The law, economics and psychology of subprime mortgage contracts

Cornell Law Review

Volumn 94, Issue 5, 2009, Pages 1073-1151

  Bar Gill, Oren ^a  

^a NEW YORK UNIVERSITY   (United States)

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EID: 70149109333     PISSN: 00108847     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (577)

1. See Yuliya Demyanyk & Otto Van Hemert, Understanding the Subprime Mortgage Crisis, 22 Rev. Fin. Stud, (forthcoming 2009) (manuscript at 6 & n.6, 7 tbl.l, 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 included 1,772,000 subprime loans originated in 2006, implying a total of 1,772,000 / (0.85 * 0.75) = 2,779,608);
2. 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] (prepared statement of Peter Orszag, Director, Congressional Budget Office) ("By the end of 2006, the outstanding value of subprime mortgages totaled more than $1 trillion and accounted for about 13 percent of all home mortgages."). The Center for Responsible Lending estimates 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, Center for Responsible Lending, http://www. responsiblelending.org/issues/mortgage/quick-ref- erences/a-snapshot-of-the- subprime.html (last visited Mar. 1, 2009) [hereinafter CRL Snapshot].
3. See Conc. Budget Office, The Budget and Economic Outlook: Fiscal Years 2008 to 2018, 23 (2008) [hereinafter CBO Outlook], available at http://www.cbo.gov/ ftpdoc.cfm?index=8917&type=l (noting estimates of between $200 billion and $500 billion for total subprime-related losses and noting the additional-and potentially substantial- indirect adverse effects of the subprime crisis on the economy);
4. Henry M. Paulson, Jr., U.S. Sec'y of the Treasury, Remarks on Current Housing and Mortgage Market Developments at the Georgetown University Law Center (Oct. 16 2007), available at http://www.ureasury.gov/press/releases/hp612.htm (noting that foreclosures on subprime loans increased more than 200 percent between 2000 and 2006 and discussing the broad impact of these foreclosures on the economy).
5. See Demyanyk & Van Hemert, supra note 1 (manuscript at 5, 7 tbl.l); Center for Responsible Lending, Mortgage Lending Overview, http://www. responsiblelending.org/issues/mortgage/(last visited Mar. 1, 2009).
6. See Lauren E. Willis, Decisionmaking and the Limits of Disclosure: The Problem of Predatory Lending: Price, 65 Md. L. Rev. 707, 720-721 (2006) (describing the development of risk-based pricing in the mortgage market).
7. A note on terminology: The residential mortgage market is divided into the prime segment and the nonprime segment. The nonprime segment is further divided into sub- prime (higher risk) and Alt-A (lower risk), although the line between subprime and Alt-A is not always clear. See infra Part I.A. Many of the contractual design features studied in this Article were common in both the subprime and Alt-A segments. For expositional convenience, I will sometimes refer to these two segments together as "subprime."
8. Truth in Lending, 73 Fed. Reg. 44,522, 44,524-525 (July 30, 2008) (to be codified at 12 C.F.R. pt. 226) ("[P]roducts in the subprime market tend to be complex, both relative to the prime market and in absolute terms....").
9. As noted above, these contractual design features appeared in the prime market well before the subprime expansion. The explanations considered below apply to prime mortgages that share the deferred-cost and high-complexity features. These explanations also reveal why these existing design features rose to prominence in the subprime market and, as argued below, even facilitated the subprime expansion.
10. To the extent that interest-rate complexity is an artifact of the deferred-cost features, the preceding discussion applies here as well.
11. See Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys., Speech at the Women in Housing and Finance and Exchequer Club Joint Luncheon, Washington, D.C.: Financial Markets, the Economic Outlook, and Monetary Policy (Jan. 10, 2008), available at http://www.federalreserve.gov/newsevents/speech/ bernanke20080110a.htm [hereinafter Bernanke January 2008 Speech] (suggesting that the ARM design responds to optimism about house prices).
12. See Edmund L. Andrews, Fed and Regulators Shrugged as the Subprime Crisis Spread: Analysis Finds Trail of Warnings on Loans, N.Y. Times, Dec. 18, 2007, at Al (quoting Edward M. Gramlich, the former Federal Reserve governor, asking "Why are the most risky loan products sold to the least sophisticated borrowers?... The question answers itself-the least sophisticated borrowers are probably duped into taking these products.").
13. There are numerous accounts of abusive practices falling under the general heading of predatory lending, many of them predating the recent subprime crisis. See U.S. Dep't of Hous. & Urban Dev., Unequal Burden: Income & Racial Disparities in Sub- prime Lending in America 1 (2000), available at http://www.huduser.org/Publications/ pdf/unequal-full.pdf (documenting "the rapid growth of subprime lending during the 1990's" and calling for increased scrutiny of subprime loans due to "growing evidence of widespread predatory practices in the subprime market"). While there is surely some overlap between the contractual design features studied in this Article and the problem of predatory lending, the extent of the overlap is unclear, largely because there is no agreed- upon definition of predatory lending.
14. See U.S. Dep't of Hous. & Urban Dev. & U.S. Dep't of the Treasury, Curbing Predatory Home Mortgage Lending 17 (2000), available at http://www.huduser.org/publications/hsgfin/curbing.html available at [hereinafter HUD-Treasury Report]. Yet, two observations can be made: First, the more severe instances of predatory lending go far beyond manipulation of contractual design. Second, the identified contractual design features are more ubiquitous than at least the more severe manifestations of predatory lending.
15. Cf. Todd J. Zywicki & Joseph D. Adamson, The Law & Economics of Subprime Lending, 80 U. COLO. L. REV. 1, 11-20 (2009) (discussing the relationship between predatory lending and subprime lending).
16. In some cases, borrowers engaged in outright fraud. See Jennifer E. Bethel, Allen Ferrell & Gang Hu, Legal and Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis 17 (Harvard Law & Econ. Discussion Paper No. 212; Harvard Law Sch. Program on Risk Regulation Research Paper No. 08-5, 2008), available at http://ssrn.com/abstract=1096582 (citing evidence of widespread fraud in the application and appraisal processes among early payment default loans).
17. An immediate response is that lenders priced the increased risk. And there is some evidence of such pricing. See Demyanyk & Van Hemert, supra note 1 (manuscript at 5). But this response is misleading. The evidence shows that subprime risks were not accurately priced.
18. See U.S. Sec. & Exch. Comm'n, Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating Agencies 34-35 (2008), available at http://www.sec.gov/news/studies/2008/craexamination070808. pdf [hereinafter SEC Rating Agencies Report] (finding that rating agencies underestimated risks associated with subprime mortgage-backed securities);
19. Bethel et al., supra note 12. Bethel, Ferrell, and Hu argue that even sophisticated market participants had limited experience with and understanding of the assets (subprime residential mortgages) underlying the securities (RMBSs and CDOs), and what risks these assets generate when pooled and securitized. In addition, credit-rating models underestimate the correlation of defaults and thus understate risk. Moreover, major investment banks are under investigation by the SEC, the FBI, and state attorneys general with respect to pricing of RMBSs and CDOs, suggesting that mispricing may be the result of malice, not only incompetence.
20. See Bethel et al., supra note 12, at 2
21. See also SEC Rating Agencies Report supra, at 12 (citing an analyst from one rating agency who wrote in an e-mail that "her firm's model did not capture 'half of the deal's risk");
22. Carrick Mollenkamp et al., Behind AIG's Fall, Risk Models Failed to Pass Real- World Test, Wall St. J., Nov. 3, 2008, at Al (discussing the failure of AIG's risk models and quoting Warren Buffett: "All I can say is, beware of geeks... bearing formulas.").
23. See Scott Woll, The Buildup to a Fall, Mortgage Banking, Nov. 2007, at 50, 53-54 (describing how lenders and securitizers profiting from increased loan volume "started looking at new ideas [to increase loan volume].... What followed was the largest introduction of new products to the mortgage market in decades.");
24. see also Zywicki & Adamson supra note 11, at 51-53 (discussing agency costs in the subprime market);
25. Frederic S. Mishkin, Governor, Bd. of Governors of the Fed. Reserve Sys., Speech at the U.S. Monetary Policy Forum, New York, New York: Leveraged Losses: Lessons from the Mortgage Meltdown (Feb. 29, 2008), available at http://www.federalreserve.gov/newsevents/speech/mishkin20080229a.htm (arguing that rating agencies, underwriters, and CDO mangers were driven by fees).
26. But see Gary B. Gorton, The Subprime Panic 27-31 (Nat'l Bureau of Econ. Research, Working Paper No. 14398 2008) available at http://www.nber.org/pa- pers/wl4398 (arguing that agency costs were not that large, as many agents along the securitization chain retained substantial risks on their balance sheets).
27. On the compensation structure and incentives of loan originators, see Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys., Testimony Before the Committee on Financial Services, U.S. House of Representatives: Subprime Mortgage Lending and Mitigating Foreclosures (Sept. 20, 2007), available at http://www.federalreserve.gov/newsevents/testimony/ bernanke20070920a.htm (noting that since originators profited from fees and yield-spread premiums, they were more interested in increasing loan volume than in increasing loan quality).
28. On the compensation structure and incentives of the rating agencies charged with assessing the risk associated with mortgage-backed securities, see SEC Rating Agencies Report, supra note 13 (finding inadequate rating procedures and conflicts of interest, which led to underestimation of risk, which in turn contributed to the failure of investors and investment banks to press originators for safer loans);
29. Jan A. Kregel, Changes in the U.S. Financial System and the Subprime Crisis 16 (Levy Econ. Inst, of Bard Coll., Working Paper No. 530, 2008), available at http://ssrn.com/abstract=l 123937 (noting how rating agencies that provided more lax assessment of subprime risks got more business-and more fees- from securitizers). These interinstitutional agency costs come on top of the intrainstitutional agency costs stemming from the imperfect alignment of incentives between each one of the financial intermediaries and its employees.
30. See., eg., Martin Wolf, Why regulators should intervene in bankers' pay, Fin. Times, Jan. 16, 2008, at 13 (discussing the conflicts of interest that exist within lending institutions). Beyond these more subde-albeit financially substantial-agency costs, there is evidence that some agents-intermediaries withheld information from principals-investors.
31. See Bethel et al supra note 12, at 2 (noting that investment banks are under investigation by the SEC, the FBI, and state attorneys general for withholding information affecting credit risk from rating agencies and investors).
32. See Bethel et al., supra note 12, at 27 ("The market appears to have not fully anticipated the probability or effect of correlated market events or the very small probability of an extremely negative outcome.");
33. Martin S. Feldstein, Housing, Credit Markets and the Business Cycle3-4 (Nat'l Bureau of Econ. Research, Working Paper No. 13471, 2007), available at http://www.nber.org/papers/wl3471 (arguing that investors underestimated and mis- priced risks);
34. Gorton, supra note 14, at 26 (arguing that the complexity of the securitization process led to a loss of information along the securitization chain);
35. Joseph R. Mason & Joshua Rosner, Where Did The Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions 35-36 (SSRN Working Paper, 2007), available at http://ssm.com/abstract=1027475 (arguing that investors and investment banks falsely believed that pooling mortgages diversifies risk). Much of this underestimation of risk harkens back to optimism about house prices.
36. See, e.g., Thomas L. Friedman, Op-Ed All Fall Down, N.Y. Times, Nov 26 2008, at A33 (citing Michael Lewis, The End of Wall Street's Boom, Portfolio.com, Dec. 2008 http://www.portfolio.com/news-markets/national-news/ portfolio/2008/11/11/The-End-of-Wall-Streets-Boom (reporting, based on a telephone conversation between hedge fund investor Steve Eisman and a Standard & Poor's employee, that S&P's models assumed that home prices would keep going up));
37. Kristopher S. Gerardi et al., MakingSense of the Subprime Crisis 1 (Fed. Reserve Bank of Boston, Public Policy Discussion Paper No. 09-1, 2008), available at http://www.bos.frb. org/economic/ppdp/2009/ppdp0901.htm (finding that analysts in 2005 understood the risks of a steep decline in house prices but believed that the probability of such a decline was very low);
38. see also, e.g., Julio Rotemberc, Subprime Meltdown: American Housing and Global Financial Turmoil 1 (2008) (quoting a letter that Fannie Mae CEO Franklin Raines sent to shareholders in 2001: "Housing is a safe, leveraged investment-the only leveraged investment available to most families-and it is one of the best returning investments to make.... Homes will continue to appreciate in value. Home values are expected to rise even faster in this decade than in the 1990's.").
39. See Bethel et al., supra note 12, at 21, 81 tbl.2 (summarizing the tens of billions of dollars worth of subprime-related write-offs by banks; citing an estimate of $150 billion in writedowns as of February 2008 and a forecast that this amount will more than double);
40. Press Release, Standard & Poor's, Subprime Write-Downs Could Reach $285 Billion, But Are Likely Past The Halfway Mark (Mar. 13, 2008), available at http://www2.standardand poors.com/portal/site/sp/en/us/page. article/4,5,5,1,1204834027864.html (discussing Standard & Poor's increased estimate of writedowns at $285 billion, up from $265 billion earlier in the year). These losses do not provide conclusive evidence that sophisticated players made mistakes; they could be the realization of the large (!) down-side risk in an (ex ante) rational bet.
41. See Audrey Pavlov & Susan Wachter, Subprime Lending and House Price Volatility 2 (Univ. of Pa. Law Sch. Inst, for Law & Econ., Research Paper No. 08-33, 2008), available at http://ssrn.com/abstract=1316891 (establishing a link between the use of aggressive mortgage lending instruments and house price volatility). While contractual design contributed to the subprime expansion, there are other factors that likely played a more central role in generating the subprime expansion. One such factor is the advent of new technology that enabled efficient risk-based pricing.
42. See U.S. Gen. Accounting Office, Report to the Chairman and Ranking Minority Member, Special Committee on Aging, U.S. Senate, GAO-04-280, Consumer Protection: Federal and State Agencies Face Challenges in Combating Predatory Lending 21 (2204) [hereinafter GAO Consumer Protection Report] available at www.gao.gov/new.items/d04280.pdf. Another factor is the increase in the supply (or availability) of funds brought about by securitization and the global saving glut.
43. See generally Atif Mian & Amir Sufi, The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis (Nat'l Bureau of Econ. Research, Working Paper No. 13936, 2008), available at http://ssrn.com/abstract=1072304 (arguing that the expansion in mortgage credit to subprime zip codes and its dissociation from income growth is closely correlated with the increase in securitization of subprime mortgages);
44. Ben S. Bernanke, Governor, Bd. of Governors of the Fed. Reserve Sys., Remarks at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia: The Global Saving Glut and the U.S. Current Account Deficit (Mar. 10, 2005), available at http://www.feder- alreserve.gov/boarddocs/speeches/2005/ 200503102/ (discussing how the global saving glut reversed the flow of credit to developing and emerging-market economies). A third factor is the increase in supply of funds for risky investments caused by investors' underestimation of risk.
45. See Feldstein supra note 15. It is important to emphasize that the main purpose of this Article is to explain the contractual design features common in subprime mortgages-not the subprime expansion itself-although, as argued above, contractual design did contribute to the subprime expansion.
46. Cf. Oren Bar-Gill, The Behavioral Economics of Consumer Contracts, 92 Minn. L. Rev. 749,751 (2008) [hereinafter Bar-Gill, Consumer Contracts] (explaining that competition will not always alleviate mistakes in the consumer-contracts market);
47. Oren Bar-Gill, Seduction by Plastic, 98 Nw. U. L. Rev. 1373, 1388 (2004) [hereinafter Bar-Gill, Seduction] (arguing that consumers' underestimation of their future borrowing leads to inefficiencies "that cannot be cured even by perfect competition");
48. Oren Bar-Gill & Elizabeth Warren, Making Credit Safer, 157 U. Pa. L. Rev. 1, 69 (2008) (noting that competition in the credit markets creates valuable products and features while also creating an "array of risky products and unsafe features").
49. Mortgage reform bills recendy proposed in Congress include Emergency Home Ownership and Mortgage Equity Protection Act of 2007, H.R. 3609, 110th Cong. (2007);
50. Helping Families Save Their Homes in Bankruptcy Act of 2007, S. 2136, 110th Cong. (2007);
51. Home Owners Mortgage and Equity Savings Act, H.R. 3778, 110th Cong. (2007).
52. See Truth in Lending, 73 Fed. Reg. 44,522, 44,524-525 (July 30, 2008) (to be codified at 12 C.F.R. pt. 226);
53. see also Housing and Economic Recovery Act of 2008, Pub. L. No.110-289, § 2502(a), 122 Stat. 2654, 2855-57 (to be codified at 15 U.S.C. § 1638(b)(2)).
