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									       R&C
Subprime Lending




          April 2007

   Research & Commentary
         Prepared by
THE HEARTLAND INSTITUTE
 publisher of Budget & Tax News
                                April 2007

       Research and Commentary on Subprime Lending
                              Table of Contents


1. Steve Stanek, “Introduction to an R&C on Subprime Lending,” The Heartland
   Institute, April 2007

2. Jeff Brown, “Subprime Lending Does Have its Benefits,” Belleville News
   Democrat, March 25 2007
   http://www.belleville.com/mld/belleville/business/16970314.htm

3. Sue Kirchoff, “Minorities Depend On Subprime Loans,” USA TODAY, March
   13, 2005
   http://www.usatoday.com/money/perfi/housing/2005-03-16-subprime-usat_x.htm

4. Morgan Long, “Left With Nothing: The True Predator Behind Subprime
   Lending,” American Legislative Exchange Council, October 2001
   http://www.alec.org/meSWFiles/pdf/0127.pdf

5. Austan Goolsbee, “‘Irresponsible’ Mortgages Have Opened Doors to Many of
   the Excluded,” New York Times, March 29 2007
   http://www.nytimes.com/2007/03/29/business/29scene.html?ex=1176264000
   &en=5d6de32ca1035f3c&ei=5070

6. Alex J. Pollock, “How Sharp Minds Got Lost in Subprime Bust,” American
   Enterprise Institute, March 39 2007
   http://www.aei.org/include/pub_print.asp?pubID=25871

7. “Subprime Meltdown: Who’s to Blame and How Should We Fix It?”,
   Knowledge@Wharton, University of Pennsylvania, March 21 2007
   http://knowledge.wharton.upenn.edu/article.cfm?articleid=1691

8. Daniel Crane, “The Perverse Effects of Predatory Pricing Law,”Regulation,
   Winter 2005-2006, Cato Institute
   http://www.cato.org/pubs/regulation/regv28n4/v28n4-4.pdf
                                   Introduction
                          to an R&C on Subprime Lending
                                      By Steve Stanek
                             Managing Editor, Budget & Tax News
                                        April 2007


Growing anger and angst aimed at the subprime mortgage industry by some lawmakers and
consumer groups appears to be misplaced. The following articles help explain the issues and
argue for circumspection and restraint by lawmakers.

The latest figures available, for the fourth quarter of 2006, show subprime mortgage delinquency
rates were higher in 2001 and 2002 than they are now, at about 13 percent. Delinquencies have
exceeded 10 percent every quarter of the past decade.

The recent increase in delinquencies seems to be linked to specific local and regional economies,
not to problems inherent in the subprime mortgage market. The latest industry figures show most
foreclosures are occurring in states with serious economic problems, including Michigan and
Ohio, where the auto industry is taking a beating, and along the Gulf Coast, where the economic
effects of Hurricanes Katrina and Rita are still being felt.

Cracking down on subprime lenders, as some recommend, could hurt large numbers of people
who cannot qualify for standard loans. The subprime lending market has helped thousands of
families with poor credit or no credit become homeowners. That some of these subprime loans
are going bad should come as no surprise. A subprime loan, by definition, is riskier than a
standard loan.

One irony in the attacks by lawmakers and consumer groups who want government action is that
government and consumer groups have themselves encouraged the growth of subprime loans.
The push by government began in the 1970s with the passage of the Community Reinvestment
Act, which pressured lenders to extend more credit in low-income neighborhoods. Subprime
mortgages were the response, as they make credit available to persons who otherwise could not
qualify for it.

Another irony in the attacks is that this is one government push that appears to have worked.
Nearly 70 percent of homes are now owned by their occupants, a record level of home ownership
in the U.S.

The lending industry is already one of the most heavily regulated industries in the nation. The
further regulations now under consideration could dry up credit for women and minorities, who
have benefitted the most from the subprime mortgage industry.

                                              ###
Posted on Sun, Mar. 25, 2007




Subprime lending does have its benefits


Don't get me wrong -- I don't want to defend sleazy lending practices that have hurt homeowners who have subprime
mortgages.

But as one mortgage expert told me the other day, there's a difference between subprime lending and predatory lending:
Subprime is good, predatory is bad.

You can hardly see the distinction these days because so many news stories trace problems in the economy and financial
markets to the "meltdown" in subprime loans, given to borrowers with low incomes or checkered credit who cannot get
ordinary "prime" mortgages.

There are problems: Most subprime loans carry higher interest rates than prime loans. And, after the first one, two or
three years, those rates typically adjust every 12 months. Many borrowers are now seeing their payments jump 30
percent to 50 percent, to levels they cannot afford. And because the housing market has slowed, many troubled
borrowers may not be able to sell their homes for as much as they owe.

Last week, Sen. Chris Dodd, D-Conn., chairman of the Senate Banking Committee, said he would introduce legislation to
assist homeowners facing foreclosure and to curb predatory lending practices. And consumer groups have been pushing
a variety of government-backed remedies.

Perhaps some measures would make sense, but let's keep the problem in perspective.

In the fourth quarter of 2006, 13.3 percent of subprime borrowers were behind in their payments compared with 2.6
percent for prime loans, the Mortgage Bankers Association reported last week. About 4.5 percent of subprime loans were
somewhere in the foreclosure process compared with 0.5 percent for prime loans.

Clearly, subprime loans are riskier than prime loans. But they are not much riskier than they used to be. In fact,
subprime delinquencies rates were higher in 2001 and 2002 than today, and they have exceeded 10 percent every
quarter for the past decade.

What's changed is that more homeowners have subprime loans today, so the same failure rates affect more people. One
consumers' group estimates that 2.2 million homeowners are at risk of foreclosure over the next few years. There were
1.2 million foreclosure filings in 2006, a 42 percent increase from the year before.

But look at the numbers the other way around: More than 86 percent of subprime borrowers are not late in payments,
and more than 95 percent are not in foreclosure.

Surely, many of these homeowners, probably most, are glad they got subprime loans because without them they'd still
be renters.

Today's subprime loans have their roots in the federal Community Reinvestment Act of 1977, which pressured lenders to
offer mortgages in poor communities. In the 1990s, Congress and the Clinton administration worked to encourage
broader homeownership. It's now at a near-record level, with about 69 percent of homes owned by their occupants.

Also, research in the 1980s and '90s showed that borrowers with low incomes and weak credit scores were not as risky
as lenders had previously thought. Additionally, the 1990s saw a mushrooming of "securitization," the bundling of
mortgages into a form of bond that can be traded on the secondary market, allowing the lender to pass risks to willing
    investors, and then to lend more.

    These factors, along with low interest rates and booming housing prices, fueled the growth in subprime lending.
    Basically, this was a good thing.

    Certainly, there have been predatory practices in recent years -- occasions when mortgage brokers or lenders have
    steered borrowers to subprime loans that were too risky for them. Experts say brokers' commissions on subprime loans
    can be two to three times those on prime loans -- a formula for abuse.

    That should be disclosed to borrowers -- as should all the special risks that come with subprime loans, such as the
    possibility that mortgage payments can soar. Regulators and legislators ought to strengthen disclosure rules and perhaps
    impose stronger penalties on brokers and lenders who conceal risks.

    But they should not try to restrict creation and marketing of innovative products that allow millions of people to buy
    homes that they otherwise couldn't. As long as borrowers go in with their eyes open, they have a right to take the risks
    that come with subprime mortgages.

    Jeff Brown is a business columnist for The Philadelphia Inquirer. E-mail him at brownj@phillynews.com.
 
Minorities depend on subprime loans
By Sue Kirchhoff, USA TODAY
WASHINGTON — Women, minorities and lower-income borrowers depend on subprime lenders, firms
that specialize in higher-cost loans to people with blemished credit records, for a disproportionate share
of mortgages and refinance loans.

A new study of the 331 U.S. metropolitan areas using 2003 federal data showed women were more likely
to get subprime, rather than prime, loans in every one.

 FAIR LENDING DISPARITIES
 Prime lenders lagged subprime lenders by the following percent of metro areas nationwide:
 Women                                                                     100%
 African Americans                                                         98.5%
 Hispanics                                                                 89.1%
 Source: National Community Reinvestment Coalition




Subprime loans were more prevalent among blacks in 98.5% of the metropolitan areas, while Hispanics
were more apt to hold a subprime mortgage or refinance loan in nearly 89.1%, according to the National
Community Reinvestment Coalition (NCRC), a non-profit focused on lending and community-
development issues.

Lower-income borrowers also turned to subprime lenders in large numbers, with prime lenders lagging
the subprime industry in serving those with incomes 80% or less of their area median, in about 86% of
cities studied. In neighborhoods with a concentration of low-income households, that rose to 98%.

An industry expert says differences in lending patterns don't, on their face, prove discrimination, and
could instead show differences in credit worthiness or the fact subprime lenders are reaching hard-to-
serve populations. Federal housing data don't outline such financial factors as credit scores and income
that are key to lending.

"It's not at all surprising that, at least in many metropolitan areas, you would have high concentrations of
African-Americans and Hispanics getting subprime loans. ... African-Americans and Hispanics as a group
are more economically disadvantaged," says Wright Andrews, an attorney who represents the Coalition
for Fair and Affordable Lending, a group of subprime lenders.

