As we search for the many causes of the economic crisis we now find ourselves in so that we can adopt measures to avert future crises, we should not ignore the failures of consumer law, including failures that policymakers have not yet addressed.
Changes in lending markets outstripped in many ways the regulatory changes in response, and these ways included the way loans are made.
As loan terms evolved and became more complex, mandated federal disclosures did not change quickly enough to make these terms comprehensible. As a result, borrowers were not well equipped to evaluate whether loans were suitable for them and may have agreed to loans that were not in their best interests.
Our major mechanism for conveying information about mortgages is the federal Truth in Lending Act, which is intended to disclose information about consumer loans simply and clearly. But evidence is mounting that the law failed many borrowers.
A 2007 Federal Trade Commission study of mortgage borrowers found that many did not understand key loan terms. Thus, half, when asked, could not state the amount of a loan even with the loan form in front of them.
As for features that are common in complex loans, two-thirds of the borrowers could not tell from a form that a penalty would be charged for refinancing within two years, and 30% did not realize that the form they were looking at disclosed a large, "balloon" payment at the loan's maturity.
Even this level of understanding assumes that people read mortgage documents. But that too is in doubt.
Recent studies have begun to confirm the long-entertained intuition that many people do not read the contracts they enter into, thwarting the possibility that they could detect problems in the contracts — such as balloon payments. In one study, 95% of the subjects signed a form without noticing that it bound them to do push-ups and administer electric shocks to others, even if they were screaming in pain. Though these studies do not settle the matter conclusively, they do raise questions about how many people learn from documents what they need in order to act in their best interests.
In sum, we have lost a significant check on the making of unwise loans. Our system permits borrowers to make inappropriate judgments because they cannot understand loan terms or are unwilling to try to understand them.
Though it is tempting to say of this latter group that they should bear the consequences of their own negligence, the fact that we are all bearing the consequences gives us an interest in preventing such negligence from recurring.
What should we do? Policymakers have already begun revising disclosure forms to increase the likelihood that those who can learn from written disclosures will be able to determine whether a particular loan is right for them. This process should continue.
But we should also recognize that some consumers are unlikely to learn from written disclosures and adopt measures that will communicate to them what they need to know. Such borrowers may need a disinterested counselor — not a mortgage broker who will profit if the loan is made — to walk them through loan terms and explain what they need to know.
Perhaps we should administer tests to loan applicants to see whether they understand their loan terms; those who fail should not be permitted to borrow unless a neutral counselor certifies that they understand the terms.
And it may be that some loan terms should be outlawed because they are too confusing. We need to install additional checks on lending, and one way to do this is to insure that borrowers understand their loan obligations.