Consumer Law & Policy Blog

Default Rules and the Arbitration Fairness Debate

by Deepak Gupta

Jeff Sovern and Paul Bland have contributed thoughtful posts on a proposal being pitched as a "compromise" in the debate over arbitration fairness.  It goes something like this: Instead of passing a law like the Arbitration Fairness Act that would make arbitration voluntary, let's just allow consumers to "opt out" of mandatory arbitration clauses, presumably by means of fine-print notices that nobody will actually read, let alone respond to. Professor Sovern rightly describes this as illusory consumer protection and, as Paul Bland notes, it's a technique that many corporations are already employing to try to defeat unconscionability arguments.

The proposal strikes me as a great illustration of the importance of default rules in choice architecture, a subject explored in the literature of law and behavioral economics and discussed in Cass Sunstein and Richard Thaler's recent book, Nudge.  Their argument revolves around a pretty simple empirical premise: “[I]f, for a given choice, there is a default option—an option that will obtain if the chooser does nothing—then we can expect a large number of people to end up with that option, whether or not it is good for them.”  Corporations take advantage of this insight all the time in consumer transactions. Thaler and Sunstein give the example of offers for magazine subscriptions that consumers continue to receive unless they take affirmative steps to cancel them; Sunstein says he himself has been paying for subscriptions for years because he hasn't gotten around to canceling them. Another example is employer retirement plans; research shows that participation is greatly increased by making it the default instead of requiring employees to opt in.

So I wonder whether proponents of the "compromise" proposal on arbitration fairness would continue to support it if the opt-out mechanism stayed the same, but the default rule were switched: Instead of opting out of mandatory arbitration, consumers would have to read a notice and affirmatively opt in.  I suspect enthusiasm for the proposal would vanish--demonstrating that a truly voluntary system is not the true objective.

Ray Brescia on the Community Reinvestment Act's Link to the Financial Crisis

Ray Brescia of Albany has written Part of the Disease or Part of the Cure: The Financial Crisis and the Community Reinvestment Act, 60 University of Sourthern Carolina Law Review 617 (2009).  Here's the abstract:

Some commentators charge that the federal Community Reinvestment Act of 1977 (CRA) spurred the mortgage crisis and the financial fallout that has followed. Born out of the Civil Rights Movement, Congress adopted the CRA at a time when many low- and moderate-income communities, often communities of color, were denied basic banking services such as home lending and small business investment. Advocates argued that when the federal government guaranteed bank deposits through federal deposit insurance, it created a social compact that served as a justification for expecting that institutions accepting such insurance should have to meet the needs of the communities making those deposits. Federal deposit insurance made bank customers confident in their bank’s holdings, which in turn made the business of banking -lending - possible and became a justification for the adoption of the CRA.

In the thirty years since the CRA’s adoption, the banking industry has been transformed. Banks are global in their reach and their outlook. Banks, in all of their forms, are no longer brick-and-mortar institutions on Main Street that take deposits from the grocer and lend to the baker. The CRA, which Congress designed to ensure that banks would meet the credit needs of the low- and moderate-income communities from which those banks take their deposits proved a weak bulwark against the subprime mortgage crisis; unsafe and unsound lending practices carried out by mortgage companies (i.e., entities not covered by the CRA because they are not depository institutions) have decimated the same communities that the CRA was supposed to protect.
The argument that the CRA is to blame for the financial crisis is hard to reconcile under any reading of the statute’s terms and after any assessment of the CRA’s true reach. As this article explains, the CRA was not too strong, but rather too weak. Designed to fight the last war, the CRA became the financial equivalent of the Maginot Line: easily circumvented, lightly defended, and quickly overrun.

An appreciation for the true causes of the financial crisis, together with the fact that the federal government has expended billions to bail out the financial industry, offer strong justifications for expanding the reach of the CRA to cover all financial institutions, not just those that take deposits. This Article begins with a brief overview of the subprime mortgage crisis and its impacts. Following this overview, it outlines the legislative history and structure of the CRA as well as the enforcement mechanisms Congress adopted to carry out the CRA’s core purpose. Next is an assessment of whether the manner in which the Act was enforced may have contributed to the subprime mortgage crisis followed by an examination of the failure of the courts to serve as a check on weak regulatory enforcement of the CRA. It concludes with the development of a series of principles to inform efforts to modernize the CRA to bring it in line with the nature of banking in the twenty-first century. While such CRA modernization might not correct the worst abuses of the subprime mortgage market from the past, it might help to avoid similar crises in the future.