 Not getting the best deal
African-Americans are more likely to get a mortgage loan from a subprime than a prime lender. Metro areas with
the biggest difference:
%. of loans to African-Americans
Metropolitan area                   Prime            Subprime               Difference in pctg. points
Macon, Ga.                          13.7%             59.3%                           45.6
Florence, S.C.                      10.3%             54.5%                           44.2
Pine Bluff, Ark.                    21.0%             64.8%                           43.8
Albany, Ga.                         15.8%             58.3%                           42.4
Memphis                             14.4%             55.4%                           41.0
Rocky Mount, N.C.                   15.5%             53.4%                           37.9
Jackson, Miss.                      12.6%             50.4%                           37.8
    Montgomery, Ala.                    12.6%           50.1%                     37.5
    Greenville, N.C.                    9.3%            43.6%                     34.3
    New Orleans                         11.5%           43.8%                     32.3
    Goldsboro, N.C.                     12.0%           44.3%                     32.3
    Columbus, Ga.                       12.5%           44.7%                     32.2
    Sumter, S.C.                        18.9%           50.6%                     31.7
    Source: National Community Reinvestment Coalition



Differences in lending patterns could be stark. In Macon, Ga., prime lenders issued 13.7% of loans to
blacks, compared with 59.3% for subprime lenders. The 25 areas with the greatest difference in lending
to blacks were in the South.

In Salinas, Calif., about 58% of loans by subprime firms went to Hispanics, compared with 25.5% for
prime lenders, according to the data collected under the federal Home Mortgage Disclosure Act.

NCRC Vice President for Policy and Research Joshua Silver says one of the more surprising parts of the
study was how geographically broad the lending patterns were.

"Disparities were particularly bad in the medium-sized metropolitan areas, where there are a lot of
African-Americans. For Hispanics, it was the South and the West," Silver says.

In recent years the subprime mortgage industry has expanded faster than the prime sector, while home
ownership rates for minorities have risen. Government and banking officials say that shows that subprime
lenders have filled a legitimate need. But there has been a rise in predatory lending — unaffordable loans
borrowers have no realistic way to repay — with dozens of states passing laws to curb it.

The NCRC study comes as Congress prepares for a possible debate on a bill to set national predatory
lending standards. The subprime industry is also bracing for 2004 housing data including loan pricing.

The NCRC report generally found that as white/black segregation rose in neighborhoods, so did
disparities. Of the 331 metropolitan areas, 22% had a 15-percentage- point or greater difference in
subprime vs. prime lending to blacks. In Florence, S.C., prime lenders made 10.3% of their loans to
blacks, subprime firms 54.5%. In St. Cloud, Minn., prime lenders made 0.3% of loans to blacks, subprime
1.1%.

 
                                      AMERICAN LEGISLATIVE EXCHANGE COUNCIL


                                              Left With Nothing:
                                  The True Predator Behind Subprime Lending
                            By Morgan Long                                                                               October 2001



                            W
 Jeffersonian                           hy is it that self-appointed consumer     but also to America’s mom and pop stores. The
  Principles                            advocates have so little regard for       corner bakery, pizzeria, dry-cleaner, and the local
  in Action                             consumers? In their world, it seems       diner are regularly subject to credit blemishes,
                            that consumers are misguided dupes in constant        common in the world of small entrepreneurs;
                            need of protection from the marketplace. In           such businesses may find it difficult to secure a
   ALEC Issue Analysis

                            their latest cause du jour, consumer advocates        bank loan for expansion, renovation, working
                            and their allies are advising city council leaders,   capital, or the like if subprime lending is regulated
                            state legislators, and Congress to impose new         out of the lending market. Twenty to thirty
                            regulations on lending practices in the subprime      percent of the nation’s six million small busi-
                            market—in an unsolicited effort to protect            nesses are considered poor credit prospects and
                            borrowers from themselves.                            must seek alternates to conventional bank loans
                                 A poor credit rating can limit or hamper the     when they need a cash infusion.3 Seeking to
                            buying power of individuals or businesses, but        eliminate high risk lending would in effect
                            subprime lending opens the door for new finan-        remove access to money not only for thousands
                            cial opportunities. This increased access to          of low-income earners but also small business.
                            credit has afforded low income working Ameri-         Who then, is the real predator?
                            cans the opportunity to own their own homes,                             Background
                            secure capital to start their own businesses, and
                                                                                       Markets develop to fill demands. Subprime
                            to obtain finances to send their children off to
                                                                                  lending is an excellent example of a market that
                            college. But rather than recognize these lending
                                                                                  developed through the advancement of technol-
                            market accomplishments, consumer advocates
                                                                                  ogy to answer sub par credit borrowers’ demand
                            are demonizing subprime lenders. Accused of
                                                                                  for money. Since the early 1990’s subprime
                            praying on grandmothers, single mothers, and
                                                                                  mortgage originations have skyrocketed—
                            minorities, regulation advocates have portrayed
                                                                                  increasing tenfold since 1993.4 The dollar
                            lenders as predatory sharks, tricking the less
                                                                                  volume of subprime mortgages was less than five
                            advantaged with lending schemes and forcing
                                                                                  percent of all mortgage originations in 1994, but
                            them out of their homes.
                                                                                  by 1998 it had risen to 12.5 percent.5 Between
                                 The reality of the subprime lending market,
                                                                                  1993 and 1998, mortgages extended to Hispanic
                            however, is a far cry from the images of the
                                                                                  Americans and African Americans increased the
                            unscrupulous feeding off the uneducated and
                                                                                  most, by 78 and 95 percent respectively, largely
                            poor. Subprime lending—loans made to individu-
                                                                                  due to the growth in subprime lending.6 Access
                            als with troubled credit histories who are unable
                                                                                  to subprime loans has resulted in the fulfillment
                            to obtain credit at the prime interest rate—has
                                                                                  of the American Dream to many who thought
                            lead to the realization of the American dream for
                                                                                  they were closed out from such opportunity.
                            many people who thought they would never own
                                                                                       The technology advancement that enables
                            their own home, rebuild their credit, or have
                                                                                  lenders to project the relative risk of a loan has
                            other financial opportunities. Subprime credit
                                                                                  drastically increased the availability of credit to
                            accounts for twenty-five percent of outstanding
                                                                                  those who were formerly turned down by
                            home equity credit.1 More than $100 billion in
                                                                                  traditional lenders. Such practices as risk pricing,
                            mortgage loans secured by subprime lenders are
                                                                                  using Fair Isaac Co. (FICO) scores, and the use
                            made annually to people with tarnished credit
                                                                                  of points, insurance, and prepayment penalties
                            histories.2 Small business benefits too.
910 17th Street N.W.                                                              limit the risks lenders and borrowers bear and the
                            Subprime lending opens access to money not
      Fifth Floor                                                                 costs borrowers pay.7 These practices make
  Washington, D.C.          only to individuals with personal credit problems,
                                                                                  economic sense and bring essential benefits to
        20006
 Tel. (202) 466-3800
                                  Morgan Long is the Director of the Telecommunications and Information Technology Task Force
FAX (202) 466-3801
              October
   www.ALEC.org                                          for the American Legislative Exchange Council
                         2001 _________________________________________________________________________________               1
consumers. Such market innovations allow lenders to          prepayment penalties, and restricts credit terms,
gauge, price, and control risk better than before            consumer advocates are demanding more regulation.
thereby allowing them to tolerate greater gradations of      They forget that lending is already one of the most
risk among borrowers. The result has increased               heavily regulated industries. Not only subject to
competition and choice in the subprime market, greatly       pervasive states regulations, lenders must also comply
improving the allocation of financial resources to those     with a wide array of federal consumer protections
borrowers who were formerly turned down.                     laws.10 In fact, laws already on the books, if enforced,
     Those included in the subprime market are people        would silence the cries of fowl uttered by proponents
who have delinquent bills, bankruptcies, or other            of new anti-subprime lending legislation. Many of the
financial problems that keep major bank lenders from         predatory abuses violate current law or result from
lending them money. Institutions who participate in          lack of disclosure, which also violate current law.
subprime lending are lending money at above average          Increased regulation that jeopardizes the existence of
risks. The probability of default on a mortgage for the      the subprime lending industry does nothing to prohibit
highest risk class of subprime borrowers is approxi-         practices that are already illegal.
mately twenty-three percent—more than one thou-                   The result of such medalling in personal finances is
sand times the default risk of the lowest risk class of      a loss of access to money for people who need the
prime mortgage borrowers.8 Keep in mind that this is         loans the most. Banning the use of prepayment
an average, so some subprime mortgages have even             penalties—often identified as one of the most abusive
higher risk of default. To accept such risk of loss,         predatory lending practices—increases costs to not
subprime lenders have to charge higher interest rates        only the borrower but also to the lender. Advocates of
to be able to sustain financial resources to borrowers       increased regulation forget that default risk is not the
with rocky credit history. This is not a predatory           only risk that lenders bear. Prepayment risk is just as
practice, but rather the reality of financial allocation.    damaging to the survival of a lending institution as a
                The Predatory Abuse                          loan defaulting. Loans are made with the cost of
                                                             originating and servicing the loan spread out over the
     Consumer advocates seem to glaze over the
                                                             loan’s duration—each payment pays part of the debt
increased access to credit, in favor of painting the
                                                             and part of the service cost associated with the loan.
subprime market as loan sharks feeding on the unedu-
                                                             Prepayment results in loss to the lender. An additional
cated and elderly. Highlighting abusive loan practices
                                                             loss to the lender results from the reduction in the value
practiced by fraudulent individuals, advocates are
                                                             of the loans network when revenue is lost by prepay-
demanding legislation to protect those in our communi-
                                                             ment. If policymakers prohibit lenders from protecting
ties “who need it most.” But are these advocates truly
                                                             themselves from prepayment loss, lenders will have to
acting against predatory lending to protect such
                                                             “frontload” the cost of the loan, making it more difficult
troubled communities? Those who oppose “predatory”
                                                             for low-income borrowers to access money.11
lending argue that these targeted people are too
                                                                  Another cry of injustice is the higher interest rates
irresponsible to be trusted with such financial decisions.
                                                             charged to subprime borrowers—rates that are higher
However, ninety-six percent of those who used
                                                             because the risk of default is greater. Placing price
subprime lending from American Financial Services
                                                             caps on interest rates for subprime loans would have
Association members have done so successfully.9 Just
                                                             the same impact as a price ceiling in any other industry:
short of calling these individuals too unintelligent to
                                                             demand would exceed supply. Access to money for
manage their own financial decisions, policymakers
                                                             many low-income, poor credit people, would disappear,
have launched into a campaign to strangle the subprime
                                                             removing their opportunity to purchase homes, buy
market, which will cause irreparable harm—leaving
                                                             cars, or obtain other high-ticket items.
those who need access to money the most with
                                                                  North Carolina was the first state to enact a
nothing. Demanding the elimination of prepayment
                                                             predatory lending law in 1999. Designed to protect
penalties and the reduction of interest rates for sub-par
                                                             lower-income, less educated consumers from being
credit borrowers, such consumer advocates are
                                                             “taken advantage of by unscrupulous lenders,” this law
threatening access to credit for the same people they
                                                             has resulted in a shrinking of credit to the same people
are allegedly helping.
                                                             for whom the legislation was drafted to protect.
     Armed with new legislation that, at the least,
                                                             Countrywide Home Loans, Inc. is among the first
establishes price caps on interest rates and fees, bans
                                                             financial lenders to withdraw from subprime lending in

