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Abstract: The 2007 subprime mortgage crisis resulted in home foreclosures at unprecedented levels, and calls for government action. The Bush Administration's response relied primarily on exhorting the mortgage industry to voluntarily modify the terms of existing mortgages to help struggling homeowners reduce their debt burden and bring mortgage debt in line with declining home values. Industry reports have tallied the rapid increase in voluntarily negotiated workouts, without specifying what the terms of those workouts have been.
To better understand the effectiveness of the voluntary mortgage crisis resolution plan, this paper reports detailed empirical information from a newly-created database. Loan-level information on the number and type of negotiated mortgage modifications was compiled from monthly servicer remittance reports from July 2007 through June 2008 for twenty-six mortgage loan pools.
The data show that while the number of modifications rose rapidly during the crisis, mortgage modifications in the aggregate are not reducing subprime mortgage debt. Mortgage modifications rarely if ever reduced principal debt, and in many cases increased the debt. Nor are modification agreements uniformly reducing payment burdens on households. About half of all loan modifications resulted in a reduced monthly payment, while many modifications actually increased the monthly payment. Finally, there is tremendous variation in the extent, if any, of payment relief offered by different mortgage servicers.
The combined effect of dwindling refinancing activity and modifications that do not write down mortgage debt, and in many cases do not even reduce monthly payments, is to delay, but not prevent, large numbers of foreclosures. Given the continuing accumulation of loans in the foreclosure and real-estate-owned categories, the subprime crisis will be worked out only over many years through painstakingly slow repayment, foreclosure and disposition of properties.
Abstract: The subprime foreclosure crisis has resulted in residential mortgage debt burdens far beyond what borrowers can repay. Many economists have recognized the need to deleverage the American homeowner. The excess mortgage debt is depressing home prices and consumer spending, and acting as a drag on the broader economy. Empirical evidence from mortgage servicer reports to investors show that for the most part, the necessary deleveraging of homeowners is not happening.
In a prior paper I compiled mortgage foreclosure and modification data from a sample of securitized subprime mortgage pools. This paper reports on an expanded study of data on more than 3.5 million subprime and alt-A mortgages, including about one-sixth of all foreclosures pending, and about 20% of the monthly total modifications in November 2008.
My findings from both the smaller sample and the larger sample are consistent, and are as follows:
1. Modifications are not reducing principal debt, they are increasing it. Almost no modifications include significant cancellation of either past due interest or principal, and many modifications involve capitalizing unpaid interest and fees and reamortizing the loan. This occurred in 68% of loan modifications. The average capitalized amount added to loans was $10,800, on average mortgage debt of about $210,000. Some principal was canceled, and reported as a partial loss, for about 10% of modifications. However, two servicers (out of 43), Litton Loan Servicing and Ocwen Loan Servicing, accounted for nearly all of these principal reductions. Only 8% of loans reflected some write-off of unpaid interest.
2. Servicers are incurring huge losses for investors by foreclosing. The average foreclosure loss on a first mortgage in November 2008 was $145,000 or about 55% of the average amount due. Loss severities increased steadily throughout 2007 and 2008 and are expected to worsen in 2009. In these circumstances, rational investors should accept mortgage principal reductions corresponding to home value declines of 20% or so, were it not for the various obstacles to servicers' restructuring of mortgage loans. 3. Voluntary mortgage modifications are not consistently reducing monthly payment burdens. Only 49% of modifications in the November 2008 report reduced monthly payments below the initial payment, while 17% left the payment the same and 34% increased the monthly payment.
4. The variations among servicers in the number and quality of modifications are enormous. This variation suggests that not every servicer is doing the maximum possible to reach and work out terms with every defaulted borrower.
5. Fewer than half of modifications made in January 2008 were current in payments on November 25, 2008. This is not surprising, given the onerous terms of the 2008 modifications.
6. Many modifications are temporary. For example, some adjusted interest rate and amortization term only for five years, with rate and payment increases after five years. Servicers also use balloon payments and other forms of deferrals in order to reduce payments without reducing total debt. Thus, the totals reported by the industry include many loans that are being modified to include deferred payment shocks, negative amortization or other non-amortizing features of the sort that caused the foreclosure crisis.