Adam Levitin on How States Can Regulate National Bank Lending by Regulating the Secondary Market

Adam Levitin of Georgetown has written Hydraulic Regulation: Regulating Credit Markets Upstream, 26 Yale Journal of Regulation (2009), the imaginative thesis of which he presented at the AALS meeting in San Diego.  Here's the abstract:

Consumer protection in financial services has failed. A crisis is now playing itself out in the mortgage, credit card, auto loan, title loan, refund anticipation loan, and payday loan markets. Consumer protection was a traditional element states' regulatory power until federal preemption ousted states from almost all direct regulation of federally-chartered banks without substituting equivalent protections and enforcement.

This Article argues that one avenue may remain to permit states to engage in consumer protection regulation of federally-chartered banks. Recent changes in financial markets have placed the majority of consumer debt in the hands of secondary market entities, such as securitization trusts and debt collectors, which are not protected by federal preemption. States' ability to directly regulate the secondary consumer debt market also gives them the ability to indirectly regulate the primary market, even when direct regulation would be preempted.

States can impose targeted regulatory costs on the secondary market tied to the presence or absence of particular terms in consumer debts, regardless of what type of institution initiated the debt. By tying regulation to the terms of the debt, states can channel the hydraulic force of the market, which will pass these costs on to the originators of the debts - including federally-chartered banks. This would create an incentive for originating lenders to adjust the terms under which they originate consumer debts so as to avoid state regulatory costs. This Article contends that such regulation would not run afoul of preemption doctrine because it does not directly regulate federally-chartered banks; it affects them only indirectly, through the market.

Do Law Students Get What They Pay for When Law Professors Blog?

by Jeff Sovern

The question assumes that law students pay for faculty blogging, in that the tuition they pay goes to law faculty salaries.  That assumption is probably true, in that most law schools are largely tuition-driven, meaning that law student tuition pays for what most professors do.  You could, however, argue that blogging is something we do on our own time.  I don't know how to figure out whether that's true.  Certainly a lot of blogging gets done outside of normal business hours, but then so does teaching at the many law schools that offer evening program.  It's likely that a lot of bloggers put in more than the standard forty-hour week on their work, which suggests that blogging is an extra.  But then, probably most bloggers report to their deans that they blog, in the hope of eliciting higher raises, which would suggest that the bloggers view it as part of the job, and if it does generate larger raises, that the school does too.  Anyway, let's assume that blogging is part of the job that law students are paying for.

So what do law students get from professorial blogging?  At least three things: first, to the extent that blogging enhances a school's prestige, the students benefit from that.  Some compare being a student or an alum of a school to owning stock; as the stock/law school's reputation appreciates in value, so does the student/alum.  But does blogging really enhance prestige?  The argument that it does is that blog posts reach a lot of people which may enhance readers' views of the professor and hence the institution.  The argument that it doesn't is that the people it reaches may not vote in the reputation rankings for U.S. News, and unfortunately (in my view, at least), that seems to be the chief measure of prestige in the law school world.  At the end of the day, this is a question that can be tested empirically over the next few years: do schools with more and better bloggers rise in the rankings?  I'm not holding my breath, but we'll see.

Second, professors who blog may become more informed teachers.  My own experience, and I have no idea how universal this is, is that the fact that I blog increases my diet of consumer protection news, because I look for things to blog about.  Often what I blog about ends up as fodder for class.  But that helps only in my consumer protection class. 

Third, as my colleague Chris Borgen pointed out to me (Chris founded Opinio Juris, a leading international law blog), students also benefit when their professors blog because they can learn more about the subject by reading the blog.  Probably that also helps them understand their professor's thinking better.