2    __________________________ Issue Analysis — Left With Nothing: The True Predator Behind Sub-Prime Lending
North Carolina since the predatory lending legislation                                           Notes:
was passed.12 Originations of subprime mortgage             1 Wallace, George. Testimony before the US Senate Committee on Banking, Housing,
loans in North Carolina have plummeted after the           and Urban Affairs’ hearing on Predatory Mortgage Lending. American Financial
                                                           Services Association, July 27, 2001.
passage of law—a result directly related to the de-         2 Talley, Karen. Norwest Bids to Dominate Subprime Lending Under New Chief.
                                                           American Banker, August, 1996.
crease in the supply of loans. For borrowers making         3 Santilli, Beverly. What are Your Alternatives For Financing? About.com, http://
less than $25,000 a year, mortgage originations dropped    entrepreneurs.about.com/library/weekly/n011001.html
                                                            4 US Department of Housing and Urban Development and US Department of the Trea-
by half; for those making under $49,000, originations      sury (2000). Curbing Predatory Home Mortgage Lending: A Joint Report. June.
dropped where cut by a third.13 Excessive regulation        5 Calomiris, Charles. What to Do, and What Not to Do, About Predatory Lending.
                                                           American Enterprise Institute, July 26, 2001.
has devastated the supply of mortgage loans to lower        6 Ibid.
income workers in the state. The justification by           7 Ibid.
                                                            8 Ibid.
policymakers for limiting borrowing because the cost is     9 Wallace, George. Testimony before the US Senate Committee on Banking, Housing,
more than some observers would willingly pay, or the       and Urban Affairs’ hearing on Predatory Mortgage Lending. American Financial
                                                           Services Association, July 27, 2001. The American Financial Services Association is
amount borrowed strikes some as being too high, is         a trade association for a wide variety of market-funded lenders, including both prime and
                                                           subprime lenders. This study was taken over a five year period.
ludicrous.                                                  10 Federal consumer protection lending laws: Truth in Lending Act, Real Estate Settle-
     North Carolina is not alone in ill-drafted lending    ment Procedures Act, Fair housing Act, Fair Credit Reporting Act, Equal Credit Oppor-
                                                           tunity Act, Fair Credit Billing Act, Home Mortgage Disclosure Act, Federal Trade Com-
legislation. New York and Massachusetts have both          mission Act, and Fair Debt Collection Practices Act.
recently increased restrictions in lending. California,     11 “Frontloading” is the practice of charging points and reducing the interest rate on
                                                           the loan to protect against prepayment risk to the lender. Such a practice reduces the
Illinois, Tennessee, and Washington are considering        incentive of the borrower to refinance when interest rates fall.
increased lending regulation. Counties and city councils    12 Oppel, Richard Jr. and McGeehan, Patrick. Lenders Try to Fend Of Laws on Subprime
                                                           Loans. The New York Times, April 4, 2001.
have also jumped into the mess of deciding who should       13 Staten, Michael and Elliehausen, Gregory. The Impact of The Federal Reserve
have access to money. Dayton and Cleveland, Ohio,          Board’s Proposed Revisions to HOEPA on the Number and Characteristics of HOEPA
                                                           Loans. Georgetown University, July 2001. Through statistical research, Staten com-
Philadelphia, Pennsylvania, and Oakland, California,       pares changes in mortgage originations in North Carolina with those in South Carolina
                                                           and Virginia, before and after the passage of the North Carolina Predatory Lending Law.
are among the local-level governments effectively
removing access to money for those who have the
most difficulty securing it.
                 The Consequences
     By hamstringing the subprime market, policymak-
ers will have to face a series of unintended conse-
quences. Broadly limiting fairly set rates charged by
financial institutions to certain borrowers will reduce
the total amount of money available to lend to high-risk
loan applicants. Such intrusion into the mechanics of
the financial market will force subprime applicants to
borrow from less regulated lenders who charge even
higher effective rates. Should sub par credit quality
borrowers be given fewer choices than prime borrow-
ers?
     Would you rather have access to nothing? Those
in favor of predatory lending laws would prefer to
eliminate access to money for those shut out from
prime credit markets, rather than to allow those
individuals with blemished credit histories to receive
loans at subprime rates. If over-burdensome regulation
such as the North Carolina predatory lending law
continues, traditional lenders such as prominent banks     Founded in 1973, The American Legislative Exchange Council (ALEC)
                                                           is the nation's largest individual membership association of state legis-
and other reputable lending companies will close their     lators, with 2,400 members nationwide. ALEC is a 501(c)(3) non-profit
subprime lending branches—removing opportunity for         educational and public policy association. Nothing contained herein
those individuals who cannot qualify for loans under       should be construed as an attempt to aid or hinder the passage of any
normal conditions. The result: credit challenged           bill in the U.S. Congress or any state legislature.
individuals and businesses will be left with nothing.      Publications Code: 0127 $5.00 for non-members


October 2001 _________________________________________________________________________________                                              3
March 29, 2007
ECONOMIC SCENE

‘Irresponsible’ Mortgages Have Opened Doors to
Many of the Excluded
By AUSTAN GOOLSBEE


“We are sitting on a time bomb,” the mortgage analyst said — a huge increase in
unconventional home loans like balloon mortgages taken out by consumers who cannot
qualify for regular mortgages. The high payments, he continued, “are just beginning to
come due and a lot of people who were betting interest rates would come down by now risk
losing their homes because they can’t pay the debt.”

He would have given great testimony at the current Senate hearings on subprime
mortgage lending. The only problem is, he said it in 1981 — when soon after several of the
alternative mortgage products like those with adjustable rates and balloons first became
popular.

When Senator Christopher J. Dodd, Democrat of Connecticut, gave his opening statement
last week at the hearings lambasting the rise of “risky exotic and subprime mortgages,” he
was actually tapping into a very old vein of suspicion against innovations in the mortgage
market.

Almost every new form of mortgage lending — from adjustable-rate mortgages to home
equity lines of credit to no-money-down mortgages — has tended to expand the pool of
people who qualify but has also been greeted by a large number of people saying that it
harms consumers and will fool people into thinking they can afford homes that they
cannot.

Congress is contemplating a serious tightening of regulations to make the new forms of
lending more difficult. New research from some of the leading housing economists in the
country, however, examines the long history of mortgage market innovations and suggests
that regulators should be mindful of the potential downside in tightening too much.

A study conducted by Kristopher Gerardi and Paul S. Willen from the Federal Reserve
Bank of Boston and Harvey S. Rosen of Princeton, Do Households Benefit from Financial
Deregulation and Innovation? The Case of the Mortgage Market (National Bureau of
Economic Research Working Paper 12967), shows that the three decades from 1970 to
2000 witnessed an incredible flowering of new types of home loans. These innovations
mainly served to give people power to make their own decisions about housing, and they
ended up being quite sensible with their newfound access to capital.

These economists followed thousands of people over their lives and examined the evidence
for whether mortgage markets have become more efficient over time. Lost in the current
discussion about borrowers’ income levels in the subprime market is the fact that someone
with a low income now but who stands to earn much more in the future would, in a perfect
market, be able to borrow from a bank to buy a house. That is how economists view the
efficiency of a capital market: people’s decisions unrestricted by the amount of money they
have right now.

