The Law and Economics of Subprime Lending

This working paper by Senior Scholar Todd Zywicki explores the most benefitial regulatory responses to the subprime lending crisis.



  • Sensible regulation of the subprime market should seek to preserve expanded access and competitive choice to consumers while attacking abuses.
  • The expansion of the subprime market has also brought substantial costs. Foreclosure rates generally are higher for subprime mortgages than for traditional mortgages.  Nonetheless, empirical evidence suggests that not all subprime mortgages are equally problematic and that some subprime mortgages become riskier only when several terms are combined. Thus, it is difficult to advocate blanket regulations of subprime lending.
  • Foreclosure can also be understood as a type of put "option" that a borrower may rationally exercise in the event of falling home prices. Default and foreclosure rates are higher in cities with lower real estate price appreciation over the past several years.  Moreover, empirical studies indicate that default and foreclosure rates are higher in states with "antideficiency" or "non-recourse" statutes that limit lender's remedies in the event of foreclosure to the value of the house and prohibit lenders from securing deficiency judgments against the borrower. Many of the states with unusually high foreclosure rates are also those with antideficiency statutes.
  • The causes of rising foreclosures remain ambiguous and caution is appropriate until the sources of this problem are better understood.  Foreclosures can be said to result from two different models: a "distress" model and an "option" model.  Financial distress can be the source of many foreclosures.  This includes such factors as unexpected increases in adjustable rate mortgages, job loss, and other financial setbacks.

By the Numbers

  • Over the past decade, homeownership in the United States expanded dramatically, reaching record levels of approximately 69%.  Much of this expansion has been attributed to the development of the subprime lending market which provided access to many families who were unable to qualify for mortgages in the past. Home ownership is the primary vehicle for wealth accumulation for lower-income families. Moreover, home ownership generally leads to stronger communities, better life results for children, lower crime rates, and other socially-beneficial results.
  • Statistics suggest that a growing percentage of subprime borrowers over recent years were real estate speculators seeking to "flip" houses in an expected rising real estate market. These speculators are short-term owners who would be those most likely to respond to the incentives to exercise a "put option" in a falling real estate market. Many of these speculators held "nothing down" or "negative amortization" loans. These loans are those most prone to default when property values fall.


  • Regulatory responses to the subprime lending crisis should take care not to bail out real estate speculators or the lenders who imprudently lent to these borrowers.
  • Regulators should consider improving the quality of consumer disclosures in the residential real estate market.  Recent research by the Federal Trade Commission demonstrates widespread consumer confusion among all mortgage consumers and provides recommendations for improved disclosures. Given the inherent complexity of subprime loan terms, these consumers would benefit greatly from more consumer-friendly disclosures.
  • Until the underlying causes of the subprime crisis is better understood, regulators should move cautiously to avoid creating unintended consequences of regulation.