowers, borrowers who misled and defrauded lenders, and one suspects in some cases borrowers and lenders mutually misleading one another.  Few financial messes in American history have been as bizarre or expensive as this one.  Foreclosure is expensive not only to borrowers and lenders but to the communities that surround them.

At the same time, the expansion of the market to subprime borrowers boosted the homeownership rate in America to record levels, putting many low-income families on the path to economic progress and providing neighborhoods for children.  And at least some of this expansion was prompted by conscious governmental policies designed to extend credit to traditionally underserved segments of society, such as the Community Reinvestment Act and other fair lending laws.  As Federal Reserve Chairman Ben Bernanke recently observed, “[R]ecent problems in mortgage markets illustrate that an underlying assumption of the CRA that more lending equals better outcomes for local communities may not always hold.   He adds that differentiating good from bad lending in the CRA context is an issue that is likely to challenge us for some time.”

Sensible regulatory responses will try to retain these benefits of the expansion of the subprime lending market while limiting fraud, abuse, and predatory practices.  Crafting a sensible regulatory response begins with understanding the causes of the subprime meltdown.  Failure to properly understand the causes of the subprime crisis can generate unintended consequences such as exacerbating moral hazard and adverse selection problems by bailing out reckless lenders and speculative buyers while offering little relief to those for whom such policies are intended.

Three theories have been offered for the subprime crisis.  Each theory has some truth but none seems wholly complete:

First, subprime borrowers are unreasonably risky.  Some certainly were.  But the majority of subprime borrowers are little different substantively from prime borrowers but simply lacked traditional underwriting criteria.  On the other hand, Federal Reserve data suggests that the number of subprime borrowers engaged in speculative investments (such as house-flipping) may have risen over the past several years.  But these borrowers are riskier because they are speculators, not because they are poor.  Moreover, an extensive study by the Federal Trade Commission found that subprime borrowers on average are similar to prime borrowers in their ability to understand loan terms.

Second, subprime loans are unreasonably risky.  Subprime loans differ in many material ways from prime mortgages in that they are substantially more likely to have adjustable interest rates and prepayment penalties.  But empirical research suggests that these terms are consistent with risk-based pricing.  Moreover, the United States is almost unique in the world in having 30-yearfixed-rate mortgages with an unlimited right to prepayment.  Although a fixed rate mortgage obviously provides insurance when interest rates rise, they can prove quite costly when interest rates fall.  As Alan Greenspan noted in 2004, Americans with fixed mortgages paid tens of millions of dollars in higher interest rates and closing costs in order to refinance during the low interest rate climate of the early 2000s.  Thus, it is clear that ARMs are risky when interest rates rise, but they are also beneficial when interest rates fall.

Third, the market mispriced the risk.  There appears to be some evidence that the market systematically mispriced the risk of mortgage lending during this period.  In part this may be that the market failed to appreciate the peculiar problems of adverse selection and moral hazard when compared to the prime mortgage market.  Although some foreclosures result from unexpected payment shocks others result from borrowers who treat default and foreclosure as a put option and choose to permit foreclosure when their property is underwater.  The exercise of this option may be especially attractive in those states with antideficiency or non-recourse laws that prohibit the lender from recovering from the borrower personally for any deficiency remaining upon deficiency.  Prior empirical research has concluded that antideficiency laws and other limitations on lender remedies result in higher foreclosure rates.  In the current market situation this seems to be the case as well states with antideficiency laws (such as California, Arizona, and Colorado) are among those with the highest foreclosure rates.

What to do then about the subprime crisis?  Until we have a better understanding of its causes, I would urge caution.  Certainly lenders and Wall Street have learned some lessons the hard way, thus the market can be counted on to correct some of the excesses of recent years.  Moreover, this should be embraced as an opportunity to embrace reforms that will improve the functioning of consumer lending markets generally.  For instance, a Federal Trade Commission study identifies many areas for improvement in current disclosure rules that could be made more user-friendly and comprehensible for consumers.  Moreover, there is a larger economic question that we must wrestle with as a society what is the economically optimal level of foreclosures?  Given the myriad benefits of homeownership to families and communities, traditional governmental policies have strongly encouraged the expansion of home ownership.  We are now seeing the downside of that expansion, but that alone does not resolve the question of how many failures are too many.  Until the overall goals of our home ownership policies are better specified and the underlying causes of the subprime crisis are better understood, regulators should tread cautiously in this area to avoid unintended consequences and unwise bailouts to profligate lenders and speculative borrowers.

This discussion is based on Todd J. Zywicki & Joseph Adamson “The Law and Economics of Subprime Lending,” __ University of Colorado L. Rev. __ (Forthcoming 2009).

Melissa Jacoby: From my vantage point, the rise in subprime defaults highlighted both the existence and limits of our current system of mortgage delinquency management. A higher mortgage delinquency rate becomes more tolerable to the extent the social costs of delinquency (whether leading to home retention or exit) are minimized. The question of the optimal level of foreclosures that Todd notes cannot be properly evaluated without considering this dimension. Formal laws of foreclosure and bankruptcy shape the consequences of default for households, creditors, and communities when loss mitigation efforts fail. Debtor-creditor laws thought to involve mere two-party disputes can have rather public consequences, particularly when rising delinquencies are concentrated geographically. It is not enough to ask, as many do, only how these laws affect the cost of credit ex ante or, at the other end of the spectrum, whether they prevented home loss in the very short term. We also should be evaluating bankruptcy and foreclosure laws through the lens of common housing policy objectives. For purposes of this discussion, I take those to be household wealth building, the generation of positive psycho-social states, and community and neighborhood development.