The conclusion that students benefit from professorial blogging (blogging is also useful in other ways, but I'm just focusing here on student benefits) answers only part of the question, because of the opportunity costs of blogging.  If professors weren't blogging, what would they do with the time?  If they would, say, go to theater or watch TV, then students are better off when professors blog because the alternative doesn't benefit them. But if professors would work on a scholarly article, would students be better off?  I'm not sure.  First, there's the broader question, which I'm not addressing at the moment, of whether conventional scholarship benefits students, and on which people are divided.  But assume that it does benefit students.  Blogging seems to reach a lot more people.  SSRN gives us some measure of how many people read articles, and the answer is not many.  An awful lot of papers never get as many as 300 downloads.  In contrast, many blogs register that many hits in a day; this blog, which is fairly specialized, gets far more than that a day, and still others read our posts via email. SSRN is not a complete record of who reads a particular paper, since once a paper is published, people can read it in print without it showing up on SSRN, and some papers are posted elsewhere, but the available evidence suggests that more people read blog posts than law journal articles.  On the other hand, a blog post, which typically reflects far less thought, research, and care than an article in print, surely adds much less to the prestige of a writer or institution than an article.  A further complication is that all of this ignores the connections between blog posts and law journal writing.  For example, authors can use blog posts to try out ideas they will later use in articles, then post links to the article on their blogs.

But that assumes that the alternative to blogging is conventional writing.  What if it's something that benefits students more directly?  For example, many law school doctrinal classes famously base grades on a single exam at the end of the semester.  Suppose that professors took all the time they put into writing and instead administered midterms, and provided feedback to students on those midterms?  Or gave drafting assignments with feedback?  Or--well, you get the idea.  My own suspicion is that while students might not be enthusiastic about more work and feedback (remember the famous quote: "education is the only thing people pay for that they want less of"), the extra work and feedback would do more for them than any writing we could do for any outside audience.  But most of us would rather do our own writing than grade, say, and as Adam Smith wrote in his 1776 book, On the Wealth of Nations, universities are run for the faculty.

Skiba and Tobacman on Patterns of Borrowing, Repayment, and Default in Payday Loans

Paige Marta Skiba of Vanderbilt and Jeremy Tobacman of Penn have co-authored Payday Loans, Uncertainty and Discounting: Explaining Patterns of Borrowing, Repayment, and Default.  Here's the abstract:

Ten million American households borrowed on payday loans in 2002. Typically, to receive two weeks of liquidity from these loans households paid annualized (compounded) interest rates over 7000%. Using an administrative dataset from a payday lender, we seek to explain demand-side behavior in the payday loan market. We estimate a structural dynamic programming model that includes standard features like liquidity constraints and stochastic income, and we also incorporate institutionally realistic payday loans, default opportunities, and generalizations of the discount function. Method of Simulated Moments estimates of the key parameters are identified by two novel pieces of evidence. First, over half of payday borrowers default on a payday loan within one year of their first loans. Second, defaulting borrowers have on average already repaid or serviced five payday loans, making interest payments of 90% of their original loan's principal. Such costly delay of default, we find, is most consistent with partially naive quasi-hyperbolic discounting, and we statistically reject nested benchmark alternatives.

Howell E. Jackson on the Trilateral Dilemma in Financial Regulation

Howell E. Jackson of Harvard has written The Trilateral Dilemma in Financial Regulation in IMPROVING THE EFFECTIVENESS OF FINANCIAL EDUCATION AND SAVINGS PROGRAM (Anna Maria Lusardi, ed., University of Chicago Press, 2008).  Here's the abstract:

In choosing financial products and services, consumers often rely on financial advisers to recommend products or services. With surprising frequency, these advisers receive side payments or other forms of compensation from the firms that provide the products or services the advisers recommend. Many times these payments are not clearly disclosed to consumers; often they are entirely secret. These practices, which I label the trilateral dilemma of financial regulation, raise concerns that advisers may be giving their customers biased advice. Side payments of this sort also have the potential to increase the cost of financial products and services. In this article, I describe how trilateral dilemmas have arisen in many different sectors of the financial services industry, including mortgage lending, retirement savings, investment management, insurance brokering, student loans, and banking services. I then review the many different regulatory strategies that Congress and regulatory agencies have employed to police trilateral dilemmas and assess the efficacy of these techniques in solving the problems that side payments of this sort pose. I also evaluate the possibility that side payments and other forms of indirect compensation may in fact be an efficient or at least innocuous means of financing the cost of distributing financial products and services. The article concludes with a brief discussion of how consumer education might address trilateral dilemmas.