7. Significant numbers of mortgage loans are seriously delinquent, but not in a modification program or in foreclosure. The foreclosure crisis is overwhelming the ability of servicers to either restructure or foreclose on all the delinquent loans.
The paper discusses the many reasons that necessary mortgage restructuring is not happening and proposes several policy responses.
subprime, foreclosure, financial crisis, mortgage modification
Abstract: While the subprime mortgage boom was in full swing, its benefits to American society were widely touted. Subprime mortgages were said to have increased homeownership. The subprime effect was supposed to have been especially strong for low-income and minority families previously unable to buy homes. The democratization of credit was also attributed to subprime mortgages.
The empirical data do not support these welfare claims. The U.S. homeownership rate increased somewhat between 1994 and 2007. Subprime mortgages, however, were mostly made to existing homeowners to refinance debt; very few were made to first-time home buyers. The number of homes lost due to subprime foreclosures significantly exceeded the new homeowners added by subprime mortgages. Subprime mortgages also displaced the safer and lower-cost FHA loans that would otherwise have been made. Conventional prime mortgages for purchases fully accounted for the observed increase in homeownership.
The welfare harms caused by subprime mortgage lending are readily measurable. They include the direct impact of more than two million foreclosures on families, the resulting property value losses, the social and fiscal impact on cities where subprime mortgages were concentrated, the price discrimination resulting in black and Latino homeowners paying unnecessarily high rates, and the broader impacts on the credit markets and the economy.
The disastrous consequences of subprime mortgage lending were in part the result of deregulating mortgage interest rates. Similar harms can be prevented in the future by re-imposing reasonable interest rate limits on first-lien mortgages. FHA should be restored to its role as the primary provider of mortgages to first-time, low- and moderate-income home buyers.
banking and finance, consumer protection law, law and economics, law and society, social welfare
Abstract: The policy debate surrounding predatory lending laws and the subprime mortgage market opposes two hypotheses. The first is that an efficient market is providing broader access to credit, offering mortgages with higher rates and fees to higher risk borrowers, and that prices relate directly to the added risk. The contrary hypothesis is that high interest rates and loan fees are charged in the subprime market well in excess of the risk-related costs. A number of readily observed facts about the subprime mortgage market support the opportunity pricing hypothesis. Existing research includes simple descriptive price information, papers inferring a correlation between high prices and high risk of credit loss from observed default rates, theoretical discussions to explain the observed pricing dispersion, and studies trying to determine whether laws that indirectly restrict mortgage prices have reduced the supply of mortgage credit. Information asymmetries, seller obfuscation and search costs contribute to the observed inefficiencies in this market, and suggest several policy responses.
Risk-Based Pricing, mortgage, subprime, predatory lending
Abstract: The law of contracts and consumer protection has been dominated in the recent past by the ideology of rational choice theory. As a descriptive project, rational choice theory holds that consumers express their preferences and maximize their expected utility by making choices in the marketplace. As a normative project, rational choice theory has promoted deregulation of contract terms, based on underlying values of utilitarianism and autonomy. Legislators, judges and agencies have internalized these norms and adopted the deregulation program.
The behavioral economics literature has seriously undermined rational choice theory as a description of consumer and seller behavior. In the real world, consumers use abbreviated and biased reasoning and short cuts, are heavily influenced by affect and channeling factors, and respond to framing and endowment effects. Sellers study and understand consumer behavior, and exploit this knowledge. The result in a deregulated marketplace is seller exploitation and consumer harm. Numerous empirical examples of "irrational" consumer behavior and seller exploitation are explored.
Law and economics scholarship has been reluctant to face the normative implications of the improved understanding of consumer and seller behavior. "Soft paternalism" seeks to retain the ideal of a perfect market by fixing the information and bias problems, clinging to the values of utilitarianism and autonomy. The insights of behavioral economics may enlighten lawmakers as to how better to strive for genuine autonomy, and genuine utility maximization. Viewing contract law as a tool for justice, however, requires doing more than improving the means without rethinking the ends. A deeper notion of justice requires that we return to the prevention of exploitation of the weak by the powerful, an equity-based value, as one of lodestars for what the law of contracts ought to be.