54. Truth in Lending Act, Pub. L. No.90-321, § 107, 82 Stat. 146, 149 (1968) (codified as amended at 15 U.S.C. § 1606 (2006)) (defining the APR);
55. Truth in Lending Act, Pub. L. No.90-321, §§ 121-31, 82 Stat. 146, 152-57 (1968) (codified as amended at 15 U.S.C. §§ 1631-1649 (2006)) (requiring disclosure of the APR).
56. See Truth in Lending, 73 Fed. Reg. at 44,524 ("The final rule requires creditors to provide transaction-specific mortgage loan disclosures such as the APR and payment schedule for all home-secured, closed-end loans no later than three business days after application, and before the consumer pays any fee except a reasonable fee for the review of the consumer's credit history.").
57. See Housing and Economic Recovery Act of 2008 § 2502(a).
58. See Elizabeth Renuart & Diane E. Thompson, The Truth, The Whole Truth, and Nothing but the Truth: Fulfilling the Promise of Truth in Lending, 25 Yale J. on Reg. 181 (2008). Renuart and Thompson, however, are not the first to recognize that the APR is not sufficiently inclusive, nor are they the first to propose a more inclusive APR.
59. See HUD-Treasury Report supra note 11, at 69 (proposing that the law be amended "to require that the full costs of credit be included in the APR");
60. William N. Eskridge, Jr., One Hundred Years of Ineptitude: The Need for Mortgage Rules Consonant with the Economic and Psychological Dynamics of the Home Sale and Ijian Transaction, 70 Va. L. Rev. 1083, 1166 (1984) (proposing, over twenty years ago, a more inclusive APR).
61. See Christopher L. Cagan, First Am. CoreLogic, Inc., Mortgage Payment Reset: The Issue and the Impact 2 (2007).
62. See Stan J. Liebowitz, Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, in Indep. Inst., Housing America: Buildinc Out of a Crisis (Randall G. Holcombe & Benjamin Powell eds., forthcoming July 2009), available at http://ssrn.com/abstract=1211822 (explaining that ARM defaults and foreclosures are as prevalent in the prime market as in the subprime market);
63. Gorton, supra note 14, at 21 ("Problems in the Alt-A market are still mostly in the future, and it is likely that this market will also shut down.").
64. I say "in theory" since many low-risk borrowers end up with high-price subprime loans. See infra Part III.A.
65. An important legal antecedent to the subprime market was the Depository Institutions Deregulation and Monetary Control Act of 1980 that "preempted state interest caps and allowed lenders to charge higher interest rates." See Zywicki & Adamson, supra note 11, at 6.
66. See, e.g., Ivy L. Zelman et al., Credit Suisse, Mortgage Liquidity du Jour: Underestimated No More 13 (2007) [hereinafter Credit Suisse Report] (noting that prime conforming conventional loans are "typically limited to buyers with [FICO] scores above 620");
67. Kristopher Gerardi, Adam Hale Shapiro & Paul S. Willen, Subprime Outcomes: Risky Mortgages, Homeoumership Experiences, and Foreclosures 5 (Fed. Reserve Bank of Boston, Working Paper No. 07-15, 2007), available at http://www.bos.frb.org/economic/wp/wp2007/ wp0715.htm ("In the United States, a subprime borrower today typically refers to an individual with a FICO score below 620, who has become delinquent on some form of debt repayment in the previous 12 to 24 months, or who has even filed for bankruptcy in the last few years.").
68. Credit Suisse Report, supra note 29, at 21. In 2006, the average FICO score of a borrower on a first-lien subprime loan was 618.1.
69. See Demyanyk & Van Hemert supra note 1 (manuscript at 7 tbl.l). These data reflect the trend of making subprime loans to high- FlCO-score borrowers who exhibit risk factors other than an impaired credit history, such as borrowers who do not wish to produce a down payment ("zero-down borrowers"), borrowers who do not wish to fully disclose their income and financial wealth ("no-doc" and "low-doc borrowers"), and borrowers seeking a high LTV loan.
70. See Gerardi et al., supra note 29, at 6-7.
71. See Michael LaCour-Little, Economic Factors Affecting Home Mortgage Disclosure Act Reporting, 29 J. Real Est. Res. 479, 506 n.3 (2007).
72. Truth in Lending, 73 Fed. Reg. 44,522, 44,531-32 (July 30, 2008) (to be codified at 12 C.F.R. pt. 226) (stating that "[t]he definition of 'higher-priced mortgage loans' appears in § 226.35(a)" and that the average prime offer rate is derived from the Freddie Mac Primary Mortgage Market Survey ®).
73. See Demyanyk & Van Hemert, supra note 1. The authors' data include 452,000 loans in 2001 and 1,772,000 loans in 2006.
74. Id. manuscript at 7 tbl.l).
75. These data cover approximately 85 percent of securitized subprime loans. Id. (manuscript at 6).
76. In 2001, 54 percent of subprime loans were securitized, implying a total of 452,000 / (0.85 * 0.54) = 984,749.
77. See id. (manuscript at 6 n.6). In 2006, 75 percent of subprime loans were securitized, implying a total of 1,772,000 / (0.85 * 0.75) = 2,779,608).
78. See id.
79. see also CBO Outlook, supra note 2, at 23-24 ("The number of subprime mortgages has grown rapidly in recent years: In 2005 and 2006, such loans made up about one-fifth of all originations of home mortgages (in dollar terms)....");
80. Zywicki & Adamson, supra note 11, at 20 (noting that subprime mortgage originations increased from $65 billion in 1995 to $332 billion in 2003);
81. Christopher J. Mayer, Karen M. Pence & Shane M. Sherlund, The Rise in Mortgage Defaults 3 (Bd. of Governors of the Fed. Reserve Sys., Fin. & Econ. Discussion Series Paper No. 2008-2059, 2008) (recording LP data showing a rise in subprime originations from 1.1 million in 2003 to 1.9 million in 2005);
82. CRL Snapshot, supra note 1 (noting that subprime originations accounted or 28 percent of total loan volume in 2006). Focusing on purchase loans, subprime originations have also grown substantially.
83. Focusing on purchase loans, subprime originations have also grown substantially. See Credit Suisse Re-port, supra note 29, at 4 (noting that the share of subprime purchase loans grew to approximately 20 percent in 2006);
84. Mayer et al., supra, at 6 ("[P]urchase loans (as opposed to refinance loans) rose from 30 to 42 percent as a share of subprime originations over the 2003-2006 period....").
85. CBO Outlook, supra note 2, at 24.
86. Truth in Lending, 73 Fed. Reg. at 44,533;
87. see also Mayer et al., supra note 33, at 3 (explaining that "Alt-A originations grew... from 304,000 in 2003 to 1.1 million in 2005").
88. See Demyanyk & Van Hemert, supra note 1 (manuscript at 7 tbl.l).
89. See id. Of the 57.6 percent of refinance loans in 2006, 51.4 percent were refinance/cash-out loans, and 6.2 percent were refinance/no-cash-out loans. Id. At the peak of the subprime expansion, in 2004, only 35.8 percent of first-lien subprime loans were purchase loans, and 64.2 percent were refinance loans.
90. See id. (including both cash-out and no-cash- out loans in the refinance percentage);
91. see also Michael Frvtantoni et al., Mortgage Bankers Ass'n, The Residential Mortgage Market and Its Economic Context in 2007, at 24 (MBA Research Monograph Series, 2007) (showing subprime originations by loan purpose and type);
92. LaCour-Little, supra note 31, at 498 (noting that a little more than half of the loans in 2004-2005 were refinancing loans).
93. See generally Yan Chang & Frank E. Nothaft, Demystifying the Refi-Share Mystery, 29 J. Real Est. Res. 511 (2007). The importance of this distinction is highlighted by the finding that the average number of mortgages per borrower, per property is close to three.
94. See Gerardi et al. supra note 29, at 4-5, 14 (emphasizing the importance of distinguishing subprime loans made for initial purchase from subprime refinances of existing mortgages and finding that "the average number of mortgages over the life of completed homeownerships is 2.7").
95. See Demyanyk 8c Van Hemert, supra note 1 (manuscript at 7 tbl.l).
96. See Mayer et al., supra note 33, at 6.
97. Id.
98. See Paulson, supra note 2 ("A mortgage loan is likely to be originated, serviced, and owned by three different entities. Originators often sell mortgages to securitizers who package them into mortgage-backed securities, which are then divided and sold again to a global network of investors.").
99. On the role of servicers, see, for example, Kurt Eggert, Limiting Abuse and Opportunism by Mortgage Servicers, 15 Housing Pol'y Debate 753, 755 (2007).
100. U.S. Gov't Accountability Office, Report to the Chairman, Subcommittee on Housing and Transportation, Committee on Banking, Housing, and Urban Affairs, U.S. Senate, GAO-06-1021, Alternative Mortgage Products: Impact on Defaults RUnclear, but Disclosure of Risks to Borrowers Could Be Improved 7 (2006) [hereinafter GAO AMP Report] ("Borrowers arrange residential mortgages through either mortgage lenders or brokers. The funding for mortgages can come from federally or state- chartered banks, mortgage lending subsidiaries of these banks or financial holding companies, or independent mortgage lenders, which are neither banks nor affiliates of banks."). Indirect originations also played an important role.
101. See LaCour-Little, supra note 31, at 498 ("A little less than one-third of all loans were originated through indirect, wholesale channels, which include mortgage brokers, certain correspondent lending relationships, builder programs and the like.").
102. Robert B. Avery, Kenneth P. Brevoort & Glenn B. Canner, Opportunities and Issues in Using HMDA Data, 29 J. Real Est. Res. 351, 353 (2007) ("Depository institutions account for the bulk of the reporting institutions, but mortgage companies report the majority of the applications and loans. In 2005, for example, nearly 80% of the 8,850 reporting institutions were depository institutions but together they reported only 37% of all the lending- related activity. Mortgage companies accounted for 63% of all the reported lending; 70% of these institutions were independent and not related in any way to a depository institution.").
103. GAO AMP Report, supra note 43. Brokers also play a more direct role via indirect originations.
104. See LaCour-Little supra note 31, at 498.
105. Press Release, Access Mortgage Research & Consulting, Inc., New Broker Research Published (Aug. 17, 2007), available at http:// accessmtgresearch.com/?p=40 ("[T]he average firm produced $32.4 million (151 loans)... conforming loans accounted for 48% of brokers' production volume; the most used wholesalers were Countrywide (for conventional loans) and New Century (for subprime loans)....").
106. 47 See, e.g., Kathleen C. Engel & Patricia A. McCoy, Turning a Blind Eye: Wall Street Finance of Predatory Lending, 75 Fordham L. Rev. 2039, 2045 (2007).
107. See Credit Suisse Report, supra note 29, at 11 (Finding 75 percent securitization rate);
108. Demyanyk & Van Hemert, supra note 1 (manuscript at 6 n.6) (reporting securitization rates of 76 percent and 75 percent in 2005 and 2006, respectively).
109. For a good exposition on securitization, see Engel & McCoy, supra note 47, at 2045-2048
110. See generally Bethel et al supra note 12.
111. See Credit Suisse Report, supra note 29, at 22 (noting that the market shares of the top subprime lenders in 2006 were: Wells Fargo 13.0%, HSBC Finance 8.3%, New Century 8.1%, Countrywide Financial 6.3%, CitiMortgage 5.9%, WMC Mortgage 5.2%, Fremont Investment 5.0%, Ameriquest 4.6%, Option One 4.5%, First Franklin 4.3%, Washington Mutual 4.2%, Residential Funding 3.4%, Aegis Mortgage 2.7%, American General 2.4%, Accredited Lenders 2.3%, and that the top fifteen lenders commanded 80.5% of the market). Similar numbers are reported by other sources.
112. See, e.g., 2 MARKET SHARE REPORTER: AN ANNUAL COMPILATION OF REPORTED MARKET SHARE DATA ON COMPANIES, PRODUCTS, AND SERVICES: 2008, at 704-05 (Robert S. Lazich, ed., 2008) (reporting that the top ten lenders commanded less than 58.8 percent of the market with no single lender controlling more than 8.3 percent of the market, based on a conservative combination of the two sources cited in Market Share Reporter). The 2005 figures are similar.
113. See 2 Market Share Reporter: An Annual Compilation of Reported Market Share Data on Companies, Products, and Services: 2007, at 719 (Robert S. Lazich ed., 2007) (reporting that the top ten lenders commanded less than 51 percent of the market with no single lender controlling more than 9 percent of the market). These numbers represent the outcome of a consolidation process.
114. See Randall M. Scheessele, HUD Subprime and Manufactured Home Lender List, HUD User, Mar. 16, 2007, http://www.huduser.org/datasets/manu.html (describing the 2005 list). Many other lenders, while not specializing in subprime lending, also offer subprime loans.
115. See Avery et al., supra note 44, at 353 (noting that there were 8,850 Home Mortgage Disclosure Act (HMDA) reporting institutions in 2005).
116. See Engel & McCoy, supra note 47, at 2041 ("[Securitization funds small, thinly capitalized lenders and brokers, thus enabling them to enter the subprime market. These originators are more prone to commit loan abuses because they are less heavily regulated, have reduced reputational risk, and operate with low capital, helping to make them judgment-proof.").
117. See, e.g., LendingTree.com, Lender Ratings, http://www.lendingtree.com/ stm3/lenders/scorecard.asp (last visited Mar. 10, 2009) (listing over 250 affiliated lenders). Although clearly not all of these lenders offer subprime loans, and those who do might not offer loans nationally.
118. Truth in Lending, 73 Fed. Reg. 1672, 1674 (proposed Jan. 9, 2008) (to be codified at 12 C.F.R. pt. 226) ("Underwriting standards loosened in large parts of the mortgage market in recent years as lenders-particularly nondepository institutions, many of which have since ceased to exist-competed more aggressively for market share.").
119. See, e.g., Marsha J. Courchane, Brian J. Surette & Peter M. Zom, Subprime Borrowers: Mortgage Transitions and Outcomes, 29 J. Real Est. Fin. & Econ. 365, 371-372 (2004) (finding, based on a survey study, that subprime borrowers search less and are less informed).
120. See Willis, supra note 4, at 726-727 The limits of advertising in the subprime market further increase the cost of comparison shopping.
121. See Truth in Lending, 73 Fed Reg 44 522, 44 524 (July 30 2008) (to be codified at 12 C.F.R. pt. 226) ("[P]rice information for the subprime market is not widely and readily available to consumers. A consumer reading a newspaper, telephoning brokers or lenders, or searching the Internet can easily obtain current prime interest rate quotes for free. In contrast, subprime rates, which can vary significantly based on the individual borrower's risk profile, are not broadly advertised and are usually obtainable only after application and paying a fee.").
122. See Eskridge, supra note 24, passim (stating that imperfect information, largely driven by limited shopping, has lead to monopolistic competition, rather than perfect competition);
123. Willis, supra note 4, at 749 (arguing that lack of sufficient disclosure and low levels of financial literacy among borrowers make shopping extremely difficult). 57 See Real Estate Settlement Procedures Act (RESPA): Rule to Simplify and Improve the Process of Obtaining Mortgages and Reduce Consumer Setdement Costs, 73 Fed. Reg. 68,204, 68,207 (Nov. 17, 2008) (to be codified at 24 C.F.R. pts. 203, 3500) (describing "important changes that should increase consumer understanding and competition in the mortgage marketplace").
124. See generally U.S. Gov't Accountability Office, Report to the Committee on Financial Services, House of Representatives, GAO-05-947, Real Estate Brokerage: Factors That May Affect Price Competition (2005);
125. U.S. Dep't of Justice & Fed. Trade Comm'n, Competition in the Real Estate Brokerage Industry: A Report by the Federal Trade Commission and the U.S. Department of Justice (2007), available at www.ftc.gov/reports/realestate/ V050015.pdf [Hereinafter DOJ & FTC Report]. There are about 98,000 brokerage firms; they employ around 2.5 million real estate licensees.
126. See DOJ & FTC Report, supra, at 31. Of these firms, 60 percent have fewer than five agents and operate locally, and only about 5 percent have more than fifty agents.
127. See id. Indeed, competition among brokers is primarily local; on the national level in 2004, the top ten firms accounted for only 9.1 percent of the market share, while at the local level, top firms often control much larger market shares.
128. See id. For example, in Des Moines, Iowa, a single firm accounts for over half of all residential real estate transactions.
129. Id at 31-32. The primary barrier to entry in the brokerage market is the licensing process (which is more stringent for brokers than it is for agents).
130. Id. at 33. Competition is, however, limited by cooperative participation in multiple listings services (MLS) that are typically operated by local groups affiliated with the National Association of Realtors.
131. See id. at 10. Access to the MLS is limited to members, who use the database to list homes for sale on behalf of sellers and to search for homes on behalf of buyers.