Oren Bar-Gill on The Law, Economics and Psychology of Subprime Mortgage Contracts

Oren Bar-Gill of NYU has written The Law, Economics and Psychology of Subprime Mortgage Contracts, 94 Cornell Law Review (2009).  Here's the abstract:

Over 4 million subprime loans were originated in 2006, bringing the total value of outstanding subprime loans over a trillion dollars. A few months later the subprime crisis began, with soaring foreclosure rates and hundreds of billions, perhaps trillions, of dollars in losses to borrowers, lenders, neighborhoods and cities, not to mention broader effects on the US and world economy. In this Article, I focus on the subprime mortgage contract and its central design features. I argue that these contractual design features can be explained as a rational market response to the imperfect rationality of borrowers. Accordingly, for many subprime borrowers loan contracts were not welfare maximizing. And to the extent that the design of subprime mortgage contracts contributed to the subprime crisis, the welfare loss to borrowers, substantial in itself, is compounded by much broader social costs. Finally, I argue that a better understanding of the market failure that produced these inefficient contracts should inform the ongoing efforts to reform the regulations governing the subprime market.

Judicial Hellholes, Debunked

by Deepak Gupta

Those of us who regularly read amicus briefs by the likes of the U.S. Chamber of Commerce and other self-styled tort reform groups are used to seeing references to "judicial hellholes" -- jurisdictions that supposedly embody a "lawsuit climate" hostile to corporate defendants accused of cheating or injuring consumers.  For many years, the American Tort Reform Association has compiled a pseudoscientic annual ranking of these jurisdictions, with perennial favorite West Virginia topping the list. The lists are used not only in amicus briefs--which often suggest that the decision below is suspect because it came from such a jurisdiction--but also to help influence legislative policy.

In 2005, Public Citizen's Congress Watch released a short report, Class Action "Judicial Hellholes": Empirical Evidence Is Lacking, showing that the hellholes rankings were not backed by any actual evidence and therefore provided no justification for proposed class-action legislation. More recently, Professor Elizabeth Thornburgh (SMU Law) has published an interesting new law review article, Judicial Hellholes, Lawsuit Climates, and Bad Social Science: Lessons from West Virginia, offering a more detailed account of ATRA's "hellholes" campaign, focusing on West Virginia. My favorite part is the section that starts on page 26, "Smoke and Mirrors: The Marketing of Anecdotes," in which Thornburgh colorfully illustrates four different deceptive strategies that ATRA has used to support its "hellhole" designation of that state: treating opinions as facts; grossly distorting quotations by former West Virginia Supreme Court Justice Richard Neely; misstating the issues; and leaving out bad facts entirely. It's worth a read.

Paper on Predatory Mortgage Lending

Philip Bond, David K. Musto, and Bilge Yilmaz, all of Penn's Finance Department, have written Predatory Mortgage Lending.  Here's the abstract: 

Regulators express growing concern over predatory loans, which the authors take to mean loans that borrowers should decline. Using a model of consumer credit in which such lending is possible, they identify the circumstances in which it arises both with and without competition. The authors find that predatory lending is associated with highly collateralized loans, inefficient refinancing of subprime loans, lending without due regard to ability to pay, prepayment penalties, balloon payments, and poorly informed borrowers. Under most circumstances competition among lenders attenuates predatory lending. They use their model to analyze the effects of legislative interventions.

Amy Schmitz on Consumer Warranty Arbitration

Amy Schmitz of Colorado has written Curing Consumer Warranty Woes Through Regulated Arbitration, 23 Ohio State Journal of Dispute Resolution.  Here's the abstract: 

This article proposes legislative procedural reforms accounting for the realities of consumer arbitration that have threatened and denied consumers' access to remedies for companies' violations of public, or statutory, warranty remedies under the Magnuson-Moss Warranty Act (MMWA). Furthermore, the Article proposes to clarify and expand the MMWA's current dispute resolution template in order to resolve judicial disagreement regarding the template's application and foster beneficial use of finding arbitration. Accordingly, this is not a call to ban all pre-dispute arbitration clauses in consumer contracts, but is instead an invitation for more politically palatable reforms that preserve both companies' savings and consumers' access to warranty remedies through arbitration. The time is ripe for legislative reforms that account for the importance of procedural justice and temper contractors' and courts' deference to consumer form contracts.