And this study shows that measured this way, the mortgage market has become more
perfect, not more irresponsible. People tend to make good decisions about their own
economic prospects. As Professor Rosen said in an interview, “Our findings suggest that
people make sensible housing decisions in that the size of house they buy today relates to
their future income, not just their current income and that the innovations in mortgages
over 30 years gave many people the opportunity to own a home that they would not have
otherwise had, just because they didn’t have enough assets in the bank at the moment they
needed the house.”

Of course, basing loans on future earnings expectations is riskier than lending money to
prime borrowers at 30-year fixed interest rates. That is why interest rates are higher for
subprime borrowers and for big mortgages that require little money down. Sometimes the
risks flop. Sometimes people even have to sell their properties because they cannot make
the numbers work.

The traditional causes of foreclosure, even before there was subprime lending, were job
loss, divorce and major medical expenses. And the national foreclosure data seem to
suggest that these issues remain paramount. The latest numbers show that foreclosures
have been concentrated not in places where real estate bubbles have supposedly been
popping, but rather in places whose economies have stagnated — the hurricane-torn
communities on the Gulf of Mexico and the industrial Midwest states like Ohio, Michigan
and Indiana, where the domestic auto industry has suffered. These do not automatically
point to subprime lending as the leading cause of foreclosure problems.

Also, the historical evidence suggests that cracking down on new mortgages may hit
exactly the wrong people. As Professor Rosen explains, “The main thing that innovations
in the mortgage market have done over the past 30 years is to let in the excluded: the
young, the discriminated against, the people without a lot of money in the bank to use for a
down payment.” It has allowed them access to mortgages whereas lenders would have
once just turned them away.

The Center for Responsible Lending estimated that in 2005, a majority of home loans to
African-Americans and 40 percent of home loans to Hispanics were subprime loans. The
existence and spread of subprime lending helps explain the drastic growth of
homeownership for these same groups. Since 1995, for example, the number of African-
American households has risen by about 20 percent, but the number of African-American
homeowners has risen almost twice that rate, by about 35 percent. For Hispanics, the
number of households is up about 45 percent and the number of homeowning households
is up by almost 70 percent.

And do not forget that the vast majority of even subprime borrowers have been making
their payments. Indeed, fewer than 15 percent of borrowers in this most risky group have
even been delinquent on a payment, much less defaulted.

When contemplating ways to prevent excessive mortgages for the 13 percent of subprime
borrowers whose loans go sour, regulators must be careful that they do not wreck the
ability of the other 87 percent to obtain mortgages.

For be it ever so humble, there really is no place like home, even if it does come with a
balloon payment mortgage.

Austan Goolsbee is a professor of economics at the University of Chicago Graduate
School of Business and a research fellow at the American Bar Foundation. E-mail:
goolsbee@nytimes.com.
How Sharp Minds Got Lost in Subprime Bust
By Alex J. Pollock
Posted: Friday, March 30, 2007
ARTICLES
American Banker
Publication Date: March 30, 2007

                                The subprime mortgage lending bust, now in process, displays all the classic results of
                                recurring credit overexpansions. Such credit celebrations are based on optimism and a
                                euphoric belief in the ever-rising price of some asset class, in this case, houses and
                                condominiums. They are inevitably followed by a hangover of defaults, failures,
                                dispossession of widows and orphans (already the subject of congressional interest), and
                                the risk of a late-cycle regulatory reaction which drives the market further down.

                           In the general pattern, nothing changes. As the great student of economics and finance,
             Resident Fellow
                           Walter Bagehot, observed in 1873: "The mercantile community will have been unusually
              Alex J. Pollock
                           fortunate if during the period of rising prices it has not made great mistakes. Such a period
naturally excites the sanguine and the ardent. Every great crisis reveals the excessive speculations of many houses
which no one before suspected."

In the period of rapidly rising house prices, the mortgage lending community, some of its members no doubt sanguine,
ardent, and enjoying big commissions and bonuses, made some significant mistakes.

  The market became enamored with the statistical treatments of risk, while the most important issue is
  always the human sources of risk.

Now we have the failure of numerous subprime mortgage banks, delinquencies and defaults accelerating to
unexpectedly high levels with unexpected speed, and growing political-regulatory risk for the industry. World-class
HSBC Bank, with its recent announcement of subprime credit problems and related management changes, is a nice
example of a "house no one before suspected."

How could all this happen with the massive and wonderful computer power manipulating all the data with the complex
models built by mathematical experts we now have? The former CEO of Household International, which was bought
by HSBC, is said to have bragged that his operation had 150 Ph.D.s to model credit risk. Might this make us wonder
about the huge subprime securitization market, tranched and sold to yield-hungry investors based on the models of
the credit rating agencies?

Let us consider Moore's Law of Finance (named for my friend Mike Moore of Hillenbrand Partners): "The model works
until it doesn't." Perversely, the more everyone believes the model, and the more everyone uses the same model, the
more likely it is to induce changes in the market that make it cease to work.

It appears that in this cycle the market became enamored with the statistical treatments of risk, while the most
important issue is always the human sources of risk. These human sources include short memories and the inclination
to convince ourselves that we are experiencing "innovation" and "creativity," when all that is happening is a lowering of
credit standards by new names.

For example, with the spread of "stated income" loans, the disastrous previous experiences with "no doc" and "low
doc" loans seem to have been forgotten. Such loans are a notable temptation, or even invitation, to a little
exaggeration, let us call it, in order to facilitate the dream of buying the house whose price will always keep rising.

Human elements of risk also include optimism, gullibility, short-term focus, genuine belief in momentum or the
extrapolation of so-far successful speculation, group psychology or the lemming effect, and inevitably in some cases,
fraud.

We should not be surprised that as optimism increases, so does the incidence of fraud. As Bagehot further observed:
"The good times of too high price almost always engender much fraud. All people are most credulous when they are
most happy; there is a happy opportunity for ingenious mendacity. Almost everything will be believed for a little while."

How unhappily true. In the modern classic Manias, Panics and Crashes, Charles Kindleberger and Robert Z. Aliber
expand upon this theme: "The propensity to swindle grows parallel with the propensity to speculate during a boom.
The implosion of an asset price bubble always leads to the discovery of fraud and swindles."

If history is any guide, we can expect the same from the implosion of the subprime mortgage boom. On the same
basis, we can also expect the usual political overreaction, which may result in the Sarbanes-Oxley Act of mortgage
lending, or some similar mistake.

The subprime boom cannot be discussed without considering its driving financial engine: securitization of subprime
pools through tranched, senior-subordinated structures based on models. The lower tranches of subprime MBS are
highly leveraged to credit risk. But they are often gathered into CDOs and further tranched, thus creating securities
hyperleveraged to credit risk.

Where did these exceptionally risky tranches go--who is holding them? What will happen to them and how will they
react as the subprime mortgage bust proceeds? These essential questions must put us in mind of Stanton's Law
(named for my friend Tom Stanton of Johns Hopkins University): "Risk always migrates to the hands least competent
to manage it." This is because the more competent can manage their risk by passing it on to the less competent. But
there is another possibility: "when genius fails," the extremely clever may believe too much in their own models and
cleverness, then find out they had much more risk than they thought.

It seems we have some interesting times ahead.

Alex J. Pollock is a resident fellow at AEI.




 
                                          University of Pennsylvania



Subprime Meltdown: Who's to Blame and How Should We
Fix It?
Published: March 21, 2007 in Knowledge@Wharton
This article has been read 18,510 Times


Troubles in the subprime mortgage industry seem to be
spreading. The stock market is in turmoil. Alan Greenspan
and other economists say the economy is being hurt.
Consumer groups predict that up to two million Americans
will lose their homes.

Should the government do something?

A growing list of people say it should, from Democratic
senators Christopher Dodd and Hillary Clinton to a string of
advocates for the poor. Perhaps the money-losing lenders
should be bailed out. Or maybe there should be help for
hedge funds and other investors who have loaded up on securities backed by subprime
loans. And there could be help for homeowners who can't handle their soaring monthly
payments.

Not so fast, say Wharton faculty who have studied the mortgage market and past
government bailouts. "I think that for the moment, they should probably leave it alone,"
says Joseph Gyourko, professor of real estate and finance at Wharton, warning that bailouts
can make people more reckless in the future. "We don't want to introduce moral hazard ....
We don't understand this very well right now, so any regulation is probably going to be
wrong or imprecise."

In fact, he says, the market is already correcting the problem. Lenders have dramatically
cut their offerings of the most hazardous products --such as loans that require no down
payment or proof of the borrower's income, or those which allow borrowers to decide for
themselves how much to pay each month.

Ken Thomas, a lecturer on finance at Wharton, argues that people and institutions that
make risky choices are usually best left to suffer the consequences. "When we had the last
big financial meltdown with stocks in 2001, did we consider bailing out those who lost
money in the dot-com crash?" he asks. "We try to have markets regulate, not the
government. Markets do a much better job."
A Rare "Perfect Storm"

Subprime loans, generally issued to borrowers who cannot qualify for ordinary "prime"
mortgages because of low incomes or tarnished credit, carry special risks for all involved.
Lenders face a greater risk that borrowers will default -- i.e., stop making monthly
payments. Investors who buy bond-like securities based on baskets of subprime loans face
the risk that defaults will cause their holdings' values to plunge. And, since most subprime
loans have adjustable interest rates, borrowers face the risk that rising interest rates will
cause their monthly payments to soar.