132. Id. While the MLS limits both access and competition, it also reduces costs for brokers and customers.
133. Id. at 12-14. Competition is also limited by state law. Ten states ban rebates, which are often a key tool in price competition.
134. Id. at 49. Several states also have minimum-service laws, which limit the extent to which brokers can compete by offering a range of service packages.
135. Id. at 53. Lastly, competition is restricted by licensing requirements on for-sale-by-owner websites.
136. Id. at 62.
137. For further discussion, see Eskridge supra note 24, at 1148-49;
138. Matthew Magura, How Rebate Bans, Discriminatory MLS Listing Policies, and Minimum Service Requirements Can Reduce Price Competition for Real Estate Brokerage Services and Why It Matters (U.S. Dep't of Justice Econ. Analysis Group, Discussion Paper No. 07-8, 2007), available at http://ssrn.com/abstract= 997137.
139. See Bethel et al., supra note 12, at 81 tbl. 2.
140. William Eskridge ably summarizes the history of mortgage lending regulation in the U.S. See Eskridge, supra note 24.
141. 15 U.S.C. §§ 57b-l to -4 (2006).
142. See Comptroller of the Currency, Administrator of National Banks, Guidance on Unfair or Deceptive Acts or Practices, Advisory Letter No. AL 2002-3 (Mar. 22, 2002), available at http://www.occ.treas.gov/ftp/advisory/2002-3.doc;
143. see also Julie L. Williams & Michael S. Bylsma, On the Same Page: Federal Banking Agency Enforcement of the FTC Act to Address Unfair and Deceptive Practices by Banks, 58 Bus. Law. 1243, 1244 (2003).
144. See Truth in Lending, 73 Fed. Reg. 44,522, 44,527 (July 30, 2008) (to be codified at 12 C.F.R. pt. 226);
145. Raphael W. Bostic et al., State and Local Anti-Predatory Lending Laws: The Effect of Eegal Enforcement Mechanisms, 60 J. Econ. & Bus. 47, 49 (2008);
146. Willis, supra note 4, at 744-754
147. See, e.g., sources cited supra note 21.
148. See Real Estate Settlement Procedures Act (RESPA): Rule to Simplify and Improve the Process of Obtaining Mortgages and Reduce Consumer Setdement Costs, 73 Fed. Reg. 68,204 (Nov. 17, 2008) (to be codified at 24 C.F.R. pts. 203, 3500). RESPA applies to all "federally related mortgage loans," a somewhat broader category than loans originated by depository institutions. 24 C.F.R. § 3500.5(a) (2008).
149. Letter from Donald S. Clark, Sec'y, U.S. Fed. Trade Comm'n, to Jennifer L.Johnson, Sec'y, Bd. of Governors of the Fed. Reserve Sys. 1 (Sept. 14, 2006), available at http:// vAvw.federalreserve.gov/SECRS/2006/November/20061121/OP- 1253/OP-1253-53-l.pdf [hereinafter FTC Comment] (commenting on the FRB's hearing notice, published in the Federal Register, regarding the Home Equity Lending Market).
150. See Bostic et al., supra note 63 (describing the mini-HOEPA statutes and older anti-predatory lending laws restricting the use of prepayment penalties and balloon clauses).
151. See id.; Anthony Pennington-Cross & Giang Ho, The Termination of Subprime Hybrid and Fixed Rate Mortgages 8-9 (Fed. Reserve Bank of St. Louis, Research Div., Working Paper No. 2006-042A, 2006), available at http://research.sdouisfed.org/wp/2006/2006-042.pdf; Ctr. for Responsible Lending, CRL State Legislative Scorecard: Predatory Mortgage Lending, http://www.responsiblelending.org/issues/mortgage/statelaws.html (last visited Mar. 12, 2009).
152. See Bar-Gill & Warren, supra note 18, at 79-83;
153. see also Eggert supra note 42, at 774-775 (noting that many states have implemented regulations that are more stringent than the regulations promulgated by HUD under RESPA).
154. Julia Patterson Forrester, Still Mortgaging the American Dream: Predatory Lending, Preemption, and Federally Supported Lenders, 74 U. Cin. L. Rev. 1303 (2006);
155. Christopher L. Peterson, Preemption, Agency Cost Theory, and Predatory Lending by Banking Agents: Are Federal Regulators Biting Off More Than They Can Chew*. 56 Am. U. L. Rev. 515 (2007);
156. see also Bar-Gill & Warren supra note 18, at 79-83. Despite the increasing federal preemption on the substantive law dimension, state agencies enforce the state or federal law on lenders and brokers that fall outside the jurisdiction of the federal banking agencies.
157. See GAO AMP Report supra note 43, at 9-10. State regulators oversee independent lenders and mortgage brokers and do so by generally requiring business licenses that mandate meeting net worth, funding, and liquidity thresholds. They may also mandate certain experience, education, and operational requirements to engage in mortgage activities. Other common requirements for licensees may include maintaining records for certain periods, individual prelicensure testing, posting surety bonds, and participating in continuing education activities. States may also examine independent lenders and mortgage brokers to ensure compliance with licensing requirements, review their lending and brokerage functions for state-specific and federal regulatory compliance, and look for unfair or unethical business practices. When such practices arise, or are brought to states' attention through consumer complaints, regulators and State Attorneys General may pursue actions that include licensure suspension or revocation, monetary fines, and lawsuits.
158. Id.
159. See, e.g., Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys., Testimony Before the Committee on the Budget, U.S. House of Representatives: The Economic Outlook (Jan. 17, 2008), available at http://www.federalreserve.gov/newsevents/testimony/bernanke20080117a.htm (noting the "virtual shutdown of the subprime mortgage market").
160. See, e.g., FTC Comment, supra note 66, at 5 (describing the traditional mortgage contract);
161. see also GAO Consumer Protection Report, supra note 17, at 21 ("Because subprime loans involve a greater variety and complexity of risks, they are not the uniformly priced commodities that prime loans generally are.");
162. Willis, supra note 4, at 715-718 (describing the traditional mortgage that dominated the market until the end of the twentieth century);
163. Kristopher Gerardi, Harvey S. Rosen & Paul Willen, Do Households Benefit from Financial Deregulation and Innovation ? The Case of the Mortgage Market 1 (Nat'l Bureau of Econ. Research, Working Paper No. 12967, 2007), available at http://www.nber.org/pa- pers/wl2967 ("Gone are the days when most households got a cookie-cutter, 30-year, fixed-rate, level-payment mortgage....").
164. See Eskridge, supra note 24, at 1124-1127
165. See, e.g., FTC Comment, supra note 66, at 5 (describing the traditional mortgage contract).
166. See Mayer et al., supra note 33, at 33 tbl.2B;
167. see also FTC Comment supra note 66, at 10 n.45 (indicating that, in the few years prior to 2005, over 40 percent of first-time home buyers did not make any down payment at all);
168. Gerardi et al., supra note 29, at 44 tbl.2 (finding-using the HUD-list definition of "subprime" and Massachusetts data-that the average LTV of an initial-purchase subprime loan rose from 0.76 in 1988 to 0.84 in 2007 and that the median LTV rose from 0.80 in 1988 to 0.90 in 2007); Amy Hoak, 100% More Difficult: First-Time Home Buyers Struggle to Find Down-Payment Money, MarketWatch, Mar. 9, 2008, http://www.marketwatch.com/news/story/first-time- home-buyers-struggle-find/story.aspx?guid=%7B4BF19BC0-C4EE-4107-ACFC- F6524E878D5A%7D) (stating that for the period between July 2006 and June 2007, the National Association of Realtors estimated that 45 percent of first-time home buyers opted for 100 percent financing).
169. Mayer et al., supra note 33, at 33 tbl.2B.
170. See Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys., Speech at the Independent Community Bankers of America Annual Convention, Orlando, Florida: Reducing Preventable Mortgage Foreclosures (Mar. 4, 2008), [hereinafter Bernanke March 2008 Speech] (basing this figure on information about loans in securitized pools from First American LoanPerformance). The relevant measure is the combined LTV, which includes both the first- and second-lien mortgages. The first-lien mortgage often has an LTV of 80 percent, but the borrower then takes a second-lien mortgage-a piggyback loan-that further increases the combined LTV. If the first-lien mortgage has an LTV above 80 percent, the borrower is generally required to purchase Private Mortgage Insurance (PMI) to protect the lender from default losses.
171. See U.S. Dep't of Hous. & Urban Dev., PMI Act Information, http://www.hud.gov/offices/hsg/sfh/res/respapmi.cfm (last visited Mar. 13, 2009). The insurance premium for the PMI is often financed through a second mortgage, further increasing the LTV.
172. Mayer et al., supra note 33, at 33 tbl.2B.
173. See Demyanyk & Van Hemert, supra note 1 (manuscript at 7 tbl.l) (counting only non-I/O, nonballoon FRMs);
174. see also Pennington-Cross & Ho supra note 68, at 1 (finding that, between 2003 and 2005, "the ARM market share for securitized subprime loans has ranged from just approximately 60 percent to over 80 percent").
175. See Truth in Lending, 73 Fed. Reg. 44,522, 44,540 (July 30, 2008) (to be codified at 12 C.F.R. pt 226). Many ARMs, including prime ARMs, have a teaser rate in effect until the first rate adjustment, when the ARM rate jumps to the fully indexed (that is, index plus margin) level.
176. Seejoe Peek, A Call to ARMs: Adjustable Rate Mortgages in the 1980s, New Eng. Econ. Rev., Mar.-Apr. 1990, at 47, 54.
177. See Demyanyk & Van Hemert, supra note 1 (manuscript at 7 tbl.l) (reporting the average initial rate, 8.4 percent, and the average margin, 6.1 percent). The average long- term rate is the sum of the margin and the index. The average value of the most popular index, the 6 month LIBOR, was 5.3 percent in 2006.
178. See ARM Index Values-2006 Fannie Mae LIBOR, https://www.efanniemae.com/ sf/refmaterials/libor/index.jsp (last visited Mar. 13, 2009);
179. see also Mayer et al., supra note 33, at 11 (noting that, between 2003 and 2007, the initial (teaser) rate on subprime hybrids rrelatively constant "hover[ing] in the range of 7.5 to 8.5 percentage points" The fully indexed rate was lower than the initial rate in 2003 and early 2004 when short-term interest rates were low.
180. Id. In 2005 the fully indexed rate was nearly 350 basis points above the initial rate.
181. Id. In 2006 and early 2007, the fully indexed rate was closer to 300 basis points above the initial rate.
182. Id.
183. The actual payment shock experienced on 2005 and 2006 2-28 mortgages turned out to be less severe, thanks to relatively low market interest rates and correspondingly low index values in 2007 and 2008, when the interest rates on these loans reset. Still, the average monthly payment increased by more than 10 percent at reset. See Bernanke March 2008 Speech, supra note 77 (stating that even with the currently low LIBOR, a typical reset would raise the monthly payment by more than 10 percent);
184. Paul Willen, Would More Disclosure of Loan Terms Have Helped ? 10 (presentation at FTC Mortgage Conference, May 29, 2008), available at http://www.ftc.gov/be/workshops/mortgage/presentations/willenpaul.pdf (finding that payment shock for a typical subprime borrower in 2007 was 15 percent). Moreover, recent increases in the market interest rate are pushing monthly payments on these mortgages even higher. In any event, contractual design is determined by the ex ante expected payment shock at origination, not by the ex post actual payment shock realized two years later. An industry study assessing, as of December 2006, subprime ARMs originated between 2004 and 2006 calculated an approximate monthly payment increase of $400.
185. See Cagan supra note 25, at 44.
186. See Cagan, supra note 25, at 13 tbl.4 (showing "red" nonsubprime loans with less steep resets than the "orange" subprime loans).
187. See id. at 13 tbl.4 (estimating a 97 percent increase);
188. id. at 44 (estimating payment increases exceeding $1,500).
189. See id. The $42 billion figure covers the entire residential mortgage market, not only the subprime and Alt-A segments, but ARMs and resets were common mainly in these two segments.
190. I/Os are also "option loans" in the sense that the borrower has an option to pay only interest instead of the fully amortized payment.
191. See FTC Comment, supra note 66, at 6-7 ("I/O loans provide for an initial loan period during which borrowers pay only the interest that is accruing on the loan balance. When the initial period expires, the borrower's payments expand to pay both principal and interest.").
192. 88 See id. at 7 (describing hybrid-rate I/O loans as "[particularly popular").
193. See Credit Suisse Report, supra note 29, at 28 (showing that I/O loans constituted $171 billion of the $824 billion in subprime loans);
194. see also Mayer et al supra note 33, at 7 ("Forty percent of Alt-A mortgages involved only interest payments without any scheduled principal repayment (only about 10 percent of subprime mortgages have such an interest- only feature).").
195. FTC Comment, supra note 66, at 7 (footnotes omitted).
196. See id. at 9 ("Generally, when a consumer has made only the minimum payment [on an option ARM], the loan 'negatively amortizes,' so that the amount the person owes is increased by the difference between the interest accruing and the minimum amount paid.").
197. See Cagan, supra note 25, at 56 tbl.30 (finding that, as of December 2006, 22.4 percent of subprime ARMs originated between 2004 and 2006 had zero or negative equity). Another 5 percent drop in house prices, as happened after December 2006, increases the 22.4 percent figure to 36 percent.
198. See Mayer et al., supra note 33, at 13-14;
199. see also Credit Suisse Report supra note 29, at 26, 28 (finding, based on nonagency MBS data, that in 2006, option ARMs comprised approximately 0.5 percent of the subprime market and 30 percent of the Alt-A market).
200. Truth in Lending, 73 Fed. Reg. 44,522, 44,541 (July 30, 2008) (o be codified at 12 GF.R. pc 226) (stating that, according to one estimate, 78 percent of Alt-A originations in 2006 were either I/O or option mortgages). Looking more broadly at the entire residential mortgage market, the Government Accountability Office found that "[f]rom 2003 through 2005, AMP originations grew threefold, from less than 10 percent of residential mortgage originations to about 30 percent Most of the AMPs originated during this period consisted of interest-only and payment-option ARMs." GAO AMP Report, supra note 43, at 3. Likewise, the Mortgage Bankers Association (MBA) noted that "[i] merest only (IO) loans, with both adjustable- and fixed-rates, and payment option loans that allow negative amortization, have become a very important part of the [residential mortgage] market."
201. Fratantoni et al., supra note 37, at 3.
202. See GAO AMP Report, supra note 43, at 14 (describing an example with a 128 percent increase in the monthly payment at the end of the 5-year payment option period);
203. FTC Comment, supra note 66, at 9 (referring to "payment shock"). With an option ARM, the payment increase might occur before the end of the introductory period. The loan contracts allow for negative amortization but set a maximum allowable negative amortization cap of 110 percent or 115 percent. When this cap is reached-and this can happen before the end of the introductory period-monthly mortgage payments will increase.
204. See LaCour-Litde, supra note 31, at 484;
205. FTC Comment, supra note 66, at 9.
206. See Mayer et al., supra note 33, at 7;
207. see also Demyanyk 8c Van Hemert, supra note 1 (manuscript at 7 tbl.l) (showing that in 2006, 71 percent of first-lien subprime loans included a prepayment penalty). Prepayment penalties are most common in hybrid loans: 70 percent of hybrids have prepayment penalties, as compared to FRMs, only 40 percent of which have prepayment penalties.
208. See Pennington-Cross & Ho, supra note 68, at 11-12.
209. See Michael D. Larson, Mortgage Lenders Want a Commitment-and They're Willing to Pay You for It, Bankrate.com, Aug. 26, 1999, http://www.bankrate.com/ brm/news/mtg/ 19990826.asp (describing one contractual design that specifies a penalty of 3 percent of the outstanding balance for prepayment in the first year, a 2 percent penalty for prepayment in the second year, and a 1 percent penalty for prepayment in the third year).
210. Gretchen Morgenson, Inside the Countrywide Lending Spree, N.Y. Times, Aug. 26, 2007, § 3, at 1;
211. see also Eric Stein, Coal, for Responsible Lending, Quantifying the Economic Costs of Predatory Lending 7-9 (2001), available at http://www.responsiblelending.org/pdfs/Quantl0-01.pdf (estimating prepayment penalty revenues at $2.3 billion each year).
212. See Hearing, supra note 1, at 11 (explaining how prepayment penalties "protected lenders from the potential churning of mortgages with very low initial rates");
213. Zywicki & Adamson, supra note 11, at 18 (noting that lenders needed prepayment penalties to recoup their upfront costs because subprime borrowers often financed closing costs and had low introductory rates).
214. See Michael LaCour-Litde & Cynthia Holmes, Prepayment Penalties in Residential Mortgage Contracts: A Cost-Benefit Analysis, 19 Housing Pol'y Debate 631, 635 (2008).
