Decisionmaking & the Limits of Disclosure: The Problem of Predatory Lending

Abstract

Despite the importance of the transaction, many Americans are not making optimal home loan decisions, in two important respects. First, many borrowers are not obtaining home loans at optimal price terms, prices that a competitive market of borrowers engaged in effective price-shopping would produce. Second, the home loan decisions of many borrowers are not optimal choices with regard to risk of loss of the home, both in that the benefits of the loan are outweighed by the risk of loss of the home imposed by the loan, and in that borrowers are failing to take advantage of alternatives that are preferable, in cost-benefit terms, to shouldering that risk of loss. The households paying these high prices and facing this high risk of foreclosure are disproportionately African-American, Latino, and low to moderate income, households that already have fewer financial resources and significantly lower homeownership rates. The sale of these overpriced and overly risky home loans constitutes what has come to be known as predatory lending. From a legal and policy perspective, what is puzzling about this problem is that borrowers are agreeing to these loans against their own self-interest and despite federally-mandated disclosures regarding loan price, and, for some loans, risk of foreclosure. This paper argues that the problem is not so puzzling when the structure of the home loan market and consumer decisionmaking within that market are carefully analyzed. Federal law regarding home lending is based on a rational actor model of borrower decisionmaking, with some allowances for bounded rationality. But borrowers frequently depart from the law's model due to widespread cognitive limitations, heuristics, biases, and emotional coping mechanisms. This paper explains how sellers are able to take advantage of these impediments to optimal decisionmaking and the structure of the market to convince significant numbers of borrowers to take loans that are overpriced and overly risky. The paper also makes a number of suggestions for reform.