Rising rates have done just that. As a result, about 13% of subprime borrowers had fallen
behind with their payments by the end of 2006, according to the Mortgage Bankers
Association. That's up from just over 10% two years earlier, and it compares to 2.6% for
prime loans. Because the number of subprime loans soared in 2005 and 2006, millions of
loans could be affected. Some consumer groups say as many as two million homeowners
face foreclosure.

About 20 subprime lenders have gone out of business, and others have announced billions
in losses. Stocks in financial services firms have suffered, creating problems for the stock
market in general.

Wharton real estate professor Todd Sinai describes the situation as a "perfect storm," given
that three things had to happen for the subprime market to tank: Borrowers' incomes had
to drop, interest rates had to rise and housing prices had to fall. "It is extremely rare that
all three things happen," he says.

Dodd, chairman of the Senate Banking Committee, plans to introduce legislation to protect
homeowners from foreclosure and to crack down on predatory lenders who pushed high-risk
loans on unsuspecting borrowers. Clinton is pushing for a federally mandated "foreclosure
timeout" that would give homeowners more time to catch up on their payments, and she
wants to curtail the prepayment penalties that make it hard for troubled borrowers to
refinance. The National Community Reinvestment Coalition wants the Federal Housing
Administration to be given new power to refinance subprime borrowers' loans, and it wants
the federal government to set up a fund for rescuing low-income homeowners.

But is the situation really bad enough to demand government intervention? "We just don't
know," says Sinai. "Delinquency is a long way from default," he notes, arguing that many
troubled borrowers may eventually get caught up without government help. In the past, he
adds, lenders have typically preferred to help borrowers avoid foreclosure, often by re-
negotiating loan terms. It is not certain that will happen this time, because over the past
decade increasing numbers of loans have been passed to investors in mortgage-backed
securities, potentially making lender-backed workouts more difficult. "I think a wait-and-see
attitude is appropriate," he says.
The economic research firm FirstAmerican CoreLogic of Santa Anna, Cal., reported recently
that the vast majority of homeowners with adjustable-rate loans will escape foreclosure. It
forecast 1.1 million foreclosures but said they would be spread over six or seven years, long
enough to leave the economy unharmed.

Steel, Planes and Cars

There is precedent for government intervention in financial crises.

In 1971, Congress passed the Emergency Loan Guarantee Act to enable Lockheed, the
country's largest defense contractor, to receive $250 million in bank loans to avert
bankruptcy. Lockheed had poured about $900 million into development of a new passenger
liner, but had run into trouble when Rolls-Royce, the British engine supplier, failed.
Lockheed was a classic case of a company considered "too big to fail" -- or, more
accurately, too big to be allowed to fail. Bankruptcy might have cost 60,000 jobs, severely
damaged the U.S. defense capability and had ripple effects in other industries, such as the
airlines.

In 1980, automaker Chrysler demanded and received $1.5 billion in loan guarantees to
avoid bankruptcy. Essentially, its outdated fleet of big cars could not compete in the era of
compacts that followed the Arab oil crisis of the 1970s. Again, the company was thought to
be too big and essential to the American economy to be allowed to fail.

To many, the most analogous situation to the current one was the $125 billion government
bailout during the savings-and-loan crisis of the late 1980s and early 1990s. More than
1,000 of these institutions failed after deregulation allowed them to engage in risky lending
practices and to invest in real estate. A major factor was rising interest rates, which led
many depositors to move their money to better-paying money-market funds at other
institutions, such as brokerages and mutual fund companies. Fraud and corruption
contributed as well.

In that case, the government worried about the ripple effects on the economy and the
millions of innocent depositors. Unlike the subprime borrowers, though, the S&L depositors
had not chosen to make risky bets: They had merely put their money in the bank.

"I don't think they are comparable at all," Gyourko says, comparing the S&L crisis to the
subprime meltdown. So far, only about 20 subprime lenders have failed. And because
subprime loans are packed into mortgaged-backed securities and traded on the secondary
market, losses will be diluted among investors worldwide rather than concentrated in the
institutions that originated the loans.
"You certainly do not want to bail out the lenders," Gyourko says, arguing that the
marketplace will curb risky behavior on its own. "The markets are telling lenders, 'You
know, if you issue loans like those again, it's going to be very, very costly.'"

Remember, Thomas adds, "banks are stronger than ever and have more capital than ever.
Compared to past difficult periods, we have not had a serious bank failure since June 2004."
That was the collapse of The Bank of Ephraim in Ephraim, Utah, with $46.4 million in
assets. It is not the government's role to tell lenders they should not offer risky products,
he says. Most subprime borrowers are not in trouble, and many have been able to buy
homes only because subprime loans were available. "The fact is that some of these same
groups that are pushing [for restrictions on issuance of subprime loans] are the same
groups that pushed banks to make more loans" to the poor, Thomas says.

Over the past two decades, the government has tended to take a less direct role in
managing the economy and to instead encourage efficient markets through better disclosure
of information, points out Anita Summers, emeritus professor of real estate at Wharton.
This means, for example, that there are fewer trade tariffs, but also that consumers can get
a lot more information about financial products, foods and drugs. "Industry is much more on
its own," she notes.

The main lesson to be learned from the subprime crisis may be that borrowers need to
know more about the risky products they are offered. "One of the things that's wrong here
is the issue of full information," Summers says, adding that "every subprime lender should
be required to have a statement of the particular terms that is unambiguous."

Thomas agrees: "I'm always in favor of better disclosure." Gyourko notes that "if there's
any case for regulation, it's for better information for borrowers." New regulations, for
example, could require that loan applicants be told in clearer terms exactly how their
monthly payments will rise if prevailing interest rates go up.

Subprime lenders knew they faced risks with products such as interest-only mortgages,
Sinai says. With a standard mortgage, part of every monthly payment reduces principal. As
the loan balance shrinks and housing prices rise, the lender has a growing assurance the
property can be sold in foreclosure for enough to cover the debt. But that is not the case
when the borrower pays only interest.

Subprime lenders knew the risks they were taking, as did investors, such as hedge funds,
that bought securities based on subprime loans, according to Sinai. Lenders' and investors'
willingness to take on these risks was good for borrowers who might otherwise not have
been able to get mortgages. But, he argues, there's no reason for government to bail out
businesses that lost money on bets they took willingly.

Condo Flippers in Miami
Most proposals for remedies have focused on borrowers. Dodd and some consumer groups
believe many borrowers were lured into subprime mortgages by predatory lenders who
concealed the risks, and experts say subprime lenders often paid mortgage brokers
commissions two or three times those on prime loans. Consequently, Dodd says he will
introduce measures to curb predatory lending. He has yet to offer details.

And so far it is not clear how many subprime borrowers can truly be described as victims. "I
think we don't know anything, other than anecdotally, what's happening in this particular
episode," Sinai says, adding that some borrowers are people who could not have bought
homes had they not had access to subprime loans. If they lose their homes, they will simply
return to the ranks of renters. "So how much worse off are they?" Sinai asks. "Probably not
a lot."

Other borrowers undoubtedly are speculators who were so overextended they could not get
prime loans. Are people who chose to take huge, unnecessary risks, worthy of public
sympathy and help? "Why not help those condo flippers in Miami, Vegas and elsewhere who
are facing foreclosure for putting deposits on several units and seeing them blow up?"
Thomas says. "Where do you draw the line?"

Some consumer groups are pushing for new rules requiring that lenders match borrowers
only to those products that are suitable for them. A borrower with an income that is not
likely to rise would thus not be given a loan that could require much larger monthly
payments a couple of years down the road. This would be similar to the suitability
standardsfor stock brokers and financial advisors. A broker, for example, can be suspended
or barred from the business for pushing a retiree on a small fixed income to speculate in
stock options or other high-risk investments.

But this might not work as well in the mortgage industry, says Jack Guttentag, emeritus
professor of finance at Wharton. In a March 17 guest column in The Washington Post, he
wrote: "What has made the suitability standard workable in the securities industry is that
the short-term interest of brokers in selling unsuitable securities is usually overruled by
their long-term interest in maintaining a roster of satisfied clients.... In the mortgage
market, in contrast, client-oriented loan providers are the minority group." Most providers
do not have long-term relationships with borrowers or count on repeat business, he wrote.

Better risk disclosure would be good, Sinai says, but borrowers are always going to be
subjected to salesmanship: "I really think there is no way around the fact that when there is
a competitive lending frenzy, loans are going to get made that are riskier than they are
portrayed to be."

 
                                                                                        THEORY


                                         Even if predation is possible, does intense
                                           price competition harm consumers?



