Consumer Watch: Disclosure failed this time

It's one of the great unanswered questions about the housing bubble and the financial crisis that followed: Why didn't disclosure work as promised? Why, in fact, did it bomb so miserably in the role that economists and political leaders had counted on it to play?

For years, free marketers of all political stripes have peddled the line that disclosure and transparency are keys to a well-functioning market. As long as people understand what they're buying and have real choice, we've all said, they'll get good value and steer clear of junk.

That is the logic behind a host of marketplace rules, from food ingredient labels, to equipment and mileage stickers on cars, to the "annual percentage rate" disclosures on credit card and auto loans.

So why did millions of people sign on to subprime or exotic mortgages they could never realistically hope to repay - a crucial mistake that bid up home prices, set the stage for today's crushing wave of foreclosures, and threatens economic damage for years to come?

Jeff Sovern thinks he knows: It didn't work because the vast majority of consumers didn't carefully read the "Truth in Lending" statements and other disclosures that lawmakers insisted upon, let alone understand them or use them as a basis for shopping for better, more affordable deals.

Sovern, a professor at St. John's University in New York, who specializes in consumer law, bases his hypothesis on a survey he and an assistant, Sabihul Alam, conducted in July. They interviewed more than 100 brokers in 26 states who had participated in 58,000 real estate closings, asking how closely borrowers had read the documents.

Sovern had long believed that disclosures offered spotty protection, since they are only useful to consumers who understand them. What surprised him was that they appeared to offer no protection at all.

Many borrowers read the final disclosures for less than a minute. And almost all of the brokers said no client had ever withdrawn from a loan after reading them.

Sovern's findings are another piece of a puzzle that is becoming increasingly clear.

Yes, some people - including many speculators - knowingly took out mortgages they couldn't hope to repay, based on wrongheaded assumptions that housing prices could never shift into reverse.

But a growing body of evidence shows that millions of borrowers unwittingly made bad economic decisions, such as taking out subprime loans when they would have qualified for prime loans - a choice Sovern likens to paying $30 for a gallon of milk.

Some who took out adjustable-rate loans apparently believed they were getting conventional mortgages because lenders described a two- or three-year teaser rate as a "fixed rate." The more exotic the loan, the more confused borrowers were likely to be.

So why should this matter to you? Maybe that is not obvious, especially if you're confidently employed and comfortably ensconced in an affordable home with a modest mortgage. But it should be.

Confusing loans fueled the bubble in housing prices by facilitating sales that made no economic sense. Even if you were a qualified buyer with excellent credit, you paid a price if you bought a home during the bubble years because funny money was bidding up your neighborhood.

We're all coping with the fallout. In the second quarter of this year, 16 million homeowners were "under water" in their mortgages, owing more than their homes are worth, according to Moody's Economy.com. In some places, prices are expected to take more than a dozen years to return to their peak.

That is a nightmare for those who need or want to sell. Along with unemployment, it is a key reason for the wave of foreclosures we're facing, a wave that will depress home prices for years to come.

There isn't a single answer to this mess. But the evidence at hand, including Sovern's new study, suggests the importance of two key policy proposals, one currently before Congress and the other off the table now but deserving of return.

To push lenders to accept the consequences of their own unwise risks, Congress needs to reconsider a proposal it dropped earlier this year when the finance industry raised a fuss: giving bankruptcy judges authority to write down the value of a primary residential mortgage to a home's actual market value.

Judges already have that authority for owners of vacation homes and virtually every other kind of asset, including commercial properties purchased by sophisticated buyers with legions of lawyers at their disposal. There is no reason to treat homeowners - the least-sophisticated buyers - any worse.

The other key proposal, still on the table, is the creation of a "Consumer Financial Products Agency." For the first time, there would be a financial-regulatory agency focused on protecting consumers, not banks - an agency with authority to write rules protecting borrowers from abusive mortgages, credit cards, and other financial products.

The recession has been deep and painful, and it has destroyed trillions of dollars in household wealth. Americans are justifiably angry at the finance industry, especially over bonuses and bailouts.

Across-the-board, incentives need to be fixed so that excessive risk-taking is not rewarded. The place to start is by boosting basic protections, so consumers no longer have to trust that disclosure solves everything while bearing the brunt of the finance industry's risks.