215. See Mayer et al., supra note 33, at 12 ("[P] repayment penalties were scheduled to be in effect after the end of the teaser period for only 7 percent of the subprime short-term hybrids originated from 2003 to 2007, and over these years the share originated with such a provision dropped from 10 to 2 percent.").
216. See Gregory Elliehausen, Michael E. Staten & Jevgenijs Steinbuks, The Effect of Prepayment Penalties on the Pricing of Subprime Mortgages, 60 J. ECON. & BUS. 33, 34 (2008);
217. LaCour-Little & Holmes, supra note 101, at 642;
218. Chris Mayer, Tomasz Piskorski & Alexei Tchistyi, The Inefficiency of Refinancing: Why Prepayment Penalties Are Good for Risky Borrowers 18 (Apr. 28, 2008) (unpublished manuscript), available at http://wwwl.gsb.columbia.edu/mygsb/ faculty/research/pubfiles/3065/Inefficiency%20of%20Refinancing. pdf.
219. See GAO CONSUMER PROTECTION REPORT, supra note 17, at 6, 21 (emphasizing "the complexity of mortgage transactions" and the "greater variety and complexity of risks" associated with subprime loans as compared to prime loans);
220. JAMES M. LACKO & JANIS K. PAP- PALARDO, FED. Trade Comm'n, Improving Consumer Mortgage Disclosures: An Empirical Assessment of Current and Prototype Disclosure Forms, at ES-11 (2007) (explaining that subprime borrowers have more difficulty answering questions about their loans than prime borrowers);
221. Renuart & Thompson, supra note 24, at 196 ("The lender- created complexity of mortgage loans now exceeds what most consumers, even highly educated consumers, are capable of comprehending.");
222. Zywicki & Adamson, supra note 11, at 55-56 (explaining that subprime loans are more complex than prime loans, and that it is more likely that a subprime borrower will misunderstand her loan terms).
223. See Peek, supra note 80, at 53.
224. See supra Part II.A.2.
225. See Elizabeth Renuart, An Overview of the Predatory Mortgage Lending Process, 15 Housing Pol'y Debate 467, 493 (2004).
226. 108 Morgenson, supra note 99. As Morgenson points out, "It's a big business: During the last 12 months, Countrywide did 3.5 million flood certifications, conducted 10.8 million credit checks and 1.3 million appraisals, its filings show."
227. Id.
228. Id.
229. Pamela Reeves, Many Settle for Really Bad Terms to Get a House, Scripps Howard News Service, July 19, 2001;
230. Mortgage Ctr., Inside Scoop-Current Tips: Junk Fees-What You Don't Know Can Hurt You, http://www.mtgctr.com/tips/default.asp?gaid=4 (last visited Apr. 9, 2009).
231. See Renuart, supra note 107, at 493
232. Willis, supra note 4, at 725. According to one- now dated-estimate, financed credit insurance costs borrowers $2.1 billion each year.
233. See Stein, supra note 99, at 5-7.
234. Renuart, supra note 107, at 493.
235. Morgenson, supra note 99.
236. Renuart, supra note 107, at 493.
237. See Willis, supra note 4, at 786;
238. see also HUD-Treasury Report, supra note 11, at 21 (noting origination fees of up to 10 percent of the loan amount, "far exceed[ing] what would be expected or justified based on economic grounds"). According to HUD, borrowers are paying excess fees averaging $700 per mortgage.
239. See News Release, U.S. Dep't of Hous. & Urban Dev., HUD Proposes Mortgage Reform to Help Consumers Better Understand Their Loan, Shop for Lower Costs (Mar. 14, 2008), available at http://www.hud.gov/news/release.cfm?content= pr08-033.cfm. According to Michael Kratzer, founder of FeeDisclosure.com, a website intended to help consumers reduce fees on mortgages, of the estimated $50 billion in transaction fees paid by mortgage borrowers (not only in the sub- prime and Alt-A markets), $17 billion consist of junk fees, like $100 e-mail charges, $75 document preparation fees, and $25 FedEx charges.
240. See Gretchen Morgenson, Clicking the Way to Mortgage Savings, N.Y. Times, Dec. 23, 2007, § 3, at 1. Kratzer estimates that "junk fees" have risen 50 percent in recent years.
241. See Gretchen Morgenson, Given a Shovel, Digging Deeper Into Debt, N.Y. Times, July 20, 2008, at Al.
242. See Willis, supra note 4, at 725. According to one, now dated, estimate, exorbitant fees-defined as fees exceeding 5 percent of the loan amount and fees reflecting no tangible benefit to borrowers-cost borrowers $1.8 billion each year.
243. See Stein, supra note 99, at 7.
244. See Willis, supra note 4, at 725.
245. See supra Part II.A.3.
246. See Freddie Mac, Glossary of Finance and Economic Terms, http://www.freddiemac.eom/smm/g-m.htm#L (last visited Mar. 13, 2009);
247. see also Morgenson, supra note 99 (noting that, in 2006, Countrywide's revenues from late charges amounted to $285 million).
248. See Sumit Agarvval, John C. Driscoll 8c David Laibson, Optimal Mortgage Refinancing: A Closed Form Solution 5-6 (Nat'l Bureau of Econ. Research, Working Paper No. 13487, 2007), available at http://www.nber.org/papers/wl3487.
249. See William C. Apgar, Jr. & Christopher E. Herbert, U.S. Dep't of Hous. & Urban Dev., Subprime Lending and Alternative Financial Service Providers: A Literature Review and Empirical Analysis § 2.2.3 (2006) (describing "the bewildering array of mortgage products available").
250. I do not purport to cover all the design features that appear in the wide variety of subprime mortgages. For example, I did not discuss low-doc and no-doc loans. Unlike the traditional mortgage transaction, many subprime mortgages are based on little or no documentation of income and assets. In 2006, 62.3 percent of first-lien subprime loans were no- doc or low-doc loans. See Demyanyk and Van Hemert, supra note 1 (manuscript at 7 tbl.l);
251. see also Credit Suisse Report, supra note 29, at 4 ("Roughly 50% of all subprime borrowers in the past two years [i.e., 2005-2006] have provided limited documentation regarding their incomes."). Further, "[w]hile many believe that buyers choose to provide limited or no documentation for convenience rather than necessity, a study by the Mortgage Asset Research Institute sampling 100 stated income (low/no documentation) loans found that 60% of borrowers had 'exaggerated' their income by more than 50%."
252. Credit Suisse Report, supra note 29, at 5.
253. See Peek, supra note 80, at 50, 54;
254. see also Zywicki and Adamson, supra note 11, at 5-7 (explaining how legal reform in the early 1980s-specifically the Alternative Mortgage Transaction Parity Act of 1982-lifted severe restrictions on the design of mortgage contracts). Moreover, deferred-cost loans are common in other countries (interest-only mortgages are standard in the United Kingdom) and in other sectors (corporate bonds are designed as interest-only loans).
255. See Credit Suisse Report, supra note 29, at 1 ("Major lenders such as Countrywide, Option One and Wells Fargo have already announced plans to discontinue certain high CLTV and stated income loan programs....");
256. Morgenson, supra note 99 (reporting that on February 23, 2007 Countrywide stopped offering no-doc loans for more than 95 percent of a home's appraised value, and on March 16, 2007 it eliminated piggyback loans);
257. See GAO AMP REPORT, supra note 43, at Abstract ("Federally and state-regulated banks and independent mortgage lenders and brokers market AMPs [mosdy I/O and payment-option loans], which have been used for years as a financial management tool by wealthy and financially sophisticated borrowers. In recent years, however, AMPs have been marketed as an 'affordability' product to allow borrowers to purchase homes they otherwise might not be able to afford with a conventional fixed-rate mortgage.");
258. Mayer et al., supra note 33, at 7 ("[SJubprime borrowers may have turned to these products in an attempt to obtain more affordable monthly payments."). Affordability concerns were especially acute in areas where rapidly rising home prices forced borrowers to take larger loans, which, if they were traditional FRMs, implied larger down payments and higher monthly payments.
259. See Credit Suisse Report, supra note 29, at 29 ("We have long been of the opinion that the current housing downturn is as much a function of deteriorating affordability as an issue of over supply from fleeing investors and aggressive homebuilders.... In order to mitigate the record price increases seen throughout the majority of the country in the first half of this decade, home buyers became increasingly dependant on exotic mortgage products intended to reduce down payments and monthly payments.");
260. FRATANTONI ET AL., supra note 37, at 23 ("IOs in particular allowed borrowers to afford homes in a booming market.");
261. Szu-Yin Kathy Hung & Charles Tu, An Examination of Housing Price Appreciation in California and the Impact of Alternative Mortgage Instruments, 17 J. Housing Res. 33 (2008) (finding that in California increased use of ARMs led to greater housing affordability and high housing-price appreciation during the housing boom in the first half of this decade).
262. The failure to adopt this long-term affordability perspective has been the subject of criticism. In particular, lenders have been criticized for qualifying borrowers who can make the low short-term payments but not the high long-term payments. See Hearing, supra note 1, at 11 ("Some subprime lenders... established borrowers' qualification for mortgages on the basis of initially low teaser rates."). The FRB addresses this concern in its recently adopted TILA amendments. See Truth in Lending, 73 Fed. Reg. 44,522, 44,539 (July 30, 2008) (to be codified at 12 C.F.R. pt. 226) ("TILA Section 129(h), 15 U.S.C. 1639(h), and Regulation Z § 226.34(a)(4) prohibit a pattern or practice of extending credit subject to § 226.32 (HOEPA loans) based on consumers' collateral without regard to their repayment ability. The regulation creates a presumption of a violation where a creditor has a pattern or practice of failing to verify and document repayment ability."). The effect of these regulations, had they come sooner, could have been substantial. In a presentation to investors, Countrywide Financial acknowledged that it would have refused 89 percent of its 2006 borrowers and 83 percent of its 2005 borrowers, representing $138 billion in mortgage loans, had it followed the long-term affordability standards adopted in the FRB's regulations.
263. See Binyamin Appelbaum & Ellen Nakashima, Banking Regulator Played Advocate over Enforcer: Agency Let Lenders Grow out of Control, Then Fail, Wash. Post, Nov. 23, 2008, at Al. Some have blamed the government for the lowering of underwriting standards.
264. See Liebowitz, supra note 26 (manuscript at 3-8) (arguing that policymakers, eager to expand home ownership, especially in lower-income and minority segments, facilitated-even mandated, through threats of Community Reinvestment Act challenges-lower underwriting standards).
265. See Bd. of Governors of the Fed. Reserve Sys. et al., Interest-Only Mortgage Payments and Payment-Option ARMs-Are They for You? 7 (2006), available al hup://www.federalreserve.gov/pubs/mortgage-interestonly/mortgage- interestonly.pdf [hereinafter FRB, Interest Only];
266. see also FTC Comment, supra note 66, at 8 (noting the advantage of alternative mortgage products for "upwardly mobile" borrowers). Empirical evidence confirms that younger households with a college education, and thus better future-income prospects, were more likely to opt for innovative mortgage products with low initial interest rates.
267. See Mark S. Doms & John Krainer, Innovations in Mortgage Markets and Increased Spending on Housing 35 tbl.2, 39 tbl.6 (Fed. Reserve Bank of San Francisco, Working Paper No. 2007-05, 2007), available at http://www.frbsf.org/ publications/economics/papers/2007/wp07-05bk.pdf.
268. The three million estimate is based on the 2,780,000 first-lien subprime loans originated in 2006, see supra Part I.B, multiplied by the 75 percent of hybrid ARMs among subprime loans.
269. See supra Part II.A.2.
270. FRB, Interest Only, supra note 127 (advising borrowers that I/O loans and option ARMs may be suitable for them if they "have irregular income (such as commissions or seasonal earnings) and want the flexibility of making I-O or opdon-ARM minimum payments during low-income periods and larger payments during higher-income periods");
271. see also FTC Comment, supra note 66, at 8 (noting the advantage of alternative mortgage products for borrowers with variable income).
272. gee Paulson, supra note 2. In October 2007, Treasury Secretary Hank Paulson observed, mortgage defaults and foreclosures are rising. While the delinquency rate today is near the 2001 rate, there are over seven times more
273. Id. Recall that for most of the 620,000 subprime foreclosures that Secretary Paulson anticipates, the underlying loan contract was a deferred-cost contract.
274. See infra Part V.C.
275. See Truth in Lending, 73 Fed. Reg. 1672, 1687 (proposed Jan. 9, 2008) (to be codified at 12 C.F.R. pt. 226) ("Consumers may also benefit from loans with payments that could increase after an initial period of reduced payments if they have a realistic chance of refinancing, before the payment burden increases substantially, into lower-rate loans that were more affordable on a longer-term basis. This benefit is, however, quite uncertain, and it is accompanied by substantial risk....");
276. FTC Comment, supra note 66, at 8 ("[B]orrowers who are confident they will sell or refinance their homes for an equal or increased value before the introductory period of the loan expires may benefit from alternative loan options.").
277. See Mayer et al., supra note 33, at 11 ("Industry participants claim that teaser mortgages were never designed as long-term mortgage products. Instead, they argue that the two- or three-year teaser period was designed for consumers with tarnished credit to improve their credit scores by making regular payments....").
278. Prepayment to avoid high post-reset rates was common before the subprime crisis hit and the credit crunch set in. See Pennington-Cross & Ho, supra note 68, at 10 (finding, based on LP data, that hybrid mortgages tend to prepay quickly around the first mortgage reset date);
279. Shane M. Sherlund, The Past, Present, and Future of Subprime Mortgages 10 (Bd. of Governors of the Fed. Reserve Sys., Fin. & Econ. Discussion Series Paper No. 2008-2063, 2008) (finding that "prepayments jump during reset periods").
280. Truth in Lending, 73 Fed. Reg. at 1688. The possibility of refinancing and prepayment provides another explanation for deferred-cost contracts. Assuming that low-risk borrowers will be the first to get attractive refinance offers and prepay, the lender expects her pool of borrowers to become more and more risky over time. The increasing risk justifies increasing interest rates. See Mayer et al. supra note 103, at 12.
281. Similar reasoning explains the prevalence of prepayment penalties: Assume that ex ante all borrowers are identical, and at some point each borrower experiences a credit shock that places the borrower in either the low-risk group or the high-risk group. Borrowers can pay for the prepayment option ex ante, through higher initial rates, before learning which risk group they will belong to. Or the high-risk borrowers can pay for the prepayment option that the low-risk borrowers exercise through higher long-term rates. A third alternative would have the low-risk borrowers who exercise the prepayment option pay for it through prepayment penalties. This third option provides valuable insurance against a bad realization of the credit shock. See id. at 12-13.
282. Arguably this is the situation in the prime market, where prepayment penalties are less common.
283. See supra Part II.A.3.
284. 137 See LaCour-Litde & Holmes, supra note 101, at 662 (comparing 2-28 ARMs with lower initial rates and prepayment penalties to 2-28 ARMs with higher initial rates and without prepayment penalties, and finding that the total interest-rate savings is significantly less than the amount of the expected prepayment penalty).
285. Other studies find that adding a prepayment penalty leads to no reduction in ex ante interest rates and is, in fact, associated with higher ex ante interest rates. See Engel and McCoy, supra note 47, at 2060.
286. I focus on the effects of home-price trends and expectations about home-price trends. A similar argument can be made about market interest rates and expectations about market interest rates.
287. Mayer et al., supra note 33, at 19 (reporting the shares of loans originated on investment properties in the subprime and Alt-A markets).
288. Professor Todd Sinai articulated this strategy nicely: There's a whole lot of people who would've been stuck as renters without these exotic loan products. Now it's like they can do their renting from the bank, and if house values go up, they become the owner. If they go down, you have the choice to give the house back to the bank. You aren't any worse off than renting, and you got a chance to do extremely well. If it's heads I win, tails the bank loses, it's worth the gamble. John Leland, Facing Default, Some Abandon Homes to Banks, N.Y. Times, Feb. 29, 2008, at Al (reporting the statement by Professor Sinai).
289. Professor Sinai focuses on purchase loans. See, N.Y. Times id.
290. Nevertheless, it should be noted that the speculation explanation applies to refinance loans as well. Adopting the "heads-borrower wins, tails-lender loses" strategy is rational for borrowers but not for lenders. The speculation explanation is incomplete absent an account of lenders' incentives. Why did lenders play along? Agency problems- within lending institutions and among the different parties in the securitization process- provide one set of answers. See supra note 14 and accompanying text.
291. See supra note 14 and accompanying text. Another set of answers recognizes that lenders enjoyed a substantial portion of the upside benefit. In many cases, an increase in housing prices led to refinancing by the same lender. See Gorton, supra note 14, at 4-5.