A broader question is whether government has excessively promoted  homeownership, particularly but not limited to the highly leveraged variety. Government has some role to play in ensuring the availability of safe and affordable housing, which can be accomplished through a variety of housing tenures (most obviously renting and owning). The express preference for and promotion of homeownership in particular has been publicly justified on the three goals just mentioned earlier: household wealth building, the generation of positive psycho-social states, and community and neighborhood development. The rise in subprime delinquency reminds us that homeownership does not inevitably further these three ends. Rather, furtherance of these objectives hinges in part on the conditions under which homeownership is obtained, maintained, leveraged, and exited. Some individuals may better achieve those objectives through renting, at least during certain parts of their lives. Thus, a record high homeownership rate does not seem like a meaningful end in and of itself, particularly when not sustainable. In other contexts, leasehold rights are readily recognized as economically valuable property. Government doesn’t tell businesses that they always are better off buying real estate instead of entering leases. Perhaps it shouldn’t over-determine housing tenure either.

This discussion is based on Melissa Jacoby's “Home Ownership Risk Beyond a Subprime Crises: The Role of Delinquency Management,” __ Fordham L. Rev. __ (2008).

Kathleen Engel: As I read Todd’s entry, I realized that, despite our differences in perspective, there may be more agreement than disagreement among us.

There is plenty of blame to go around or put differently, there have been many points of failure in the financial services market. Thus, any solutions have to address each point of failure along the path of a loan from broker to investor. I think that Todd stopped short in his blame list and should have included rating agencies, federal regulators, and investment banks, all of whom knew of the problems in subprime. News articles and academic papers had been reporting high-risk, asset-based lending for a decade before the crisis hit. Subprime lenders had failed in the past—Conseco and the Money Store went belly up over five years ago, with losses in the billions of dollars. Multiple lawsuits against auto finance companies had revealed abuses generated by commission-based pricing. And, evidence of racial disparities in loan pricing suggested exploitation in the market. Despite this and other evidence, regulators, rating agencies, and investments banks neglected to engage in the oversight and due diligence that would have prevented the subprime collapse.

Rating agencies and investment banks were mutually dependent. The rating agencies needed bond issues to generate fees and investment banks needed ratings from the rating agencies to issue the bonds. Both made money as long as the bonds were issued and unloaded on investors. And, they made this money even when the quality of the underlying collateral was suspect until, of course, the collateral stopped performing.

Federal banking, consumer protection and securities regulators were passive as financial institutions created new products that should have been subject to scrutiny. Worse yet, by not staying on top of abusive lending, bank regulators may have given regulated institutions Community Reinvestment Act credits for their involvement in making or funding predatory loans.

I have two other quibbles:

1. Subprime lending does not deserve credit for fueling homeownership gains. The significant gains in homeownership pre-dated the meteoric rise in subprime loans.

2. Todd relies on a recent FTC study to assert that prime and subprime borrowers are similar in their ability to understand loan terms. I do not think that this is the right or important conclusion to draw from the FTC study. Rather, the study suggests that if you give people loans with complex terms, no amount of knowledge of the terms will lead them to make optimal decisions.

I agree completely with Todd and Melissa that we need thoughtful policies that take into account the goals of homeownership, possible unintended consequences, and the risk of unwarranted bail-outs, but I do not think we should move slowly. As I write this, people are ripping copper pipes and bath tubs from abandoned homes in Cleveland and home auction signs are blooming even in the most affluent of suburbs. We know what went wrong and we have an array of policy proposals to draw from. We can’t wait. It is time to put the government’s resources to the task of addressing the fall-out from the problems with subprime and preventing a future disaster.

This discussion is based on Kathleen C. Engel's & Patricia A. McCoy's “Turning a Blind Eye: Wall Street Finance of Predatory Lending,” __ Fordham L. Rev. __ (2007).

Melissa Jacoby: Kathleen rightly reminds us that minimizing the risk of and managing future crises leaves unresolved what to do right now.  The first question is whether we all would be better off if some mortgages at risk of failing were adjusted to make them feasible.  The next question is an empirical one – whether structural barriers to consensual modifications persist for securitized loans that what traditional lenders otherwise would consider to be good candidates for modification.  If the answer to both questions is “yes,” allowing non-consensual modifications in bankruptcy, at least for interest rate adjustments, should be put on the table. Sorting devices can be put in place to reduce potential costs of this approach and also should minimize concerns about promoting unsustainable homeownership.   Outside of Washington, I have encountered people across the political spectrum, including some who have worked for financial institutions, who find merit in the bankruptcy proposal. 

Kathleen Engel: Melissa makes important points that should be part of the current policy discussions.  I would also consider asking whether non-consensual modifications might also be valuable outside of bankruptcy fora.  It is true that non-consensual modifications, both within and outside bankruptcy proceedings, could give rise to moral hazard problems, but these problems will arise with almost any intervention.  As the recent assistance to Bear Stearns exemplifies, moral hazard is not a reason for government inaction if the social costs exceed the moral hazard risk.

There is also a risk that modifications outside of bankruptcy could reward undeserving borrowers.  This could be addressed through provisions, for example, that allowed servicers to prove borrowers were complicit and therefore not eligible for modifications.

Melissa, by the way, provided a very interesting commentary on modifications from the "land of broken contracts" at the recent Emerging Issues in Subprime and Predatory Lending Research" conference held at Seton Hall.