Limits of Transparency

If lawyers and MBAs don't understand their mortgage documents, what chance do the rest of us have?

Megan McArdle and new hubby Peter Suderman are buying a house, a first time experience for both.   And she’s had a startling realization:

Actually going through the mortgage process is a reminder of one of the reasons that things went so badly wrong during the housing bubble; we are inundated with paper.  There are disclosures about the Mortgage Disclosure Improvement Act telling us we have seven days to review any change in our APR; disclosures about the Home Valuation Code of Conduct, even a disclosure solemnly informing us that the bank intends to check credit scores and may not loan us money if there’s a bad payment history of too much debt.

I’m pretty good with paperwork, and I understand all the terms being used (not to mention the laws being referenced), and I find it impossible to keep track of it all mentally–especially when you add in the tax returns, the W-2s, the bank statments and sworn certifications that all the money being used was legitimately earned or received as gifts.  In fairness, we’re going through our credit union, which is apparently especially bureaucratic, but still–it’s very easy to develop a sort of attentional blindness and keep signing things.  I requires heroic effort to read every document.

This illustrates, I think, the limits of transparency.  Much of this paperwork is the product of earlier acts designed to help uninformed borrowers deal with the complexity of their loans.  If you read and understand all of it, perhaps you do.  But there’s so much of it that it’s relatively easier to overlook something.

She spends the rest of the essay noting that simplifying the process to make it harder to cheat naive purchasers comes at the price of making it more difficult for savvy buyers to customize loans to best fit their circumstances.  Which, of course, is right.

What’s noteworthy is that Megan has an MBA from one of the top schools in the country and both she and Peter are almost certainly in the 99th percentile of intelligence.   If the process is confounding to them, it’s simply unfathomable to normal people.

In this instance, at least, I’m one of them.   A PhD in political science doesn’t provide much in the way of specialized training for navigating the forms, although I happen to have taken a few law courses along the way.  Of course, that was more than 20 years ago now.

Between us, my wife and I have signed mortgage paperwork at least a dozen times either separately or together.  And we pretty much take the opposite of Megan’s approach:  We just sign where they tell us as quickly as possible, reading nothing except whatever’s written or typed into the blanks.   We’ve already had whatever questions we had answered by our mortgage broker, who we’ve used at least a half dozen times.  And we figure that the rest of it is just the standard legalese.

Interestingly, we don’t take that approach to buying automobiles.  Despite it being a comparatively minor purchase, we read far more carefully.   Why?   Because we trust the system much more in the case of home purchases, feeling much more likely to be cheated by automobile dealerships.  Partly, that’s because of the sleazy nature of that business, where even straightforward cash transactions seem like an elaborate con game.   Mostly, though, it’s because mortgages are much more standardized and regulated.

Despite the paperwork itself being complicated, people signing mortgages generally know what they’re getting into.  The Truth In Lending disclosure is pretty simple and tells you all you need to know; the rest is there for the lawyers.  The problem isn’t lack of transparency but lack of a crystal ball and poor risk analysis.

People know that they’re signing up for an interest-only loan with variable interest rates.  But they don’t plan adequately for when interest rates skyrocket and their monthly payments go up radically.   They don’t really understand that a 2 point hike in their interest rate translates into something radically higher than a 2 percent hike in their monthly bill.

People know that, if the value of their home drops by 20 percent, they’ll be underwater on their loan and stuck with it, unable to refinance when their ARM runs out or to sell it and walk away whole.   But they think the value of their home will instead increase by 20 percent — or more! — and they’ll be in the clover.

This isn’t a problem fixable by better disclosure.

FILED UNDER: Economics and Business, Law and the Courts, , , , , , , , , ,
James Joyner
About James Joyner
James Joyner is Professor and Department Head of Security Studies at Marine Corps University's Command and Staff College. He's a former Army officer and Desert Storm veteran. Views expressed here are his own. Follow James on Twitter @DrJJoyner.


  1. Between the lawyers and the politicians, I really do think that things like mortgage applications have become so complicated with mandatory disclosures and CYA provisions that it’s actually harder to understand than it needs to be.

    A few years ago, I happened to run across the closing documents that my parents received when they bought their house in New Jersey in 1965. The amount of paper was less than half the size of the huge packets I’ve gotten to two times I’ve bought a home. And, it was easier to understand.

  2. Gerry W. says:

    (off subject)
    Wanted to respond to Juneau on the thread “Democrats “new” strategy: Blame Bush” but my post was rather long winded. Did not know how to shorten that. Would appreciate if that was posted. Thanks.

  3. john personna says:

    Isn’t this an illogical claim?  We are asked to believe that since simplifications always make things more complex … huh?
    That is not the way it works in other countries with simplified mortgage systems.  The Danish mortgage market is often cited:

    No, I’m afraid Megan has set us up again, and perhaps a Atlantic Magazine value network is attempting to support her.  God help us if say Elizabeth Warren wanted to get in there and make things _actually_ simpler.
    (post retry after hang)

  4. john personna says:

    Between the lawyers and the politicians, I really do think that things like mortgage applications have become so complicated with mandatory disclosures and CYA provisions that it’s actually harder to understand than it needs to be.”