292. 141 See 2 Michael T. Madison, Jeffry R. Dwver, & Steven W. Bender, The Law of Real Estate Financing § 12:69 (rev. ed. 2008). A full list of state laws is available at http://www.foreclosurelaw.org/.
293. For further discussion, see Zywicki & Adamson, supra note 11, at 29 n.134 ("It is difficult to estimate exactly how many states have antideficiency laws as foreclosure rules vary a great deal from state to state, but an approximation may be about fifteen to twenty states, including many larger states.").
294. 142 See Zywicki & Adamson, supra note 11, at 30.
295. See Ellen Schloemer et al., Ctr. For Responsible Lending, Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners 16 (2006), available at http://www.responsiblelending.org/pdfs/foreclosure-paper-report-2- 17.pdf (estimating, based on a dataset including loans originated between 1998 and 2006 on owner- occupied homes, that 2.2 million will lose their homes to foreclosure, and they will lose a total of $164 billion, which translates into approximately $75,000 per borrower; this estimate assumes that borrowers hold relatively high equity levels, and is therefore probably excessive);
296. Bernanke March 2008 Speech, supra note 77 ("A recent estimate [of foreclosure-related costs] based on subprime mortgages foreclosed in the fourth quarter of 2007 indicated that total losses exceeded 50 percent of the principal balance, with legal, sales, and maintenance expenses alone amounting to more than 10 percent of principal.").
297. The- upside benefit is also not as straightforward as implied in the initial description. Sale and refinancing involve transaction costs and, in many cases, also prepayment penalties. Moreover, even with increasing house prices, a borrower may be left with low or negative equity, the result of high initial LTVs and slow-zero or even negative-amortization, severely reducing sale and refinancing options. But, again, this only means that a rational speculator must have expected a substantial increase in house prices-an increase sufficient to outweigh the costs and difficulties of sale and refinancing.
298. Robert J. Shiller, Understanding Recent Trends in House Prices and Home Ownership 4-5 (Yale Univ. Econ. Dep't, Working Paper No. 28, 2007), available at http://www.econ.yale.edu/ddp/ddp25/ddp0028.pdf.
299. Hearing, supra note 1, at 10. One indicator, cited by both the CBO and Shiller, that housing prices were high relative to underlying fundamentals, particularly in 2005-2006, was the ratio of housing prices to rents.
300. CBO Outlook, supra note 2, at 8;
301. Shiller, supra note 145, at 4-5.
302. On the limits of this indicator, see Jonathan McCarthy & Richard W. Peach, Are Home Prices the Next 'Bubble'?, Fed. Res. Bank N.Y. Econ. Pol'yRev., Dec. 2004, at 1, 7-8;
303. Housing Price-Rental Ratios, http://cboblog.cbo.gov/?p=52 (Dec. 21, 2007, 05:38 EST).
304. Rational speculation is more plausibly attributed to the Wall Street banks that securitized and sold the MBSs. Additionally, the banks' sophisticated clients who purchased these MBSs may have also been rational speculators. And there is reason to believe that even these sophisticated parties were making irrational assessments.
305. See Hearing supra note 1, at 11 ("[T]he rating agencies appear to have miscalculated the risks of some securities backed by subprime loans, and they may have unduly emphasized the unusual period of appreciating prices.").
306. 148 See Karl E. Case & Robert J. Shiller, The Behavior of Home Buyers in Boom and Post- Boom Markets, New. Enc. Econ. Rev., Nov.-Dec. 1988, at 29;
307. see also Karl E. Case & Robert J. Shiller, Is There a Bubble in the Housing Market?, 2003 Brookincs Papers on Econ. Activity, No. 2, at 299;
308. Robert J. Shiller, Speculative Prices and Popular Models, J. Econ. Persp., Spring 1990, at 55, 58-61.
309. Moreover Case and Shiller found that many home buyers believe that home prices cannot decline. Id. at 59.
310. Case and Shiller repeated their study for the recent housing bubble, obtaining similar results. See Karl E. Case, Robert J. Shiller, Home Buyer Survey Results 1988-2006 (unpublished paper, Yale University, 2006);
311. See Christopher Mayer & Todd Sinai Housing; Behavioral Finance (Sept. 25 2007) (unpublished manuscript), available at http://real.wharton.upenn.edu/- sinai/papers/Housing-Behavioral-Boston-Fed-v9.pdf. In addition, Christopher Mayer and Todd Sinai found that "the lagged five-year average of house price growth is positively associated with increases in the price-rent ratio." see also Shiller, supra note 145, at 11. These survey results are also supported by evidence of borrower behavior. In particular, home buyers extend themselves more-via higher LTVs and higher payment-to-income ratios-when buying a home in markets with high historical appreciation rates.
312. See id. at 22. On the other hand, contrary to the Case-Shiller survey results, Mayer and Sinai find that the prior year's house-price growth does not affect the price-rent ratio.
313. Id. at 23. Mayer and Karen Pence found that "[a] one standard deviation increase in house price appreciation in [2004] is associated with a 39 percent increase in subprime loans [in 2005].".
314. Christopher J. Mayer & Karen Pence, Sub- prime Mortgages: What, Where, and to Whom? 13 (Nat'l Bureau of Econ. Research, Working Paper No. 14083, 2008), avaifaife 〈rthttp://ssrn.com/abstract=l 149330. Since it is a lagged appreciation variable that is correlated with the increase in subprime originations, this finding is consistent with a behavioral story that demand for subprime loans was driven by expectations of future house-price appreciation based on extrapolation from past trends.
315. This is consistent with a leading economic theory of bubbles, which posits the existence of both rational and irrational traders. See]. Bradford De Long et al., Noise Trader Risk in Financial Markets, 98 J. Pol. Econ. 703, 705 (1990);
316. J. Bradford De Long et al., Positive Feedback Investment Strategies and Destabilizing Rational Speculation, 45 J. Fin. 379, 380 (1990);
317. Andrei Shleifer & Lawrence H. Summers, The Noise Trader Approach to Finance, J. Econ. Persp., Spring 1990, at 19, 28-29;
318. see also Robert J. Shiller, Irrational Exuberance 60-64 (2000) (developing a market-psychological theory of bubbles).
319. See Peek, supra note 80, at 48.
320. 151 See Mark D. Shroder, The Value of the Sunshine Cure: The Efficacy of the Real Estate Settlement Procedures Act Disclosure Strategy, 9 Cityscape:J. Pol'y Dev. & Res., No.1, at 73, 84 (2007) (noting, for example, that the cost of obtaining a credit report, "a standard national, largely automated, service" is typically about $50, yet credit report fees range from $25 to $100).
321. Richard K. Green & Susan M. Wachter, The American Mortgage in Historical and International Context, J. Econ. Persp., Fall 2005, at 93, 101.
322. A more sophisticated rational-choice explanation recognizes that complexity-of a single product and of the array of offered products-increases the cost of shopping. When shopping costs more, the rational borrower will shop less. Since shopping creates a positive externality, there is a risk that the market will produce an inefficiently high level of complexity.
323. See infra Part IV.C.
324. In theory, the demand generated by rational borrowers, even if they are a minority, could determine the contractual design of all mortgage contracts, including those offered to imperfectly rational borrowers. Cf. Alan Schwartz & Louis L. Wilde, Intervening in Markets on the Basis of Imperfect Information: A Legal and Economic Analysis, 127 U. Pa. L. Rev. 630, 633-634 (1979) (noting that courts and legislatures often determine and enforce purchase terms based on their conception of rational consumer preferences).
325. This theory assumes that lenders cannot, or cannot efficiently, discriminate between the two groups of borrowers and offer different contracts to the different groups. This assumption is unrealistic in the subprime and Alt-A mortgage markets. Note that, to exercise such discrimination, lenders need not identify in advance the rational borrowers and the imperfectly rational borrowers. Instead, lenders only need to offer two sets of contracts-one attractive to rational borrowers and the other attractive to imperfectly rational borrowers-and let the borrowers self-select. See Bar-Gill & Warren, supra note 18, at 35-36 (describing a market experiment in which a bank "offered consumers a choice between two credit card contracts: one with an annual fee and a lower interest rate, and one with no annual fee and a higher interest rate").For a good, early behavioral analysis of mortgage-market imperfections, see Eskridge, supra note 24, at 1112-1118 (arguing that the high stress involved in the home-buying and mortgage-borrowing process leads many buyers-borrowers to acquire insufficient information and to make suboptimal choices).
326. Eskridge also discusses the influence of agents-brokers whose interests are not aligned with those of the buyers, arguing that these agents- brokers take advantage of buyers' imperfect information and imperfect rationality. See id. at 1118-1123.
327. The CBO has recently suggested that "[t]he rise in defaults of subprime mortgages may also reflect the fact that some borrowers lacked a complete understanding of the complex terms of their mortgages and assumed mortgages that they would have trouble repaying." Hearing, supra note 1, at 13.
328. Further, "[c]ertain ARMs may have been among the more difficult mortgages for first-time borrowers to understand. Many of those mortgages made in recent years included teaser rates, which may have confused some borrowers about the eventual size of their mortgage payments when their mortgage rates were reset." Id. at 21 n.3.
329. Time discounting is ignored for simplicity.
330. 159 Cf. David Miles, The U.K. Mortgage Market: Taking a Longer-Term View, Interim Report: Information, Incentives and Pricing 3 (2003), available at http://www.hm-treasury.gov.uk/consult-miles-index.htm (noting that borrowers tend to focus disproportionately on the initial, rather than the long-term, cost of a loan);
331. Monica Paiella & Alberto Franco Pozzolo, Choosing Between Fixed and Adjustable Rate Mortgages 1 (Mar. 26, 2007) (unpublished manuscript), available at http://ssrn.com/abstract=976346 (finding, based the Bank of Italy's Survey of Household Income and Wealth, that "ARM holders do not fully take into account the risk of a rise of the reference interest rates. On the other hand, lenders price quite expensively this risk and borrowers end up paying a high price for the benefit of low initial payments.").
332. An especially troubling manifestation of myopia is the problem of insufficient saving for retirement. See Brigitte C. Madrian & Dennis F. Shea, The Power of Suggestion: Inertia in 40I(k) Participation and Savings Behavior, 116 Q.J. Econ. 1149, 1150 (2001) (documenting the problem of insufficient saving for retirement);
333. Deborah M. Weiss, Paternalistic Pension Policy: Psychological Evidence and Economic Theory, 58 U. Chi. L. Rev. 1275, 1275 (1991) ("Left to their own devices, many people will not save enough for their old age.").
334. See Rick Brooks & Ruth Simon, Subprime Debacle Traps Even Very Credit-Worthy: As Housing Boomed, Industry Pushed Loans to a Broader Market, Wall St. J., Dec. 3, 2007, at Al ("During the housing boom, the lower introductory rate on adjustable-rate mortgages made them feel closer in cost to regular loans to many subprime borrowers, but those rates can jump after two or three years. Brokers had extra incentives to sell those loans, which have terms that often are confusing to borrowers."). The term "payment shock," used to describe the experience of a borrower who has seen his interest rate reset and his monthly payment increase, implies a less than perfect understanding of this contractual design feature. The term "payment shock" is used, for example, by the FRB and the FTC. See Fed. Reserve Bd., Consumer Handbook on Adjustable Rate Mortgages 20 (2006), available at http://www.federalreserve.gov/pubs/arms/arms-english.htm;
335. FRB, Interest Only, supra note 127; FTC Comment, supra note 66, at 9.
336. See Ola Svenson, Are We All Less Risky and More Skillful than Our Fellow Drivers?, 47 Acta Psychologica 143, 143 (1981) (describing a study revealing that the majority of people "regard themselves as more skillful and less risky than the average driver");
337. Neil D. Weinstein, Unrealistic Optimism About Future Life Events, 39 J. Personality & Soc. Psychol. 806, 806 (1980) (describing two studies revealing that people tend to be unrealistically optimistic about future life events);
338. see also In re Eashai, 87 F.3d 1082, 1090 (9th Cir. 1996) ("[W]e recognize the fragility of human nature. '[H]uman experience tells us debtors can be unreasonably optimistic despite their financial circumstances.'" (quoting In re Cox, 182 B.R. 626, 635 (Bankr. D. Mass. 1995)));
339. Teresa A. Sullivan, Elizabeth Warren & Jay Lawrence Westbrook, The Fragile Middle Class: Americans in Debt 114 (2000) ("The recently unemployed, hopeful that they will be back at work in a matter of days or weeks, may not be prepared to tell the children there will be no new soccer shoes this season or no back-to-school clothes.").
340. See Truth in Lending, 73 Fed. Reg. 44,522, 44,542 (July 30, 2008) (to be codified at 12 C.F.R. pt. 226) ("In addition, originators may sometimes encourage borrowers to be excessively optimistic about their ability to refinance should they be unable to sustain repayment. For example, they sometimes offer reassurances that interest rates will remain low and house prices will increase; borrowers may be swayed by such reassurances because they believe the sources are experts.");
341. see also Complaint, People v. Countrywide Fin. Corp. (Cal. Super. Ct. June 24, 2008) (claiming that Countrywide encouraged borrowers to take complex hybrid and option ARMs by emphasizing low teaser rates and misrepresenting long-term costs) (the complaint, the California settlement, signed by the California Attorney General on October 6, 2008, and the Multistate Settlement Term Sheet, signed by the Attorneys General of Arizona, Connecticut, Florida, Illinois, Iowa, Michigan, Nevada, North Carolina, Ohio, and Texas, can be found at http://www.consumerlaw.org/unre-ported);
342. Gretchen Morgenson, Countrywide Subpoenaed by Illinois, N.Y. Times, Dec. 13, 2007, at CI (stating that the Illinois Attorney General sued a Chicago mortgage broker and is investigating Countrywide Financial, the broker's primary lender, for abusive lending practices, specifically pushing borrowers into payment-option ARMs by emphasizing the low short-term payments and deemphasizing the high long-term costs).
343. 164 See supra Pan III.A.1.
344. See supra Part 1II.A.2. Cf. Robin Greenwood & Stefan Nagel, Inexperienced Investors and Bubbles (Nat'l Bureau of Econ. Research, Working Paper No. 14111, 2008), available at http://www.nber.org/papers/wl4111 (arguing that less experienced investment managers were more likely to exhibit irrational trend-chasing behavior).
345. See Richard H. Thaler, Mental Accounting Matters, 12J. Behav. Decision Making 183, 194 (1999) (Finding that small disaggregated fees are ignored).
346. cf. Truth in Lending, 73 Fed. Reg. at 44,525-526
347. See GAO AMP Report, supra note 43, at Abstract ("Regulators and others are concerned that borrowers may not be well-informed about the risks of AMPs, due to their complexity and because promotional materials by some lenders and brokers do not provide balanced information on AMPs benefits and risks.");
348. FTC Comment, supra note 66, at 14 ("[F]or loans with more complexity-such as nontraditional mortgages-consumers face further challenges in understanding all significant terms and costs.").
349. For over five years, HUD has been working on reforming the home buying process, specifically through increased transparency regarding closing costs. See Mary McGarity, Closing Nirvana, Mortgage Banking, Aug. 2005, at 32 (quoting HUD Secretary Alphonso Jackson as saying, "Buying a home today is too complicated, confusing and costly.... Each year Americans spend approximately $55 billion on closing costs they don't fully understand.").
350. See Bar-Gill, Consumer Contracts, supranote 18, at 771-78;
351. see also Willis, supra note 4, at 725-726 (describing how "a lender can creatively manipulate each component of the price of a loan to effect a desired predicted return")
352. See Brian Bucks & Karen Pence, Do Homeowners Know Their House Values and Mortgage Terms? 1 (Bd. of Governors of the Fed. Reserve Sys., Fin. & Econ. Discussion Series Paper No. 2006-3, 2006), available at http//www.federalreserve.gov/Pubs/feds/2006/200603/200603pap.pdf (noting that ARM borrowers "appear to underestimate or not know how much their interest rates could change").
353. A series of recent papers in industrial organization argue that firms introduce spurious complexity into tariff structures and by doing so inhibit competition and reduce welfare. See, e.g., Glenn Ellison, A Model of Add-On Pricing, 120 Q.J. Econ. 585 (2005);
354. Xavier Gabaix, David Laibson, Shrouded Attributes Consumer Myopia and Information Suppression in Competitive Markets 121 Q.J. Econ. 505 (2006)
355. Ran Spiegler, Competition over Agents with Boundedly Rational Expectations, 1 Theoretical Econ. 207 (2006);
356. Glenn Ellison & Sara Fisher Ellison, Search, Obfuscation, and Price Elasticities on the Internet (Nat'l Bureau of Econ. Research, Working Paper No. 10570, 2004), available at http://www.nber.org/papers/wl0570.pdf.
357. See Howard Lax et al., Subprime Lending: An Investigation of Economic Efficiency, 15 Housing Pol'y Debate 533, 544-546 (2004) (noting that subprime borrowers tend to be less educated and less sophisticated about the mortgage market).