Contracts, Consumer Behavior, Rational Choice Theory, Behavioral Economics
Abstract: The law of contracts and consumer protection has been dominated in the recent past by the ideology of rational choice theory. As a descriptive project, rational choice theory holds that consumers express their preferences and maximize their expected utility by making choices in the marketplace. As a normative project, rational choice theory has promoted deregulation of contract terms, based on underlying values of utilitarianism and autonomy. Legislators, judges and agencies have internalized these norms and adopted the deregulation program. The behavioral economics literature has seriously undermined rational choice theory as a description of consumer and seller behavior. In the real world, consumers use abbreviated and biased reasoning and short cuts, are heavily influenced by affect and channeling factors, and respond to framing and endowment effects. Sellers study and understand consumer behavior, and exploit this knowledge. The result in a deregulated marketplace is seller exploitation and consumer harm. Numerous empirical examples of irrational" consumer behavior and seller exploitation are explored. Law and economics scholarship has been reluctant to face the normative implications of the improved understanding of consumer and seller behavior. Soft paternalism" seeks to retain the ideal of a perfect market by fixing the information and bias problems, clinging to the values of utilitarianism and autonomy. The insights of behavioral economics may enlighten lawmakers as to how better to strive for genuine autonomy, and genuine utility maximization. Viewing contract law as a tool for justice, however, requires doing more than improving the means without rethinking the ends. A deeper notion of justice requires that we return to the prevention of exploitation of the weak by the powerful, an equity-based value, as one of lodestars for what the law of contracts ought to be.
Abstract: Contract law imposes on consumers a "duty to read", shorthand for a set of related doctrines including the statute of frauds, the parol evidence rule, and the reasonable reliance element of fraud as a contractual excuse. Moreover, consumer protection statutes have placed heavy emphasis on information disclosure, usually provided on additional documents, as the preferred method to deter abuses in the marketplace. The duty to read and the myriad of disclosure laws rely on unfounded assumptions about the ability of ordinary consumers to read and use written documents. The National Adult Literacy Survey (NALS) provides sobering data on the document literacy and quantitative skills of the American public. A surprisingly small percentage of the adult population has the ability to extract key information from lengthy and complex consumer contract documents and disclosure forms. Contracts and disclosures for mortgage loans, automobile leases, and other modern transactions are accessible to fewer than 10% of the consumers for whom they are intended. The present state of the law, regarding contract formation and enforceability, and the various disclosure statutes, take no account of the literacy problem. New approaches are needed to protect consumers and police the marketplace, using means other than the doctrines of fraud, unconscionability, and technical disclosure statutes, and based on the reality of the gap between adult literacy and the readability of contract forms.
literacy, contract, unconscionability, disclosure, consumer
Abstract: African-American families pay much higher interest rates on their mortgages than white families. Home Mortgage Disclosure Act reports reveal that even high-income Blacks are far more likely to pay subprime (high) mortgage rates than comparable whites. While federal enforcement agencies have been slow to take action under fair lending laws, individual and class action suits challenging mortgage price discrimination are rapidly bringing new issues before the courts and agencies.
Lenders protest that they are using mechanical pricing models, based on objective data, and that prices are often set without any face-to-face contact between a lender and borrower (particularly for mortgages originated through brokers.) Courts and agencies have struggled to apply disparate treatment and disparate impact analysis in this new context of seemingly neutral criteria producing hugely disparate results.
On closer examination, the pricing criteria used by subprime lenders expose some of the reasons that Blacks fared so poorly in so-called risk-based pricing structures. A review of the research literature and available empirical data reveals the means by which seemingly objective pricing factors allow implicit bias by brokers, appraisers and underwriters to infect the seemingly neutral risk-based pricing system to produce discriminatory results. These observations should prompt courts and bank supervisors to reconsider the disparate impact and disparate treatment principles and proof burdens applied in fair lending cases based on pricing. In particular, the burden must be on lenders to validate pricing models based on risk-associated costs, and not merely on the presence of various explanatory variables that may or may not justify price differentiation. Lenders must also account for product steering, i.e. racial segregation of borrowers into different product categories or internal lending divisions, and for pricing discretion provided to mortgage brokers.
On a deeper level, we need to consider the wisdom of permitting risk-based pricing that has the effect of redistributing income and wealth away from minority groups, and weigh the costs of risk-based pricing against its benefits to consumer welfare. This is particularly vital when it may be the higher prices that produce the risk, not the other way around, and the risk at issue is the stripping of wealth and foreclosure of homes for African-American families.
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