            The Perverse
         Effects of Predatory
             Pricing Law
                                                                           B Y D ANIEL A. C RANE
                                                                        Benjamin N. Cardozo School of Law




     T
                                    he theory of predatory pricing is                              Although very few plaintiffs succeed in winning a favorable
                            as old as the Sherman Act. Among the evils                         judgment given the strict rules imposed by the Supreme Court,
                            attributed to John D. Rockefeller and Stan-                        the tone in the academy is beginning to change. Drawing on
                            dard Oil was underpricing rivals to main-                          advances in game theory and behavioral economics, recent
                            tain a monopoly in oil production. In the                          scholarship argues that predatory pricing may be more com-
                            early years of the Sherman Act, courts fre-                        mon than the Supreme Court believed. Prominent economists
                            quently used conclusory epithets such as                           and law professors have proposed new, more restrictive rules
     “ruinous competition,” “predatory intent,” and “below-cost                                on price competition by dominant firms.
     pricing” to condemn price-cutting by dominant firms without                                   The new learning is finding its way into the courts as well.
     undertaking any meaningful inquiry into whether the chal-                                 In a 2003 predatory pricing case, the U.S. Court of Appeals for
     lenged behavior was beneficial or harmful to consumers.                                   the Tenth Circuit declared that, in light of the recent scholar-
         During the 1970s, the law-and-economics movement rev-                                 ship, it would no longer approach predation claims with the
     olutionized antitrust law, showing that many practices once                               skepticism that once prevailed. Predatory pricing theories, once
     condemned were in fact socially beneficial. Predatory pricing                             discredited, are regaining respectability.
     law received a thorough scrubbing, first at the hands of promi-                               Whether or not the new scholarship has made a convincing
     nent academics and then in the federal courts. During the mid-                            case that predatory pricing is a real monopolistic threat, one
     1980s and early 1990s, the Supreme Court cast doubt on the                                insight from the law-and-economics literature of the 1970s and
     viability of most predatory pricing claims, opining that preda-                           1980s remains unrebutted: punishing excessively low prices is
     tory pricing happens rarely, if at all, and that recognizing a                            paradoxical because the very objective of the antitrust laws is to
     claim based on price-cutting threatens to chill vigorous com-                             secure low prices for consumers. As more and more cases of
     petitive behavior by large firms.                                                         alleged predatory pricing are filed and new theories of liability
         Despite this attitudinal reversal in the academy and the courts,                      based on price discounting gain popularity, the risk grows that
     hundreds of predatory pricing cases have been filed in the past                           predatory pricing law will result in higher prices to consumers—
     decade. Most of the cases are brought by competitors alleging that                        the very antithesis of what antitrust law is supposed to achieve.
     a rival’s low prices threaten to put the plaintiff out of business.
                                                                                               W H Y A L L O F T H E P R E D AT IO N C L A I M S ?
     Daniel A. Crane is assistant professor of law at the Benjamin N. Cardozo School of Law,
     Yeshiva University. He may be contacted by e-mail at dcrane@yu.edu.                       As noted, the Supreme Court has made it very difficult for
     This article is condensed from Crane’s “The Paradox of Predatory Pricing,” Cornell Law    plaintiffs to win predatory pricing claims. Yet hundreds of
     Review, 2005, and his other recent work on bundled discounts.                             such claims have been filed since the restrictive Supreme

26   R EG U L AT IO N W I N T E R 2 0 0 5 - 2 0 0 6
Court decisions. Why would plaintiffs spend the significant           expected cost to the defendant of an adverse judgment is so
time and money it takes to file predatory pricing claims if           large. Although plaintiffs rarely win predatory pricing judg-
such claims are usually futile? A substantial part of the             ments, when they do, the numbers are often staggering.
answer is that predatory pricing plaintiffs can “win without             To illustrate, MCI won a jury verdict against at&t that, with
winning” if the mere fact of the lawsuit coerces the defendant        trebling, would have amounted to a $1.8 billion judgment in 1980
to soften its price competition.                                      dollars. In 2003, Kinetic Concepts won a jury verdict against Hil-
   The predatory pricing cause of action is a most suggestive         lenbrand Industries in a case that involved predatory pricing




tool for an inefficient firm to forestall                                                                        claims. The jury awarded
price cuts by a more efficient rival. For                                                                         $173.6 million in dam-
several reasons, a plaintiff can strate-                                                                          ages, which would have
gically misuse a predatory pricing law-                                                                           been automatically tre-
suit to force price increases by the defen-                                                                       bled to $520.8 million
dant even if the lawsuit has very little                                                                          pursuant to the Clayton
chance of succeeding on the merits.                                                                                 Act. To put that in per-
    For instance, the plaintiff can raise                                                                            spective, Hillen-
the defendant’s costs just by                                                                                        brand’s net income in
initiating expensive litigation.                                                                                     the year preceding the
Defending against a predatory                                                                                       judgment was $153
pricing lawsuit is often an                                                                                        million—less than a
extremely costly proposition. Frank                                                                              third of the amount of the
Easterbrook once reported that, during the                                                                     judgment. Largely from the
1980s, at&t spent $100 million per year                                                                   $250 million settlement
just to defend against predation claims. It is                                                          resulting from the judgment,
not uncommon for a single predation lawsuit                                                                  Hillenbrand’s net income
to cost the defendant tens of millions of dollars to litigate.                                                fell to $44 million the fol-
    Of course, the litigation will cost the plaintiff something as                                            lowing year.
well, but it will almost always be much more expensive for the                                                  Further, prevailing plain-
defendant. The plaintiff may be able to hire lawyers on con-                                             tiffs are automatically entitled
tingency, whereas the defendant must pay its lawyers on an                                           to recover their attorney fees from
hourly basis. The defendant will often be required to produce                                        the defendant, which can add tens
more documents to the plaintiff than vice versa because the                                            of millions of dollars to the price
focus of the lawsuit will be on the defendant’s pricing practices.                                      tag of an adverse judgment.
Defendants will feel compelled to hire the most expensive                                           (There is no similar provision for
lawyers and invest heavily in the defense of even an unmeri-                                       defendants to recover attorney fees
torious case because the effects of an adverse treble damages                                       from unsuccessful plaintiffs).
award on the defendant’s stock price would be disastrous.                                               It is not hard to see that the
                                                                                                                                                                 MORGAN BALLARD




Plaintiffs, by contrast, face few such pressures.                                                threat of a predatory pricing lawsuit
    In addition to raising rivals’ costs through litigation expens-   could cause a firm to forgo a perfectly innocent price-cut. Lit-
es, inefficient firms can use the threat of predatory pricing lit-    igation is an inherently unpredictable activity and there is
igation to coerce price increases from competitors because the        always a chance that the lawsuit will survive summary judg-

                                                                                                           R EG U L AT IO N W I N T E R 2 0 0 5 - 2 0 0 6   27
                                                                          THEORY

     ment and the jury will award an erroneous verdict. Suppose               Richard Posner calls “compelling evidence of predatory intent to
     that the chance that a frivolous predation claim will succeed on         the naïve,” and a smaller, often younger firm that has been dam-
     the merits is 10 percent, that the defendant firm would have to          aged by the dominant firm’s behavior. Although the “damage”
     incur $50 million to litigate it, and that an adverse judgment           may have resulted from socially beneficial price competition or
     (including trebling and attorney fees) would amount to $500              the new entrant’s comparative inefficiency, all the jurors may
     million. From the ex ante perspective, the expected cost of the          understand or care about is that the defendant was a large cor-
     price-cut is $100 million (the expected cost of an adverse judg-         poration that damaged a smaller corporation through a series of
     ment is $50 million and it will cost $50 million to defend the           tactical price cuts. In the jury box, it is David v. Goliath.
     lawsuit regardless of the outcome). If the expected profit                  This systematic jury bias against price-cutting by dominant
     increase from the price cut is less than $100 million, the firm          firms contributes to the chilling effect on price competition of
     would forgo it and stick with higher prices. By threatening              predatory pricing law. A firm considering a price cut in the face
     predatory pricing litigation, a less efficient firm may be able to       of a rival’s litigation threat must take into account not just the
     prevent price cuts by a more efficient rival.                            possibility of expensive litigation, but the prospect of facing a
                                                                              jury that may not understand the relevant law or the econom-
     D A V I D V. G O L I A T H                                               ics, but will decide the case nonetheless.
     Even in a world in which the rate of error in adjudication was
     low, firms might sometimes decide to forgo price cuts because            TA CI T C O L L U S IO N
     the cost of even an improbable finding of liability was so high.         The strategic misuse of predatory pricing law is not limited to
     The chilling effects of predatory pricing law are compounded             inefficient firms seeking to create a protective pricing floor. Effi-
     by the fact that the error rate is probably not only high but            cient firms can partake of the opportunity afforded by preda-
     directionally tilted toward false-positive errors.                       tory pricing law to sustain higher prices in the market. In par-
         The chief cause of this directional bias is the fact that juries     ticular, rent-seeking sellers can use claims of predatory pricing
     are the ultimate fact-finders in any case that makes it to trial.        to facilitate tacit collusion schemes in concentrated markets.
     It would be surprising to find that jurors actually understand               To see how this can happen, imagine a seller operating in an
     the substance of predatory pricing law when the very defini-             oligopoly with four dominant firms. Suppose that the market
     tion of predation and its elements have long been, and continue          is characterized by fungible goods and high barriers to entry.
     to be, debated by the brightest economic and legal minds.                Sellers in such a market will often be able to price above com-
         A study by Case Western law professor Arthur Austin is               petitive levels, but achieving the maximum price requires some
     telling. Austin interviewed jurors in four antitrust trials, includ-     coordination, tacit or explicit, among the firms. From the per-
     ing Brooke Group v. Brown & Williamson, the latest predatory pric-       spective of the oligopolists, the ideal solution would be an
     ing case decided by the Supreme Court. Austin’s interviews               explicit agreement on prices and output, and elaborate polic-
     revealed that “the jurors were overwhelmed, frustrated, and              ing mechanisms to ensure compliance. That, of course, is ille-
     confused by testimony well beyond their comprehension. . . .             gal, so sellers in such markets often try to coordinate prices in
     [A]t no time did any juror grasp—even at the margins—the                 less explicit ways using tools such as information exchange pro-
     law, the economics, or any other testimony related to the alle-          grams and subtle policing mechanisms to ensure compliance
     gations or defense.” Austin reports,                                     with the tacit agreement. Antitrust cases have condemned such
                                                                              cooperation as unlawful price-fixing, even though the firms
         At no time have I encountered a juror who had the fog-
                                                                              never explicitly agreed on price.
         giest notion of what oligopoly, market power, or average
                                                                                  Now imagine how a predatory pricing lawsuit could be used
         variable cost meant, much less how they applied to the
                                                                              to help organize the tacit collusion scheme in a legally privi-
         case. . . . Typical is the response I received when I asked a
                                                                              leged way. The plaintiff firm, unhappy with price cuts by a rival,
         juror whether he remembered average variable cost. The
                                                                              files a complaint detailing exactly what is wrong with the defen-
         juror replied, “Yes, explain it to me. I still don’t know what
                                                                              dant’s price cuts and what reasonable prices would be. Then
         it means.”
                                                                              follows a prolonged period of discovery—often years—in
        Mind you, the jury found that Brown & Williamson engaged              which the parties exchange reams of sensitive competitive doc-
     in predatory pricing, which required a finding that it had priced        uments and senior executives testify about their pricing strate-
     below average variable cost. If the jury did not understand the legal    gies, business plans, productive capacity, costs, and many more
     test, on what basis did it award a $148.8 judgment against Brown         pieces of business information that will come very handy to
     & Williamson? Based on his study of the Brooke Group jury, Austin        both sides when considering future pricing and output deci-
     concluded that its verdict for Liggett was based upon populist sen-      sions. While discovery and trial takes place, a judge will be
     timents inflamed by “smoking gun” documents from Brown &                 closely scrutinizing the parties’ pricing behavior and perhaps
     Williamson’s files “in which B&W executives made comments                even enjoining the defendant from lowering its prices during
     like ‘bury them’ and ‘put a lid on Liggett.’”                            the pendency of the lawsuit. Several judges have issued injunc-
        If jurors are unable to understand the legal-economic require-        tions against defendants, prohibiting them from lowering their
     ments of predatory pricing law, then they are largely left with a        prices until a final adjudication of the case. So there we have
     morality play between a dominant firm, often with superior               several ingredients of a successful tacit collusion scheme: price
     resources and files full of “smoking gun” documents that Judge           signaling, information exchange, policing mechanisms, and