358. Sumit Agarwal et al., Can Mandated Financial Counseling Improve Mortgage Decision- Making? Evidence from a Natural Experiment 27 (Fisher Coll. of Bus., Working Paper No. 2008-03-019, 2009), available at http://ssrn.com/abstract= 1285603.
359. This study also found that the mandated financial counseling led to a decline in the demand for credit. Id. at 3;
360. see also Robert J. Shiller, The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do About It 124 (2008) (noting that most people need to be financially educated);
361. Annamaria Lusardi, Household Saving Behavior: The Role of Financial Literacy, Information, and Financial Education Programs 2 (Nat'l Bureau of Econ. Research, Working Paper No. 13824, 2008), available at http://www.nber.org/ papers/wl3824 (arguing that households enter into risky financial contracts due to lack of financial education).
362. See LACKO & Pappalardo, supra note 104, at ES-6 (demonstrating the limits of mortgage disclosures and noting that many borrowers "did not understand important costs and terms of their own recently obtained mortgages. Many had loans that were significantly more costly than they believed, or contained significant restrictions, such as prepayment penalties, of which they were unaware.");
363. Bucks & Pence, supra note 170.
364. See James M. Lacko & Janis K. Pappalardo, Fed. Trade Comm'n, The Effect of Mortgage Broker Compensation Disclosures on Consumers and Competition: A Controlled Experiment, at ES-7 (2004).
365. 176 See Sumit Agarwal et al., The Age of Reason: Financial Decisions over the Lifecycle 9-11 (Oct. 21, 2008) (unpublished manuscript), available at http://ssrn.com/ abstract=973790.
366. 177 See Susan E. Woodward, Consumer Confusion in the Mortgage Market (July 14, 2003) (unpublished manuscript), available at www.sandhillecon.com/pdf/ consumer-con-fusion.pdf;
367. see also John Y. Campbell, Household Finance, 61 J. Fin., 1553, 1589 (2006) (citing Woodward, supra).
368. 178 See Campbell, supra note 177, at 1579, 1581, 1590;
369. LaCour-Little & Holmes, supra note 101, at 644 (describing the "apparent irrationality on the part of mortgage borrowers, who fail to default to the extent predicted when house prices fall and fail to prepay to the extent predicted when interest rates fall");
370. Agarwal et al., supra note 120, at 3 (surveying evidence that borrowers fail to make optimal refinancing decisions);
371. Robert Van Order, Simon Firestone & Peter Zorn, The Performance of Low Income and Minority Mortgages (Ross Sch. of Bus., Working Paper No. 1083 (2007) available at http://ssrn.com/abstract=1003444. Similar mistakes have been identified in the U.K.
372. See Miles, supra note 159, at 33; Campbell, supra note 177, at 1588. Others have argued that apparently irrational refinancing patterns can be explained within a rational-choice framework that allows for heterogeneous transaction costs and accounts for relocation and liquidity motives.
373. See Michael LaCour-Little, Another Look at the Role of Borrower Characteristics in Predicting Mortgage Prepayments, 10 J. Housing Res. 45, 47 (1999) (emphasizing the role of transaction costs and relocation and liquidity motives);
374. Richard Stanton, Rational Prepayment and the Valuation of Mortgage-Backed Securities, 8 Rev. Fin. Stud. 677, 681, 706 (1995) (arguing that heterogeneous transaction costs and exogenous factors such as divorce and sudden unemployment can explain seemingly irrational refinancing behavior). The problem of deriving the optimal time for prepayment is a complex one, and it can only be solved numerically with the help of high-powered computers. Recently, Agarwal and his colleagues have shown that the optimal prepayment decision can be approximated using an implementable formula.
375. Agarwal et al., supra note 120, at 5-6.
376. See Agarwal et al., supra note 120, at 25 ("[M]arket data... shows that many households did refinance too close to the NPV break-even rule during the last 15 years...."). Following the NPV rule, instead of the optimal-refinancing rule, leads to substantial expected losses: $26,479 on a $100,000 mortgage, $49,066 on a $250,000 mortgage, $86,955 on a $500,000 mortgage, $163,235 on a $1,000,000 mortgage.
377. Id. at 28 tbl.5.
378. See Mayer et al., supra note 33, at 16 (noting that "2 percent of outstanding loans in the 2007 vintage were in default within six months of origination, and 8 percent were in default after 12 months").
379. See Richard Stanton, Rational Prepayment and the Valuation of Mortgage-Backed Securities, 8 Rev. Fin. Stud. 677, 681, 706 (1995) id. Other early defaulters were rational speculators, who stopped paying when house prices stopped rising.
380. Richard Stanton, Rational Prepayment and the Valuation of Mortgage-Backed Securities, 8 Rev. Fin. Stud. 677, 681, 706 (1995) Id.
381. Seejames H. Carr & Lopa Kolluri, Predatory Lending: An Overview, in Financial Services in Distressed Communities: Issues and Answers 31, 37 (2001) (recording estimates by Freddie Mac and Fannie Mae that between 35 percent and 50 percent of borrowers in the subprime market could qualify for prime market loans);
382. Lew Sichelman, Community Group Claims CitiFinancial Still Predatory, Origination News, Jan. 2002, at 25 (reporting that, in 2002, researchers at Citibank concluded that at least 40 percent of those who were sold high interest rate, subprime mortgages would have qualified for prime-rate loans);
383. see also Willis, supra note 4, at 730;
384. Morgenson, supra note 99, at 9 (recounting that in December 2006, in an agreement with the New York State Attorney General, Countrywide agreed "to compensate black and Latino borrowers to whom it had improperly given high-cost loans in 2004").
385. Woodward, supra note 177, at 2.
386. Truth in Lending, 73 Fed. Reg. 44,522, 44,525-526 (July 30, 2008) (to be codified at 12 C.F.R. pt. 226) ("Consumers who do not fully understand such terms and features, however, are less able to appreciate their risks, which can be significant For example, the payment may increase sharply and a prepayment penalty may hinder the consumer from refinancing to avoid the payment increase. Thus, consumers may unwittingly accept loans that they will have difficulty repaying.").
387. 185 See Hearing, supra note 1, at 13;
388. see also GAO Consumer Protection Report, supra note 17, at 14 (describing borrowers "who lack sophistication about financial matters, are not highly educated, or suffer physical or mental infirmities").
389. See, e.g., Bucks & Pence, supra note 170, at 19-20 (finding that many borrowers do not even know that they have an ARM rather than a FRM).
390. Cf. Philip Bond, David K. Musto & Bilge Yilmaz, Predatory Mortgage Lending 3 (Fed. Reserve Bank of Phila., Working Paper No. 08-24, 2008), available at http://ssrn.com/abstract=1288094 (demonstrating that "a realistic information asymmetry between borrowers and lenders is enough to generate [predatory mortgage lending] and can explain (at least qualitatively) when and where it occurs").
391. Not all individuals make mistakes. In theory, even a minority of informed, sophisticated borrowers will induce sellers to offer welfare-maximizing products and contracts. See Alan Schwartz & Louis L. Wilde, Imperfect Information in Markets for Contract Terms: The Examples of Warranties and Security Interests, 69 Va. L. Rev. 1387 (1983);
392. Schwartz & Wilde, supra note 155;
393. Alan Schwartz & Louis L. Wilde, Product Quality and Imperfect Information, 52 Rev. Econ. Stud. 251, 251-252 (1985). The informed-minority argument has only limited relevance in the subprime mortgage market, where lenders can segment the market, offering different contracts to sophisticated and less-sophisticated borrowers.
394. See Bar-Gill & Warren, supra note 18, at 22-23;
395. Eskridge, supra note 24, at 1141-1143
396. See Truth in Lending, 73 Fed. Reg. 1672, 1676 (proposed Jan. 9, 2008) (to be codified at 12 C.F.R. pt. 226) ("Disclosures themselves, likely cannot provide this minimum understanding for transactions that are complex and that consumers engage in infrequently.");
397. Shlomo Benartzi & Richard H. Thaler, Heuristics and Biases in Retirement Savings Behavior,]. Econ. Persp., Summer 2007, at 81.
398. Experimental evidence suggests that while learning is generally effective in minimizing mistakes, biases in relatively abstract domains like math and finance are more resilient. See Heuristics and Biases: The Psychology of Intuitive Judgment (Thomas Gilovich et al. eds., 2002);
399. Keith E. Stanovich, The Fundamental Computational Biases of Human Cognition: Heuristics that (Sometimes) Impair Decision Making and Problem Solving, in The Psychology of Problem Solving 291 (Janet E. Davidson & Robert J. Steinberg eds., 2003);
400. see also Victor tango & Jonathan Zinman, Exponential Growth Bias and Household Finance, J. FIN. (forthcoming) (manuscript at 1-2), available at http://ssm.com/abstract=1081633 (documenting the "exponential growth biases" that lead borrowers to underestimate both borrowing costs and returns to savings);
401. Sumit Agarwal et al., Do Consumers Choose the Right Credit Contracts? (Fed. Reserve Bank of Chi., Working Paper No. 2006-11, 2006) (discussing how systematic and costly consumers' mistakes are in practice);
402. Agarwal et al., supra note 176 (discussing the diminished returns from learning about finances).
403. In the real estate brokerage market, there has been a recent shift, aided by legal changes, from seller agency to buyer agency. See Ronald Benton Brown, Joseph M. Grohman & Manuel L. Valcarcel, Real Estate Brokerage: Recent Changes in Relationships and a Proposed Cure, 29 Creighton L. Rev. 25 (1995) (describing this shift);
404. Christopher Curran & Joel Schrag, Does It Matter Whom an Agent Serves? Evidence from Recent Changes in Real Estate Agency Law, 43 J.L. & Econ. 265, 265-271 (2000) (describing the evolution and effects of a market for buyers' agents in Atlanta, following a 1994 change in Georgia's real estate
405. See Agarwal et al., supra note 120, at 24-25 ("Most of the advice boils down to the following necessary condition for refinancing-only refinance if you can recoup the closing costs of refinancing in reduced interest payments.... None of the 15 books and 10 web sites in our sample discuss (or quantitatively analyze) the value of waiting due to the possibility that interest rates might continue to decline.");
406. cf. Michael S. Haigh & John A. List, Do Professional Traders Exhibit Myopic Loss Aversion? An Experimental Analysis, 60 J. FIN. 523 (2005) (documenting biased decisions by financial professionals despite ample opportunities for learning).
407. See Bar-Gill, Consumer Contracts, supra note 18, at 758-761
408. Id. at 769-770
409. See supra Part 1.
410. This phenomenon is evidenced by the number of loan originators that have gone out of business during the recent crisis. See Worth Civils & Mark Gongloff, Subprime Shakeout: Lenders that Have Closed Shop, Been Acquired or Stopped Loans, Wall St. J. Online, http://online.wsj.com/public/resources/ documents/info-subprimeloans0706-sort.html (last visited Mar. 30, 2009) (listing eighty loan originators that closed or filed for bankruptcy between November 2006 and September 2007).
411. See Engel & McCoy, supra note 47, at 2041 ("[Securitization funds small, thinly capitalized lenders and brokers, thus enabling them to enter the subprime market. These originators are more prone to commit loan abuses because they are less heavily regulated, have reduced reputational risk, and operate with low capital, helping to make them judgment-proof."). So, while securitization reduces entry barriers and thus enhances competition, it is not clear that this enhanced competition is welfare enhancing.
412. 198 See Paulson, supra note 2 ("Homebuyers today have more choices than ever before in finding a mortgage that best suits their circumstances. Yet, comparing the attractiveness of one mortgage product to another can be difficult.");
413. see also Susan Block-Lieb & Edward J. Janger, The Myth of the Rational Borrower: Rationality, Behavioralism, and the Misguided "Reform" of Bankruptcy Law, 84 Tex. L. Rev. 1481, 1530, 1539-1540 (2006);
414. Engel & McCoy, supra note 47, at 2080;
415. Willis, supra note 4, at 726 (describing the increased complexity of mortgage products, and arguing that borrowers face a "bewildering array" of home loan products (citing Jinkook Lee & Jeanne M. Hogarth, The Price of Money: Consumers'Understanding ofAPRs and Contract Interest Rates, 18J. Pub. Pol'y & Marketing 66, 67 (1999)));
416. Zywicki & Adamson, supra note 11, at 70-71 (noting that, while standardization and transparency provide for easy comparison shopping and foster competition in the prime market, the same is not true of the subprime market, where lack of standardization and complexity impede comparison shopping and hinder competition). Since borrowers cannot value the different loan options, they are susceptible to skewed advertising that selectively emphasizes certain dimensions of the loan contract.
417. See FTC Comment, supra note 66, at 3-4 (describing FTC enforcement actions, taken when lenders' and brokers' advertisements and oral sales pitches were inconsistent with the offered contracts). The success of such advertising proves the imperfect information, imperfect rationality of borrowers, or both.
418. 199 See Susan E. Woodward, U.S. Dep't of Hous. & Urban Dev., A Study of Closing Costs for FHA Mortgages (2008). The Woodward study finds that complexity and multidimensionality of origination fees prevent effective shopping, hinder competition, and lead to inflated prices; it further analyzes more than 7,500 FHA-insured thirty-year fixed- rate home purchase loans with a 7 percent coupon rate closed in May and June of 2001. These were not the typical subprime loans but loans than often target similarly high-risk borrowers. According to HUD, borrowers are paying excess fees averaging around $700 per mortgage, and these excess fees can be eliminated by improved disclosure that would enhance competition.
419. See News Release, U.S. Dep't of Hous. & Urban Dev., supra note 115.
420. See Engel & McCoy, supra note 47, at 2058;
421. Howard Lax et al., Subprime trending: An Investigation of Economic Efficiency, 15 Housing Pol'y Debate 533 (2004) (arguing that sub- prime interest rates cannot be justified by risk alone);
422. see also Stein, supra note 99 (valuing the cost to borrowers of excess interest at $2.9 billion).
423. See Freddie Mac, Automated Underwriting: Making Mortgace Lending Simpler and Fairer for America's Families ch. 5 (1996), available at http://www.freddiemac.com/ corporate/reports/moseley/chap5.htm (reporting that 10 to 35 percent of subprime borrowers would qualify for lower cost conventional loans);
424. Freddie Mac, Half of Subprime Loans Categorized as 'A' Quality, Inside B&C Lending, June 10, 1996 (describing a poll of fifty subprime lenders who estimated that half of subprime borrowers could have qualified for prime loans);
425. Fannie Mae Has Played Critical Role in Expansion of Minority Homeownership Over Past Decade; Raines Pledges to Lead Market for African American Mortgage Lending, Bus. Wire, Mar. 2, 2000, LexisNexis Academic (noting that up to half of subprime borrowers would qualify for lower-cost conventional loans);
426. see also Bar-Gill 8c Warren, supra note 18, at 38-40;
427. Engel and McCoy, supra note 47, at 2058 n.92;
428. Ass'n of Cmty. Orgs, for Reform Now (ACORN), Many Borrowers in Subprime Loans Should Have Qualified for a Lower Cost Loan, ACORN.org, http://www.acorn.org/index.php?id=114. The Wall Street Journal.
429. Brooks & Simon, supra note 161
430. Gretchen Morgenson, writing for the New York Times, made a similar observation: On its way to becoming the nation's largest mortgage lender, the Countrywide Financial Corporation encouraged its sales force to court customers over the telephone with a seductive pitch that seldom varied. "I want to be sure you are getting the best loan possible," the sales representatives would say. But providing "the best loan possible" to customers wasn't always the bank's main goal, say some former employees.... Countrywide's entire operation, from its computer system to its incentive pay structure and financing arrangements, is intended to wring maxi-mum profits out of the mortgage lending boom no matter what it costs borrowers, according to interviews with former employees and brokers who worked in different units of the company and internal documents they provided. One document, for instance, shows that until last September the computer system in the company's subprime unit excluded borrowers' cash reserves, which had the effect of steering them away from lower-cost loans to those that were more expensive to homeowners and more profitable to Countrywide.
431. Morgenson, supra note 99.
432. See Morgenson, supra note 99 (explaining that internal Countrywide documents and testimonies of former employees reveal larger profit margins on subprime loans as compared to prime loans and especially large margins on loans with high prepayment penalties and high go-to rates. As a result, the commission structure rewarded brokers and sales representatives who sold subprime loans, including to borrowers who qualified for Alt-A loans, loans with higher and longer prepayment penalties, and loans with higher goto rates). Evidence refutes the alternative hypothesis that the relative increase n subprime loans reflects an increase in borrower risk.
433. See LaCour-Little, supra note 31, at 490-93 (showing empirically, through assessment of the two most common risk indicators-the FICO score and LTV-that borrower risk remained relatively stable).