    Is this the “since we are such screw-ups” defense?  Since we are such screw ups, we shouldn’t attempt to fix things at all.  We really shouldn’t try to get out of bed in the morning, let alone simplify consumer borrowing.


  5. steve says:

    I am not sure this isnt aided and abetted by the banks themselves. Look who makes money off of complexity. Credit cards are another example. I have read numerous articles by lawyers who specialize in finance issues who have had trouble deciphering credit card aps. If banks want to offer complex mortgages, and receive the higher fees that go with them (this is mostly the originators), we need to make sure the true costs of those loans is built in. People taking out plain vanilla loans should not be subsidizing the risky loans.

  6. john personna says:

    Of course Steve, the strategy by bank lobbyists would be “If I can’t stop a regulation, I should at least confuse it.”  And then of course conservatives can say “see, more bad regulation” as if that was the only choice.
    More on Denmark:

    In spite of similar house price declines in Denmark and the US, delinquencies on Danish loans have been a fraction of those in the US. From peak to trough, house and flat prices in Denmark fell 15 and 25 per cent respectively, while the fall in the US – depending on the statistics used – was between 15 and 30 per cent. Delinquencies on loans granted by Danish mortgage banks have at no time during the current crisis exceeded 0.6 per cent of outstanding loans; delinquencies on US prime mortgage loans exceed 5 per cent, and delinquencies on subprime loans easily reach double digits.”

  7. PD Shaw says:

    People don’t understand mortgages.  If you hand a recent mortgage purchasor a truth in lending disclosure form and ask them what the principal amount of their loan is, 51% will get it wrong.  20% will get the APR wrong.

    See page 10:

  8. Robert Harden says:

    It’s similar to the massive tax spaghetti bowl that we have our accountants handle every year. Just another huge ignored inefficiency in the system. Surely we could simply the paperwork with these sorts of things without creating other problems

  9. john personna says:

    Isn’t the story there the improvement over the previous form, PD?

    We could also ask to see comparisons to other countries’ forms and correct answer percent.

  10. Ted Craig says:

    You’re statement about auto sales is way off base. There’s much more incentive for a car dealer to treat you fairly than a real estate agent. They depend on repeat and refferal business. There’s a good chance that real estate agent or mortgage provider will never see you again.

  11. In my experience in the consumer law field over the past decade or so, I’d say there’s more misrepresentation and outright fraud from auto dealers, especially the used car guys, than you’ll ever find in the mortgage industry.

  12. PD Shaw says:

    John Personna, the report certainly shows substantial improvements with improved disclosure forms, but even with an improved disclsoure form 20% couldn’t correctly identify the interest rate on their mortgage.  Also consider this caveat on the limits of the study:

    “Although in real-world transactions borrowers will have greater incentive to understand loan costs, because their homes and savings are at risk, they also may face a number of factors that make it more difficult to understand their loan costs. The consumer testing was conducted in a quiet, experimental setting. Respondents did not face the time pressure of a loan closing, a large stack of other closing paperwork, or deceptive tactics aimed at obscuring loan costs, all of which are likely to aggravate the difficulties consumers have understanding their loan terms. These difficulties may be especially acute for refinance loans, for which the TILA disclosures need not be provided until closing. Further difficulties are introduced because the settlement costs disclosed earlier in the GFE are subject to change at closing.”

  13. PD Shaw says:

    By the way, Justice Posner didn’t read the documents for his home equity loan either:

    No doubt Posner is partially relying upon his wealth and ready access to the legal system to address any post-closure risks that arise.

  14. john personna says:

    Well this might be related to that “problem 20%”

    The line of interest is “I guess that’s what happens when, despite the best advice from the smartest economists in the world regarding the benefits of “financial innovation”, banks continue to require large down payments and check to see if the borrower can actually pay the money back.”

    I’d guess that by time people got a healthy down payment together they’d gathered enough financial acumen to read the improved form.  With 0% down, or those strange deals which provide a cash-back to equal down payment, we aren’t really asking buyers to invest much thought.

  15. Dantheman says:

    “Between the lawyers and the politicians, I really do think that things like mortgage applications have become so complicated with mandatory disclosures and CYA provisions that it’s actually harder to understand than it needs to be.”

    In 1989, during a job interview, I was asked by an of counsel at the firm (a real pistol who had reached mandatory retirement age for state court judges and returned to the firm he was at before his judgeship) why there were so many forms for a simple residential real estate transaction.  My response was that every time a lender loses a case, its response is to create a new form to get future borrowers to give away the right the court found in that case.

    I stand by that explanation to this day.

  16. Tim says:

    McArdle in the 99th percentile in intelligence? Clearly you haven’t read much of her stuff.  I’d buy 95th percentile.
    Anyway, there’s not much in most MBA programs (or alot of law schools, for that matter) that creates the skill of understanding complex agreements.  And generally it doesn’t seem like McArdle learned a ton about finance or commercial arrangements in getting her MBA.  She must have concentrated in Marketing.

  17. john personna says:

    I’m getting to think that McArdle’s articles could be fodder for a sophomore Logic class.  Spot the fallacy of the day.
    If she is 90+ percentile, she obviously does not think her target audience is.