An important cause of the subprime mortgage crisis was contract law’s derisory response to emotion and the defective risk-allocation model that contract law helped generate in both the common law and the regulatory environment. A proper understanding of emotion in mortgage markets is essential to determine whether recently enacted federal legislation addressing mortgage lending reform has hit its mark.
Emotion in the mortgage contract. The dream of home ownership is a long-standing part of America’s cultural fabric. First-time buyers were a group particularly motivated by the American Dream—home ownership gave them the opportunity to escape the rental market.
A 2008 article in the New York Times (“The Wrong Mortgage Derails a Mother’s Plans,” Abby Aguirre, November 9) profiled Christina Natale as an example of an honest but naive first-time subprime buyer. Natale bought a house for $385,000 with a down payment of $185,000. The loan required a $1,873.96 monthly payment. Because this payment was only about $100 less than Natale’s monthly net income, the transaction was doomed to fail. Nonetheless, her loan was approved without attempts to confirm her income, and Natale felt encouraged to attempt it. Though the adjustable interest rate was a source of concern for Natale, the broker assured her that refinancing was possible. Because she had $20,000 in savings, Natale thought she could make a go of it. But with her savings eventually gone, she refinanced in June 2007 and again in July 2008. When the lender turned down her third attempt to refinance, she arranged a short sale with her lender’s approval. She was never foreclosed on but lost her down payment. Natale then turned to the Children’s Aid Society to help her and her children get on their feet again because she had no money left whatsoever—not even for a security deposit for interim shelter. In speaking to the Times, Natale explained her emotions. Her house made her “feel good.” In the precrash economy, Natale’s optimism and the ever-rising housing market carried the day.
For its part, contract law strips emotion out of contracts and chooses abstraction instead. Its overwhelming bias against emotion also leads to huge miscalculations and misapplications, with the subprime crisis being a poignant example. Contract law’s allocation of the risk of emotion failed to consider that the lender might develop incentives to manipulate borrower emotion and place bad loans.
Erroneous allocation of the risk of emotion in the mortgage contract. The risk-allocation model assumes that the lender has no incentive to manipulate borrower emotion but, rather, has a strong stake in carefully assessing the borrower’s underlying resources and repayment prospects. Any other strategy by the lender would generate borrower default and financial loss in the lender. In short, the law regards the lender as a rational, self-interested gatekeeper, assessing borrowers and reining their loan expectations as necessary. The law also concludes that, even if incentives somehow emerged whereby the lender played upon borrower emotion, borrowers are their own best and last line of defense. If a naive borrower chooses to be “emotional” or unrealistic as to what the borrower can afford, the borrower will receive the adverse economic consequences that contract law concludes the borrower so richly deserves. In this way, the law punishes emotion even when it leads to an utterly ruinous contract.
The fatal assumption in the risk-allocation model is that the mortgagee has no incentive to manipulate borrower emotion because the mortgagee could end up with a bad loan on its books. This assumption regarding lender incentives proved to be completely, utterly, and disastrously wrong. The originate-to-distribute model of subprime lending sheltered the lender from most or all of the effects of borrower default. Thus, contrary to the law’s assumption, the lender had incentives to manipulate borrower emotion. More specifically, the subprime mortgage industry took advantage of the borrower’s “imperfect rationality” or emotionalism and designed subprime mortgage contracts with the express objective of burying the long-term cost of the loan while juicing up its seemingly attractive “deferred cost” characteristics. Regulators failed to do enough to protect the vulnerable subprime borrower.
Owing to securitization, the lender suffered no market discipline for being reckless and manipulative—a poignant irony because the borrower expected the precisely opposite attitude. Therefore, the borrower who stood to lose everything bore the largest risk of emotion. Investors in mortgage-backed and related securities bore a more diffuse risk of borrower emotion. The lender, however, had no risk of borrower emotion at all. Securitization severed the link between originator and the loan such that the market did not discipline the lender, even for egregious conduct. A collapse in lending standards ensued and brought many borrowers into the market that had nowhere near the financial resources to be there.
Mortgage lending reform and emotion. Part of the solution in lending reform is for regulators to eschew the traditional view of emotion as inherently irrational and deserving of censure. A critical first step is to address and acknowledge the reality that securitization gives lenders an incentive to hype borrower emotion. It is essential for regulation to reestablish the link between mortgagor and mortgagee that securitization has disrupted. For instance, if the originator mandatorily continues to own some of the mortgage it places or if the regulated market for that loan requires the subsequent securitizer to retain some of the risk of default, the originator has enhanced incentives to treat the mortgagor non-exploitatively. The second step is to assess the ways in which mortgagees can manipulate borrower emotion and appropriately seek to reduce those opportunities.
The lender can subject subprime mortgagors to emotional manipulation on at least two related fronts. First is the group of borrowers who feel overwhelmed by the strategic complexity of the subprime mortgage contract and trust those whom they regard as experts in the area. The other kind of subprime borrower is like Christina Natale. That borrower understands the mortgage in question, and the risks it may impose, but is caught up in magical thinking or irrational exuberance. Enhanced mortgagee disclosure obligations and keeping the unqualified applicant out of the housing market altogether should assist in protecting these two kinds of mortgagors.
In 2010, a new disclosure rule under the Real Estate Settlement Procedures Act became effective. The rule provides antecedent protection for the subprime borrower and parallels aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The new “good faith estimate” requires that all loan originators use a standard three-page form for disclosures, including the disclosure of any yield spread premiums.
In total, the new legislation and rules seem to regard emotion with more nuance than the common law because the former more robustly targets situations that place the consumer at risk of exploitation. The intended result is to keep the under-qualified buyer out of the market and out of harm’s way and to ensure that those who are qualified to take out a mortgage have the opportunity to gain a better understanding of the obligations they are assuming. Instead of standing by and permitting manipulation by originators, the legislation is preemptive and even borrower-centric. It appears that the regulatory system is facing up to emotion and seeking to curb the consequences of “infectious exuberance.”
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- This article is an abridged and edited version of one that originally appeared on page 677 of Real Property, Trust and Estate Law Journal, Winter 2011 (45:4).
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