28   R EG U L AT IO N W I N T E R 2 0 0 5 - 2 0 0 6
even sanctions for deviating from supracompetitive prices.             can’s alleged predatory pricing campaign against Continental
                                                                       and Northwest. For both of those allegations to be true, Amer-
PIE IN THE SKIES Do firms actually use predatory pricing               ican would have to be predating against Contintental and
lawsuits to raise each other’s costs or facilitate tacit collusion     Northwest at the same time as it was colluding with them.
schemes? It is hard to answer that question categorically              Although a predatory pricing campaign to discipline rivals into
because antitrust litigation tends to be quite complex and a           collusion may be plausible, the Justice Department charged that
plaintiff’s motivations are rarely reducible to a single catego-       American, Continental, and Northwest were already colluding
ry. It is not difficult, however, to find examples of predatory        at the time that Continental and Northwest alleged that Amer-
pricing lawsuits that were rejected on the merits and yet appar-       ican launched its new, allegedly predatory, pricing scheme.
ently contributed to higher prices.                                    American cannot have been both predating against, and col-




         It is not difficult to find examples of predatory
        pricing lawsuits that were rejected on the merits
        and yet apparently contributed to higher prices.

    Consider the airline industry. Since deregulation in 1978, the     luding with, the same competitors at the same moment
airline industry has seen several high-profile charges of oli-         because predation involves pricing below cost and collusion
gopolistic collusion. A well-known episode of attempted price-         involves pricing at supracompetitive levels.
fixing involved a 1982 price-war between American Airlines                 It is possible that one or both of the claims were mistaken—
and Braniff in which the Justice Department obtained a tape            indeed, the jury found that American was not predating. It is
recording of a conversation between Robert Crandall, ceo of            also possible that the allegations of collusion were correct and
American, and Howard Putnam, ceo of Braniff, in which Cran-            that the predatory pricing case itself reinforced a tacit collusive
dall encouraged Putnam to raise prices by 20 percent. In 1992,         scheme. Northwest and Continental may have facilitated a
the Justice Department sued American, Continental, North-              resumption of consciously parallel, lockstep pricing by using
west, twa, United, and USAir, alleging that they had engaged           the predatory pricing lawsuit as a price signal and information
in price signaling by disseminating future price information in        exchange device, combined with a punitive raising of Ameri-
a variety of ways. The case ended in a consent decree in which         can’s costs through expensive litigation.
the airlines agreed to cease a number of the challenged prac-              If so, the strategy seems to have worked. American
tices. In 2004, the Justice Department filed a show cause peti-        announced the challenged pricing plan on April 9, 1992, and
tion alleging that American had violated the consent decree by         other major carriers quickly matched or beat American’s price
publishing future first travel dates, apparently in order to sig-      cut. Between April and June, fares remained relatively flat. Then
nal price increases to competitors.                                    Continental filed its predatory pricing lawsuit in early June of
    During the same period that the airline industry has osten-        1992 and Northwest filed its parallel suit a few days later. A few
sibly been a hotbed of oligopolistic cooperation to price at           days after filing suit, Northwest announced a 10 percent price
supracompetitive levels, different airlines have allegedly been        increase. American and Continental soon followed with price
engaged in predatory pricing. American has faced predatory             increases of their own. Between July and the end of the year,
pricing claims by Continental and Northwest in 1992 and the            while the predatory pricing case progressed, the major airlines
Justice Department in 1999. Virgin Atlantic sued British Air-          reportedly raised prices seven times, albeit with many false
ways on what amounted to predatory pricing charges in 1993.            starts, retreats, and delays as the oligopolistic discipline frayed
Other post-deregulation predation suits include Laker against          by American’s April price cuts was restored. In December,
Sabena and klm in 1983 and Laker against PanAm in 1985.                while announcing another round of price increases, Conti-
Further, several low-cost carriers have reportedly complained          nental reported publicly that its “objective is to get back to the
to the Department of Transportation about predatory pricing            fare levels that prevailed in early April, which are fair, market-
by larger airlines, including ValuJet against Delta, Frontier          based competitive fares.” Such overt price-signaling through
against United, and Reno Air against Northwest.                        media comments frequently accompanied the upward pricing
    What is interesting about the airline cases is that at least one   movements following the filing of the predatory pricing suits.
of the alleged dates of predatory pricing corresponded with            A headline about the September fare increases in Tour and Trav-
periods in which the predator and prey were supposedly                 el News reported (apparently without conscious irony), “Airlines
engaged in oligopolistic collusion. The government’s 1992              Agree on Fare-Increase Date.”
price signaling case against American, Continental, and North-             There is little doubt that the airline fare war that began with
west (and others) concerned the same time period as Ameri-             American’s price cuts in April ended within weeks after North-

                                                                                                          R EG U L AT IO N W I N T E R 2 0 0 5 - 2 0 0 6   29
                                                                        THEORY