434. Truth in Lending, 73 Fed. Reg. 1672, 1675 (proposed Jan. 9, 2008) (to be codified at 12 C.F.R. pt. 226).
435. See supra Part IV.A.
436. See supra Part IV.A.
437. See supra Part IV.A.
438. Excessive borrowing would result even absent a contractual-design response-that is, even under the optimal contract. The contractual design response exacerbates the welfare cost.
439. Focusing on prepayment penalties, several studies found empirical evidence of one of the welfare costs associated with distorted competition. See, e.g., Engel & McCoy, supra note 47, at 2060 (reviewing studies thatfound a positive correlation between prepayment penalties and higher interest rates);
440. LaCour-Little & Holmes, supra note 101, at 660-61 (finding that, for the common 2-28 ARM, the total interest rate savings is significantly less than the amount of the expected prepayment penalty).
441. See Gerardi et al., supra note 29, at 4. According to Kristopher Gerardi, Adam Shapiro, and Paul Willen: Subprime lenders created a group of borrowers that were much more likely to default for at least two reasons. First, while they did not invent zero- equity borrowing, they did allow a much larger fraction of borrowers to start homeownership with no cushion against negative [House Price Appreciation]. Second, subprime lenders allowed borrowers with a history of cash flow problems and with monthly payments that exceeded fifty percent of current income to enter homeownership. Under the best of circumstances, subprime borrowers are at least five times as likely to become delinquent as prime borrowers.
442. See Demyanyk & Van Hemert, supra note 1 (manuscript at 19 tbl.3) (finding positive correlation coefficients, though with limited statistical significance, on ARM (vs. FRM) and Hybrid (vs. FRM) loans in regressions that try to explain default and foreclosure rates). All types of mortgages-not only the nonstandard ARMs-originated in 2006 performed badly in terms of delinquency and foreclosure rates. ARMs, however, performed worse (and many ARMs are nonstandard).
443. Cf. id. (manuscript at 11 fig.4) (showing a much higher delinquency rate for hybrids as compared to FRMs);
444. Bernanke March 2008 Speech, supra note 77 ("The worst payment problems have been among subprime adjustable-rate mortgages....");
445. Bernanke January 2008 Speech, supra note 9 ("Ample evidence suggests that responsible nonprime lending can be beneficial and safe for the borrower as well as profitable for the lender.
446. For example, even as delinquencies on subprime ARMs have soared, loss rates on subprime mortgages with fixed interest rates, though somewhat higher recently, remain in their historical range."). Mayer, Pence, and Sherlund noted the data indicating far worse performance for ARMs: [DJelinquincies have been particularly pronounced for loans that include an adjustable interest rate component-floating-rate mortgages, short-term hybrids, and long-term hybrids. For example, looking at subprime mortgages, the serious delinquency rates for both adjustable-rate and fixed-rate loans were about 5.6 percent in mid-2005. But by July 2008, serious delinquencies on adjustable-rate mortgages had risen to over 29 percent, while the similar rate for fixed-rate mortgages rose to 9 percent. Similarly, serious delinquency rates for both the adjustable-rate and fixed-rate Alt-A mortgages were about 0.6 percent in mid-2005. But by July 2008, the delinquency rate on adjustable-rate Alt-A mortgages had risen past 13 percent, while the delinquency rate on fixed-rate mortgages had risen over 5 percent. Mayer et al., supra note 33, at 8. The high default rates of ARMs, as compared to FRMs, may be due to the comparatively poor risk attributes-in terms of average FICO score and CLTV-of these loans. Mayer, Pence, and Sherlund observed: The exceptionally high default rates of subprime adjustable-rate mortgages may be due in part to the relatively poor risk attributes of these loans. Short-term hybrids, which make up almost all subprime adjustable-rate mortgages, had an average FICO credit score of only 612 and a mean combined loan-to-value ratio of 89 percent. By contrast, subprime fixed-rate mortgages have higher credit scores (FICO of 627) and lower combined loan-to-value ratios (80 percent).
447. Id. In other words, poor underwriting standards are to blame. Contractual design facilitated lower underwriting standards, such as the fact that ARMs enabled lenders to qualify borrowers based on the low, initial rate.
448. See Demyanyk & Van Hemert, supra note 1 (manuscript at 19 tbl.3) (finding positive correlation coefficients on Prepayment Penalty in regressions that try to explain default and foreclosure rates);
449. Roberto G. Quercia, Michael A. Stegman & Walter R. Davis, The Impact of Predatory Loan Terms on Subprime Foreclosures: The Special Case of Prepayment Penalties and Balloon Payments, 18 Housing Pol'y Debate 311337 (2007) (finding, based on LP data, that "lengthy"-that is, 3 years or more-prepayment penalties increaseforeclosure risk by about 20 percent and that ARMs have a 50 percent higher foreclosure risk than FRMs). Others arguethat prepayment penalties affect default and foreclosure only indirectly by enabling the lower initial interest rates thatqualify riskier borrowers
450. See Mayer et al., supra note 33, at 12-13.
451. Truth in Lending, 73 Fed. Reg. 1672, 1674 (proposed Jan. 9, 2008) (to be codified at 12 C.F.R. pt. 226).
452. See Cacan, supra note 25, at 69-70 (focusing on ARMs originated between 2004 and 2006). Cagan's estimates are sensitive to projections about house prices and the index (LIBOR) that determines the magnitude of the reset. His 12percent foreclosure estimate is based on house prices and the index level in December 2006.
453. Id. Specifically, lower market interest rates mitigate the negative impact of a loan reset, while lower house prices exacerbate the negative impact of a loan reset.
454. While resets on escalating-payments contracts are commonly blamed for triggering default and foreclosure, the evidence supporting this allegation is not conclusive. But even studies that fail to identify substantial adverse effects of resets in the current data anticipate such effects going forward. See Mayer et al., supra note 33, at 28 (noting studies showing that "borrowers with hybrid mortgages appeared more likely to refinance and prepay their mortgages around the first reset date but were not necessarily more likely to default around that time" while suggesting that "[m]ortgage rate resets may yet cause difficulties going forward"). Shane Sherlund observed: House price appreciation seems to be the primary determinant of default and prepayment behavior. Borrowers with subprime mortgages could more easily prepay when house price appreciation was high (almost regardless of the initial credit quality of the loan), but found it more difficult to prepay once house price appreciation slowed and turned negative. New, stricter underwriting further limited the ability of many borrowers with sub- prime mortgages unable to refinance or even sell. Many are then faced with the decision of default. With this in mind, mortgage rate resets could have an effect on defaults going forward, even though they have had only limited effects in the data to date. Prepayment is much more difficult for many borrowers, so their ability and willingness to face mortgage rate reset may now be an issue. Short-term interest rates have declined recently, so these borrowers are not currently facing drastically higher mortgage payments.
455. Sherlund, supra note 133, at 11.
456. Bernanke March 2008 Speech, supra note 77.
457. Cagan, supra note 25, at 69-71.
458. See Paul S. Calem & Michael LaCour-Little, Risk-Based Capital Requirements for Mortgage Loans 12 (Bd. of Governors of the Fed. Reserve Sys., Fin. & Econ. Discussion Series Paper No. 2001-2060, 2001) (assumingit costs 10 percent of the unpaid balance to dispose of the foreclosed property and that foreclosure transaction costsamount to 5 percent of unpaid balance
459. See Cagan, supra note 25, at 70 (arguing that foreclosed properties sell at a discount of up to 30 percent).
460. See Vicki Been, Dir., Furman Ctr. for Real Estate & Urban Policy, Testimony Before Committee on Oversight and Government Reform Subcommittee on Domestic Policy: External Effects of Concentrated MortgageForeclosures: Evidence from New York City 4-5 (May 21, 2008) (reporting that, in New York, properties adjacent torecent foreclosure filings sell at a 1.8 percent to 3.7 percent discount
461. see also WILLIAM C. APGAR & MARK DUDA, HOMEOWNERSHIP PRES. FOUND., COLLATERAL DAMAGE: THE MUNICIPAL IMPACT OF TODAY'S MORTGAGE FORECLOSURE BOOM (2005), available at http://www.995hope.org/content/pdf/Apgar-Duda-Study-Short- Version.pdf;
462. Ctr. for Responsible Lending, Subprime Spillover: Foreclosures Cost Neighbors $202 Billion: 40.6 Million Homes Lose $5,000 on Average (2008), available athttp://www.responsiblelending.org/issues/mortgage/research/ subprime-spillover.html
463. Family Hous. Fund, Cost Effectiveness of Mortgage Foreclosure Prevention: Summary of Findings 5 (1998) (noting foreclosure costs of around $7,000 for borrowers, $2,000 for lenders, and additional costs of$15,000 to $60,000 on third parties
464. Stein, supra note 99, at 11-13 (detailing externalities such as declines in neighboring property values and increased crime rates (citing U.S. Dep't of Hous. & Urban Dev. & U.S. Dep't of the Treasury, Curbing Predatory HomeMortgage Lending 25 (2000
465. Engel & McCoy, supra note 47, at 2042 n.12;
466. Gerardi et al., supra note 29, at 1 n.l (citing Dan Immergluck & Geoff Smith, The Impact of Single-Family Mortgage Foreclosures on Neighborhood Crime, 21 Housinc Stud. 851 (2006
467. Truth in Lending, 73 Fed. Reg. 44,522, 44,524 (July 30, 2008) (to be codified at 12 C.F.R. pt. 226).
468. Id. ("The consequences of default are severe for homeowners, who face the possibility of foreclosure, the loss of accumulated home equity, higher rates for other credit transactions, and reduced access to credit.").
469. Id.
470. Id. Consider a borrower with 20 percent equity in her home and a loan balance equal to 80 percent of the market value of the home: If the net proceeds from the foreclosure sale-the discounted sale price minus the transaction costs-are less than 80 percent of the market value, the borrower will lose all the equity that she has accumulated. Only if the net proceeds exceed 80 percent of the market value, the borrower retains part, not all, of the equity that she has accumulated. The Center for Responsible Lending projects a total equity loss of $164 billion between 1998 and 2006, or approximately $75,000 per borrower (given the 2.2 million foreclosures that CRL projects).
471. See SCHLOEMER ET AL., supra note 143, at 2-3, 11, 16. These projections are conservative on some dimensions, but liberal on others; specifically, the projections presume that total equity exceeds the cost of foreclosure, but for many borrowers this may not be the case.
472. See Demyanyk & Van Hemert, supra note 1 (manuscript at 28-29) (finding that high loan-to-value borrowers increasingly became high-risk borrowers over the past five years, in terms of elevated delinquency and foreclosure ratesand that lenders were aware of this and adjusted mortgage rates accordingly over time).
473. See Bethel et al., supra note 12, at 21, 81 tbl.2 (citing one estimate of $150 billion in writedowns as of February 2008 as well as a forecast that this amount will more than double, and summarizing the tens of billions ofdollars worth of subprime-related write-offs by banks;
474. Press Release, Standard & Poor's, supra note 16.
475. See Bar-Gill & Warren, supra note 18, at 64 ("Richer consumers are also less likely to make mistakes, if only because they can hire experts who will prevent them from making mistakes.").
476. Mayer & Pence, supra note 148, at 2.
477. See Michael S. Barr, Sendhil Mullainathan & Eldar Shafir, Behaviorally Informed Home Mortgage Credit Regulation, in Understanding Consumer Credit (Eric S. Belsky & Nicolas P. Retsinas eds.) (forthcoming 2009(manuscript at 11, on file with author) ("[L]ow-income and minority buyers are the least likely to shop for alternatefinancing arrangements.... "
478. Jinkook Lee & Jeanne M. Hogarth, Consumer Information Search for Home Mortgages: Who, What, How Much, and What Else?, 9 Fin. Services Rev. 277, 283 (2000). More generally, subprime borrowers are less likely tosearch for the best loan terms
479. See Courchane et al., supra note 54 (reporting findings from a survey study);
480. see also Zywicki & Adamson, supra note 11, at 55-56.
481. Woodward, supra note 199, at ix.
482. Michael S. Barr, Jane K. Dokko & Benjamin J. Keys, Who Gets Lost in the Subprime Mortgage Fallout? Homeowners in Low- and Moderate-Income Neighborhoods 2-3 (Apr. 2008) (unpublished manuscript), available athttp://ssrn.com/abstract=l 121215
483. See John Leland, Baltimore Finds Subprime Crisis Snags Women, N.Y. TIMES, Jan. 15, 2008, at Al;
484. see also Allen J. Fishbein & Patrick Woodall, Consumer Fed. of Am., Women Are Prime Targets for Subprime LendingWomen Are Disproportionately Represented in High-Cost Mortgage Market 1 (2006), available athttp://www.consumerfed.org/ pdfs/WomenPrimeTargetsStudy120606.pdf (finding that women are more likely to receivesubprime mortgages than men and that disparity between men and women increases as income rises
485. Nat'l Cmty. Reinvestment Coal., Homeownership and Wealth Building Impeded: Continuing Lending Disparities for Minorities and Emerging Obstacles for Middle-Income and Female Borrowers of All Races 12-14 (2006), available at http://www.ncrc.org/index.php?option=com-content&task=view&id= 344&Itemid=76 (finding that women received 37percent of high-cost home loans in 2005, compared with just 28 percent of prime loans
486. Prudential Ins. Co. of Am., Financial Experience & Behaviors Among Women 7 (2006), available at http://www.prudential.com/media/managed/ 2006WomenBrochure-FINAL.pdf (finding that "a majority of financialand investment products are unfamiliar to almost half of all women"
487. Annamaria Lusardi & Olivia S. Mitchell, Planning and Financial Literacy: How Do Women Fare? (Nat'l Bureau of Econ. Research, Working Paper No. 13750, 2008), available at http://ssrn.com/abstract=1087003 (finding thatolder women display much lower levels of financial literacy than the older population as a whole
488. Women in the Subprime Market, Consumers Union, Oct. 2002, http://www.consumersunion.org/finance/women-rptl002.htm (attributing some of the disparity both to the instability inwomen's credit status that results from divorce or family medical emergency and to the fact that women have less wealththan men
489. Bucks & Pence, supra note 170, at 3, 20-21, 26.
490. See WOODWARD, supra note 199 (finding that offers made by brokers to borrowers without a college education are $1,100 higher on average);
491. Thomas P. Boehm & Alan Schlottmann, Mortgage Pricing Differentials Across Hispanic, African-American, and White Households: Evidence from the American Housing Survey, 9 Cityscape: J. Pol'y Dev. & Res., No.2, at 93105 (2007) (finding a negative correlation between education and interest rates
492. Annamaria Lusardi, Financial Literacy: An Essential Tool for Informed Consumer Choice? 10 (Nat'l Bureau of Econ. Research, Working Paper No. 14084, 2008), available at http://ssrn.com/ abstract=l 149331 (citing a 2003 study byDanna Moore showing that low-literacy borrowers are more likely to purchase high-cost mortgages). Individuals withlittle education, women, African-Americans, and Hispanics display particularly low levels of literacy
493. Id. at 1.
494. The FRB, when proposing its recently adopted TILA amendments, endorsed a similar approach, stating: The market has responded to the current problems with increasing attention to loan quality. Structural factors, or market imperfections, however, make it necessary to consider regulations to help prevent a recurrence of these problems. New regulation can also provide the market clear 'rules of the road' at a time of uncertainty, so that responsible higher-priced lending, which serves a critical need, may continue. Truth in Lending, 73 Fed. Reg. 1672, 1675 (proposed Jan. 9, 2008) (to be codified at 12 C.F.R. pt. 226)
495. See generally LACKO 8& PAPPALARDO, supra note 104 (showing that better-designed disclosure can make a significant difference).
496. See Colin Camerer et al., Regulation for Conservatives: Behavioral Economics and the Case for "Asymmetric Paternalism", 151 U. Pa. L. Rev. 1211 (2003)
497. Cass R. Sunstein & Richard H. Thaler, Libertarian Paternalism Is Not an Oxymoron, 70 U. Chi. L. Rev. 1159 (2003)
498. See generally Bar-Gill, Seduction, supra note 18. Since the abolition of usury laws, disclosure requirements have been the centerpiece of the regulatory scheme governing the mortgage market.
499. See Eskridge, supra note 24 (describing the history of mortgage-contract regulation in the U.S. and specifically the shift from usury laws to disclosure regulation). The legislative and regulatory reaction to the recent crisis has focused on disclosure.
