The Law & Economics of Subprime Lending

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

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

Keywords: bankruptcy, consumer credit, distress model, foreclosure, homeownership, lending practices, mortgages, option model, regulation, subprime

JEL Classifications: D10, D14, D18, K35

Accepted Paper Series