     west and Continental filed their predatory pricing suits. How            program was quite reasonable. Under ordinary predatory pric-
     significant a role the predatory pricing suit played in deterring        ing rules, the plaintiff must show that the defendant priced
     aggressive price competition and restoring lockstep price                below its cost in order to establish liability. If the plaintiff is as
     increases is uncertain. The predatory pricing lawsuit was not            efficient as the defendant, then if the defendant prices above
     the only strategic tool available or utilized by competitor air-         cost, the plaintiff cannot be driven out of business because the
     lines. The competitors also took their complaint to the Senate           plaintiff could profitably match the defendant’s prices. The
     Transportation Committee and engaged in unabashed price                  same logic should follow in a case involving discounts spread
     signaling through the media. The predatory pricing lawsuit,              across multiple product lines.
     however, may have offered a unique combination of coercive                   Suppose that, for litigation purposes, the following exercise
     opportunities to complement other strategic tools, including             was undertaken: Calculate the total discounts that a customer
     raising a rival’s costs through litigation expense, the threat of        would forgo from the defendant on all product lines if it bought
     a substantial adverse judgment, and detailed information                 from the plaintiff. Reallocate those discounts to the single mar-
     exchange in discovery.                                                   ket in which the plaintiff operates. Finally, inquire whether,
         And the predatory pricing case may have taught American              after deducting all of the forgone discounts, the effective price
     a lesson. After the jury returned a verdict for American in the          in the competitive market was below cost. If the answer is no—
     predatory pricing case in the summer of 1993, American ceo               if the effective price in the competitive market was still above
     Robert Crandall—the same ceo caught on tape encouraging                  cost— then there is no reason to impose liability for the bun-
     Braniff to raise its prices—stated publicly that American “prob-         dled discount any more than there would be to impose liabil-
     ably won’t be attempting that type of leadership again.”                 ity for an above-cost price cut in a single market. An equally
                                                                              efficient competitor should still be able to compete.
     M U LT I P RO D U CT D IS C O U N T I N G : T H E N EXT F RO N T I E R       Regrettably, in a 2003 en banc decision, the full Third Circuit
     Just as conventional predatory pricing theories are being reha-          saw it differently. In a 7–3 decision, the court affirmed the jury
     bilitated, a new theory of anticompetitive exclusion through             verdict. Critically, the court found it irrelevant that the exercise
     price discounting is becoming popular in antitrust circles. A            described in the preceding paragraph had been undertaken and
     number of recent lawsuits and academic papers have explored              it was shown that 3M had not priced below cost even if all of
     the possibility that a diversified firm could offer customers dis-       the discounts on other product lines were reallocated to the
     counts contingent upon the purchase of goods in multiple mar-            transparent tape market. According to the court, multiprod-
     kets and thereby exclude a single-product firm that sold only            uct bundling is completely different from single-market preda-
     one of the products covered by the package discount.                     tory pricing and the cost/revenue comparisons required in
         The case that defines this theory for the moment is LePage’s v.      predatory pricing cases are not required in cases involving dis-
     3M. 3M is a diversified manufacturer of various household and            counts across multiple markets.
     industrial products. LePage’s competes with 3M for sales of pri-             So what is the standard of illegality for bundled discounts?
     vate-label transparent tape—a generic equivalent of 3M’s well-           In the Third Circuit, at least, the answer is completely murky.
     known Scotch tape brand. In 1995, 3M began a rebate program              As the Solicitor General pointed out in an amicus curiae Supreme
     called the Partnership Growth Fund (PFG) that incentivized 3M’s          Court brief, “the court of appeals failed to explain precisely why
     customers, large retailers like Staples, Wal-Mart, and Target, to        the evidence supported a jury verdict of liability in this case,
     purchase minimum quantities from six 3M divisions. In order to           including what precisely rendered 3M’s conduct unlawful.”
     receive the maximum 2 percent rebate, a customer needed to                   The LePage’s decision has caused well-founded alarm in the
     increase its overall purchases from 3M as well as its purchases in       business community. Bundled discounting—what economists
     a minimum number of specified product categories.                        call mixed bundling—is ubiquitous and generally beneficial to
         LePage’s alleged that, as a result of the 3M program, it lost        consumers. If liability can be imposed on dominant firms that
     private-label transparent tape sales (even though it still had a         offer bundled discounts without any clear rules for when such
     67 percent market share in the private-label side of the trans-          discounts will be found exclusionary, sellers will need to be con-
     parent tape market) and was in danger of being forced out of             cerned about potential exposure from offering such discounts.
     business. In 2002, a Philadelphia jury found that 3M had used                Not surprisingly, given the allure of treble damages awards,
     the program unlawfully to maintain a monopoly in the trans-              LePage’s has created a cottage industry of lawsuits in the Third
     parent tape market, and awarded LePage’s $22,828,899 in dam-             Circuit involving claims of bundled discounts, including amd’s
     ages (before trebling).                                                  heavily publicized monopolization lawsuit against Intel and
         In an initial three-judge decision in 2002, the U.S. Court           Broadcom’s lawsuit against Qualcomm. A number of other
     of Appeals for the Third Circuit reversed, finding that LeP-             mixed bundling cases, some of which predate the LePage’s deci-
     age’s had not shown that 3M’s bundled rebates were anti-                 sion, are pending. Bundled discounting, it is fair to say, is under
     competitive. Among other things, the two-judge majority                  heavy attack as a commercial practice.
     noted that LePage’s had not shown that it would have had to                  So not only is single-market predatory pricing being revi-
     price below cost in order to compensate customers for the                talized as an antitrust theory, but new theories of ill-defined lia-
     3M rebates they would lose if they purchased private label               bility are being opened for price discounting. And, just as with
     transparent tape from LePage’s instead of 3M.                            single-market predation claims, there is evidence that at least
         The original panel’s way of assessing the bundled discount           some of the recent bundled discounting claims are strategic

30   R EG U L AT IO N W I N T E R 2 0 0 5 - 2 0 0 6
efforts to prevent aggressive price competition by larger rivals.       ing cases. The economic rationale for treble damages in antitrust
Tellingly, in virtually none of the recent bundled discounting          cases is that because many antitrust violations will go undetect-
cases was the plaintiff actually excluded from the market. Many         ed, the magnitude of the penalty must be increased in order to
of the plaintiffs had very significant market shares in the rele-       deter violations. While that rationale may be sensible with respect
vant markets or had experienced growth and profitability                to price-fixing cartels, it has no application to predatory pricing.
despite the existence of the bundled discount program. Unfor-           Low prices are easy to spot. Indeed, most of the recent theories
tunately, the symptoms of strategic misuse of antitrust law to          that have attempted to rehabilitate the status of predatory pric-
prevent price-discounting are spreading to new frontiers.               ing as a serious threat have relied on reputational effects from
                                                                        prior acts of predation to discourage new entry in the future. If
R E S O LV I N G T H E P A R A D O X                                    predatory pricing is supposedly effective because everyone knows
Over 25 years ago, Frank Easterbrook advocated abolishing the           that it is not worth entering a price war with the predator, there
right of action for predatory pricing on the view that, even if         is little reason to allow treble damages on the theory that the pre-
predatory pricing sometimes occurs, allowing the legal claim            dation might go undetected. Detrebling damages in predatory
to be asserted does more harm than good. Time has vindicat-             pricing cases would eliminate some of the potency of predatory
ed Easterbrook’s claim, yet predatory pricing remains as pop-           pricing claims as means to chill price competition.
ular—and strategically misused—a theory as ever. What can
be done about this?                                                     CONCLUSION
    Apart from simply disallowing any claim based on exces-             Frank Easterbrook once remarked that the reason that there are
sively low prices, a number of steps could be taken to minimize         so many theories about what predatory pricing schemes look
the abuse of predatory pricing law. One step would be to elim-          like is much the same as the reason there were once so many
inate competitor standing to assert such claims. Most preda-            theories about what dragons look like. One need not believe,
tory pricing claims are brought not by injured consumers, but           with Easterbrook, that predatory pricing never occurs to
by competitors. Competitors have unique incentives to misuse            believe that legal efforts to stop predation often do more harm
predatory pricing law to chill price competition. They want to          than good.
see higher prices both in the short run and in the long run.               To be sure, there are market failures that allow firms to
    The law tolerates a competitor’s complaint that the defen-          obtain monopoly power through undesirable means. But there
dant’s prices were too low because of the further allegation that       are also legal failures that allow firms to abuse well-intentioned
the low prices would eventually lead to higher prices. But the          liability rules to stymie the very competitive forces the rules
law does not require proof of actual higher prices. In an               were intended to support. Much of one’s view about the appro-
attempted monopolization through predatory pricing case, it             priateness of penalties for excessively low prices depends on
is sufficient to prove that a defendant’s low prices created a dan-     whether one believes that market failures or legal failures will
gerous probability of subsequent higher prices. Thus, a com-            generally be more harmful. The history of predatory pricing
petitor-plaintiff is often in the position of asserting that a defen-   law suggests that, when it comes to price discounts, legal fail-
dant’s prices were anticompetitively low merely based on the            ures have done far more harm than market failures.               R

speculation that, left unchecked, the defendant would have
driven the plaintiff from the market and raised its prices—even
though that never actually happened.                                                           R E A D I N G S
    Giving firms standing to challenge their rivals’ prices as too
low on the theory that higher prices might eventually emerge               •   “3M’s Bundled Rebates: An Economic Perspective,” by Daniel
                                                                           L. Rubinfeld. University of Chicago Law Review, Vol. 72 (2005).
is like asking the fox to guard the henhouse. Consumers—the
intended beneficiaries of antitrust law—have exactly the oppo-             • The Antitrust Paradox: A Policy at War with Itself, 2nd ed., by
site incentives as competitors. They prefer sustainably low                Robert H. Bork. New York, N.Y.: The Free Press, 1993.
prices and therefore make far better-intentioned predation                 • “Misuses of the Antitrust Laws: The Competitor Plaintiff,” by
enforcers than business rivals of the “predator.” If predatory             Edward A. Synder and Thomas E. Kauper. Michigan Law Review,
                                                                           Vol. 90 (1991).
pricing were a frequent and successful enterprise, one would
expect to see many class-action lawsuits by overcharged con-               • “Mixed Bundling, Profit Sacrifice, and Consumer Welfare,”
sumers. Such lawsuits are rare, which is probably more a tes-              by Daniel A. Crane. Forthcoming (2006).
tament to the absence of successful predation schemes than to              • “Multiproduct Discounting: A Myth of Nonprice Predation,”
consumers’ deficiencies as enforcers.                                      by Daniel A. Crane. University of Chicago Law Review, Vol. 72 (2005).
    If competitors are allowed to continue asserting predatory             • “The Paradox of Predatory Pricing,” by Daniel A. Crane.
pricing claims, then two simple changes in the law would help              Cornell Law Review, Vol. 91 (2005).
deter strategic misuse. First, attorney fee shifting could become          • “Predatory Strategies and Counterstrategies,” by Frank H.
bilateral. If unsuccessful plaintiffs were required to pay defen-          Easterbrook. University of Chicago Law Review, Vol. 48 (1981).
dants’ attorney fees, filing unmeritorious predatory pricing               • “Use of Antitrust to Subvert Competition,” by William J.
lawsuits in order to coerce the defendant to raise its prices              Baumol and Janusz A. Ordover. Journal of Law and Economics,
would become significantly less attractive.                                Vol. 28 (1985).
    Second, treble damages could be disallowed in predatory pric-

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