500. See, e.g., Truth in Lending, 73 Fed. Reg. 44,522, 44,524-25 (July 30, 2008) (to be codified at 12 C.F.R. pt. 226);
501. see also, e.g., Housing and Economic Recovery Act of 2008, Pub. L. No. 110- 289, §§ 2501-2503, 122 Stat. 2654, 2855-57. The Housing and Economic Recovery Act, as well as other legal responses to the crisis, includes important loss-mitigation components that are unrelated to disclosure. But these are not rules that will govern the mortgage market going forward. Among forward-looking legal interventions, disclosure is dominant. The FRB regulations go beyond disclosure on several important dimensions, such as requiring creditors to evaluate borrowers' ability to repay; limiting the scope of permissible prepayment penalties; and requiring creditors to establish escrow accounts for the payment of property taxes and premiums for specified insurance products.
502. See Truth in Lending, 73 Fed. Reg. 44,522.
503. See Truth in Lending Act, Pub. L. No. 90-321, § 107, 82 Stat. 146, 149 (1968) (codified as amended at 15 U.S.C. § 1606 (2006)) (defining the APR);
504. Truth in Lending Act §§ 121-31, 82 Stat, at 152-57 (codified as amended at 15 U.S.C. §§ 1631-49 (2006)) (requiring disclosure of the APR).
505. SeeRenuart & Thompson, supra note 24, at 217 ("Congress designed the APR to be the single number that consumers should focus upon when shopping for credit.").
506. See id. at 214 (arguing that a comprehensive, fee-inclusive APR will help imperfectly rational consumers who cannot aggregate the multiple fees on their own).
507. 12 C.F.R. § 226.17 (2008);
508. Official Staff Commentary § 226.17(c) (1)-(10) (2008).
509. See BD. OF GOVERNORS OF THE FED. RESERVE SYS. & U.S. DEP'T OF HOUS. & URBAN DEV., JOINT REPORT TO THE CONCRESS CONCERNING REFORM TO THE TRUTH AND LENDING ACT AND THE REAL ESTATE SETTLEMENT PROCEDURES ACt 9 (1998), available at http://www.federalreserve.gov/boarddocs/press/general/1998/ 19980717/default.htm (" [T] he APR concept deters hidden or 'junk' fees to the extent that the fees must be included in the APR calculation.").
510. to clarify, it is not that lenders will be indifferent to the choice between deferring cost or not deferring cost or between adding nonsalient fees and not adding such fees; lenders will have an affirmative reason not to defer costs and not to add "junk" fees. The reason is that any such deviation from the optimal contract design will increase the total cost of the loan and thus the disclosed APR.
511. See Lee & Hogarth, supra note 229, at 286 (finding that 78 percent of homeowners who refinanced their homes report comparison shopping on the basis of the APR);
512. Lee & Hogarth, supra note 198, at 74 (reporting that more than 70 percent of the population reports using the APR to shop for closed-end credit);
513. Renuart & Thompson, supra note 24, at 189 ("TILA disclosures have been remarkably effective in educating consumers to pay attention to the APR as a key measure of the cost of credit."). The "finance charge" from which the APR is derived can be viewed as an example of a life-cycle cost measure. Empirical evidence suggests that life-cycle cost disclosures affect consumer behavior.
514. See Matthias Deutsch, The Effect of Life-Cycle Cost Disclosure on Consumer Behavior (unpublished Ph.D. dissertation, Univ. of Md., 2007), available at http://hdl.handle.net/1903/6794 (finding that shoppers who received "life-cycle cost" information chose cooling appliances and washing machines that used less energy);
515. see also Matthias Deutsch, Life-Cycle Cost Disclosure, Consumer Behavior, and Business Implications: Evidence from an Online Field Experiment, in Sustainable Consumption and Production: Framework for Action 391, 406 (Theo Geer Ken et al. eds., 2008) ("Disclosing estimated life-cycle costs to shoppers makes them opt for washing machines with, on average, 0.83% less specific energy consumption and 0.74% less specific water consumption."). see also Matthias Deutsch, Life-Cycle Cost Disclosure, Consumer Behavior, and Business Implications: Evidence from an Online Field Experiment, in SUSTAINABLE CONSUMPTION AND PRODUCTION: FRAMEWORK FOR ACTION 391, 406 (Theo Geer Ken et al. eds., 2008) ("Disclosing estimated life-cycle costs to shoppers makes them opt for washing machines with, on average, 0.83% less specific energy consumption and 0.74% less specific water consumption.").
516. 246 See. Rep. No. 96-368, at 16 (1979), reprinted in 1980 U.S.C.C.A.N. 236, 252 (crediting TILA with increasing consumer awareness of annual percentage rates and with a substantial reduction of the market share of creditors charging the highest rates);
517. Randall S. Kroszner, Governor, Bd. of Governors of the Fed. Reserve Sys., Speech at the George Washington University School of Business Financial Services Research Program Policy Forum: Creating More Effective Consumer Disclosures (May 23, 2007), available at http://www.federalreserve.gov/ newsevents/speech/Kroszner20070523a.htm
518. (stating that TILA disclosure requirements and specifically the APR disclosure "are generally believed to have improved competition and helped individual consumers" (citing BD. OF GOVERNORS OF THE FED. RESERVE SYS., ANNUAL PERCENTAGE RATE DEMONSTRATION PROJECT (1987))).
519. Victor Stango & Jonathan Zinman, Fuzzy Math, Disclosure Regulation and Credit Market Outcomes 5 (Tuck Sch. of Bus., Working Paper No. 2008-42, 2007), available at hup:// ssrn.com/abstract= 1081635.
520. The evidence showing the success of the APR is limited to the prime market. See supra notes 245-47;
521. see also Patricia A. McCoy, Rethinking Disclosure in a World of Risk-Based Pricing, 44 HARV. J. ON LEGIS. 123, 126, 138-39 (2007) (noting robust competition in the prime market and that TILA disclosures effectively facilitate this competition).
522. On the general failure of the TILA disclosure regime in the nonprime segments, see, for example, GAO AMP Report, supra note 43, at 21 (noting that current disclosure requirements "are not designed to address more complex products such as [Alternative Mortgage Products]");
523. Paulson, supra note 2;
524. E.L. Rubin Edward L. Rubin, Legislative Methodology: Some Lessons from the Truth-in-Lending Act, 80 GEO. L.J. 233, 236 (1991) (noting that shopping for credit is limited to "upscale consumers who would manage perfectly well without [the] benefit of [the TILA disclosures]"). Secretary Paulson highlighted the need for more and better information: We need simple, clear, and understandable mortgage disclosure. We must identify what information is most critical for borrowers to have so that they can make informed decisions. At closing, homebuyers get writer's cramp from initialing pages and pages of unintelligible and mostly unread boilerplate that appears to be designed to insulate the originator or lender from liability rather than to provide useful information to the borrower. We can and must do better.
525. Paulson, supra note 2.
526. See McCoy, supra note 248, at 141.
527. see id.
528. See id. at 137-43;
529. Willis, supra note 4, at 749-50;
530. FTC Comment, supra note 66, at 11-12. The exception is HOEPA loans, where binding early disclosures are required.
531. See McCoy, supra note 248, at 141.
532. See McCoy, supra note 248;
533. Willis, supra note 4, at 749-50.
534. See Comptroller of the Currency, Truth in Lending: Comptroller's Handbook 98 (2006), available at http://www.occ.treas.gov/handbook/til.pdf (showing APR does not include late fees, title insurance fees, tide examination fees, property survey fees, appraisal fees, credit report fees, document preparation fees, notary fees, flood and pest inspection fees, and seller's points);
535. Eskridge, supra note 24, at 1165-66;
536. Willis, supra note 4, at 744, 747, 750 (noting APR includes origination fees and points, but not interest rate escalations, prepayment penalties, late fees, tide insurance, and application, appraisal, and document preparation fees).
537. Elizabeth Renuart and Diane Thompson, both former members of the Consumer Advocacy Council to the Federal Reserve Board, made note of this possibility: The Board's "fee-by-fee" approach encourages all lenders to "game" the system by unbundling the cost of loan originations into an increasing number of fees that are excluded from the disclosed finance charges.... Absent mandatory, comprehensive, and simple pricing disclosures, lenders have perverse incentives to create complicated pricing structures, including different rates on different balances, multitudinous fees, variable rates, and payment options. These products, by their design, obscure the true price of credit. Unsurprisingly, lenders have responded to the current regulatory environment by evolving ever more complex and profitable products. Renuart & Thompson, supra note 24, at 185, 221.
538. Regulation has focused on "the most obvious, transparent and important terms," Zywicki & Adamson, supra note 11, at 71, such as interest rates, points, and closing costs, causing substitution to less transparent terms, such as prepayment penalties and LTV ratios. Such a focus "makes it more difficult to for borrowers to easily shop and compare terms."
539. Id.
540. See HUD-Treasury Report, supra note 11, at 66 (noting that "the APR does not account for an early payoff").
541. See Agarwal et al., supra note 120, at 28 (calculating a 26.8 percent impact on a $100,000 mortgage for using the wrong rule to make prepayment decisions; the impact of ignoring the prepayment option altogether may well be larger).
542. The actual (no prepayment) and effective (with prepayment) APRs were calculated using APRWIN (Ver. 6.1.0).
543. The following example is illustrative: To see how the APR can be misleading, suppose I give you the choice of borrowing the $100,000 at either an 8% rate and the $1,000 fee with the 360 payments of $733.76, or a 8.125% rate and a fee of $100 and 360 payments of $742.50. The APR for the 8% rate and $1,000 fee is 8.11%, and the APR for the 8.125% rate and $100 fee is 8.14%. Most consumers would think that the 8% rate is a better deal because the APR is lower. However, this is only true provided you do not pay off the loan early. For example, if you were able to refinance and payoff the loan after 3 years, with the 8% rate you would have paid a total of $27,415.36 (36 payments of $733.76 plus the $1,000 fee). With the 8.125% rate you would have paid $26,830 (36 payments of $742.50 plus $100), so the 8% rate was actually $585.36 more expensive, even though it had a lower APR. Reed Mortgage Corp., Annual Percentage Rate (APR), http://www.reedmc.com/APR.htm (last visited Mar. 13, 2009). More generally, by ignoring the prepayment option, the APR underestimates the importance of origination fees (those that are included in the APR calculation) that accrue at closing; no such underestimation afflicts interest charges that accrue gradually over the life of the loan.
544. See Renuart & Thompson, supra note 24, at 231. This may provide another explanation for the proliferation of origination fees.
545. Compare the value of the prepayment option on an FRM without a prepayment penalty to the value of the prepayment option on a negative amortization option ARM with a CLTV of 100 percent and a substantial prepayment penalty.
546. Truth in Lending, 73 Fed. Reg. 44,522, 44,551 (July 30, 2008) (to be codified at 12 C.F.R. pt. 226).
547. See id. at 44,525 ("Subprime loans are also far more likely to have prepayment penalties. Because the annual percentage rate (APR) does not reflect the price of the penalty, the consumer must both calculate the size of the penalty from a formula and assess the likelihood of moving or refinancing during the penalty period. In these and other ways, subprime products tend to be complex for consumers.");
548. see also Truth in Lending, 73 Fed. Reg. 1672, 1694 (proposed Jan. 9, 2008) (to be codified at 12 C.F.R. pt. 226) ("The injuries prepayment penalties may cause consumers are particularly concerning because of serious questions as to whether borrowers knowingly accept the risk of such injuries. Current disclosures of prepayment penalties, including the disclosure of
549. Lacko & Pappalardo, supra note 104, at 110.
550. See 73 Fed. Reg. at 44,525-26. As noted by the Federal Reserve Board in its recent revision of its Truth in Lending regulations: A consumer may focus on loan attributes that have the most obvious and immediate consequence such as loan amount, down payment, initial monthly payment, initial interest rate, and up-front fees (though up-front fees may be more obscure when added to the loan amount, and 'discount points' in particular may be difficult for consumers to understand). These consumers, therefore, may not focus on terms that may seem less immediately important to them such as future increases in payment amounts or interest rates, prepayment penalties, and negative amortization.... Consumers who do not fully understand such terms and features, however, are less able to appreciate their risks, which can be significant. For example, the payment may increase sharply and a prepayment penalty may hinder the consumer from refinancing to avoid the payment increase. Thus, consumers may unwittingly accept loans that they will have difficulty repaying.
551. Id.
552. See id. at 44,590-92;
553. see also Housing and Economic Recovery Act of 2008, Pub. L. No. 110-289, § 2502(a), 122 Stat. 2654, 2855-57 (to be codified at 15 U.S.C. § 1638(b)(2)).
554. Housing and Economic Recovery Act of 2008 § 2502(a).
555. See Kathleen C. Engel & Patricia A. McCoy, A Tale of Three Markets: The Law and Economics of Predatory Lending, 80 TEX. L. REV. 1255, 1269 (2002) (noting that lenders face no liability for errors in the Good Faith Estimate (GFE), including the GFE of the APR).
556. Moreover, it is not clear from the language of the statute that lenders cannot change the APR again between the time of the updated disclosure (three days before closing) and consummation.
557. Truth in Lending Act, 15 U.S.C. § 1640 (2006).
558. See, e.g., Dykstra v. Wayland Ford, Inc., 134 F. App'x 911 (6th Cir. 2005);
559. Baker v. Sunny Chevrolet, Inc., 349 F.3d 862 (6th Cir. 2003);
560. Brown v. Payday Check Advance, Inc., 202 F.3d 987 (7th Cir. 2000);
561. In re Ferrell, 358 B.R. 777 (B.A.P. 9th Cir. 2006). Other courts have adopted a more expansive interpretation of TILA's civil liability provisions.
562. See, e.g., Bragg v. Bill Heard Chevrolet, Inc., 374 F.3d 1060 (11th Cir. 2004).
563. See HUD-Treasury Report, supra note 11, at 67 (proposing that originators be required to provide an accurate, within a prescribed tolerance, Good Faith Estimate of, among other things, the APR). It should be recognized, however, that locking in an APR at an earlier lime would place greater interest rate risk on the lender and that this added risk would be, at least partially, passed on to borrowers. Borrowers who need the APR as a focal point for comparison shopping should be willing to accept these consequences.
564. Cf. McCoy, supra note 248, at 138 (arguing that similar rate lock-ins are common in the prime market even though lenders are not required to disclose a binding APR).
565. Renuart & Thompson, supra note 24;
566. see also HUD-Treasury Report, supra note 11, at 69 (proposing that the law be amended "to require that the full cost of credit be included in the APR");
567. Eskridge, supra note 24 (proposing a more inclusive APR more than twenty years ago).
568. Estimating the future LTV is particularly complicated. This estimate would be based on the current LTV, the contractually specified payment stream, the prepayment penalty-which would need to be financed by the new loan-and the projected future house value.
569. Note, for example, the assumptions needed for calculating the total payment period for credit card debt under BAPCPA.
570. Sophisticated valuation algorithms can be used to more closely tailor predictions to specific homes and specific loans. See Cagan, supra note 25, at 5 (describing the valuation algorithms).
571. Projections and forecasts are commonly used in the industry. See, e.g., Cagan, supra note 25;
572. Sherlund, supra note 133, at 11 ("I draw house price, interest rate, and unemployment rate forecasts from Fannie Mae's and Freddie Mac's June 2008 monthly economic outlooks....");
573. cf. W. Miles, Boom-Bust Cycles and the Forecasting Performance of Linear and Non-Linear Models of House Prices, 36 J. Real Est. Fin. & Econ. 249 (2008) (comparing the power of competing models to predict house prices). Futures markets can be used to help predict price trajectories.
574. Did lenders really have superior information during the subprime expansion? The multibillion-dollar losses that lenders have been incurring since the collapse of the sub- prime market suggest that their algorithms may well have been off the mark. Still, it is hard to imagine that lenders, including the Wall Street firms that financed them, had the same information as the average subprime borrower. Moreover, at least some of these lenders made a knowing bet that turned out sour. How many borrowers made a knowing bet?
575. The proposed disclosure would also assist rational borrowers. Currently, these borrowers must calculate the value of the prepayment option (or the probability of facing an attractive prepayment option) on their own. This is a costly exercise. And some borrowers may decide to forgo the exercise. The proposed disclosure would save the calculation costs or, for those borrowers who would forgo the exercise, reduce uncertainty about the prepayment option.
576. See Barr et al., supra note 229 (manuscript at 9) ("The need for simplicity conflicts, however, with the goal of producing comprehensive disclosures that permit consumers to comparison shop based on the real price of multi-attribute loans.").
577. The limits of the APR, even when optimally designed, warrant consideration of supplementary approaches. For example, the FRB could sponsor a web-based mortgage search tool. This tool would ask the borrower for information relevant to loan underwriting and then provide a list of best options (from the best lenders), where the best options, or at least some of them, would not necessarily be picked solely by the APR. Cf. John Lynch, Consumer Information Processing and Mortgage Disclosures (2008), available at http://www.ftc.gov/be/ workshops/mortgage/presentations/Lynch-John.pdf (proposing a "personalized screening agent website for best alternatives in region").