Disparities Arising from Standardized Contracts

Signing a standardized contract is just the beginning of a relationship between consumers and firms. Many such transactions proceed without incident, but when disputes arise, conversations between consumers and firms are usually the first step to address conflicts. Consumers can gain a great deal of value from cooperative firms that are willing to renegotiate contract terms as circumstances change. Conversely, unresponsive or unyielding companies can cause consumers to lose money, in some cases leading to financial ruin. Companies can affect the value transactions create through their discretionary choices.

In recent work, I used data on mortgage contracts to shed light on who wins and loses from firms’ discretionary choices during performance of a contract. Mortgage servicers make decisions that can have huge impacts on borrowers, including responding to borrower claims of financial hardship, offering loan modifications, setting up repayment plans for borrowers who missed payments, and deciding when to foreclose on borrowers in default.

Since the 2008 financial crisis, mortgage servicers have been widely criticized for inefficiency and negligence in these choices, due to poor incentives and weak infrastructure. Regardless, servicers have been tasked with the essential role of helping households in default during the COVID-19 crisis.

Data on servicing show that servicers regularly offer borrowers discretionary debt relief, even when they are not required to by law. More than 40 percent of loans that are three to four months behind on payments avoid foreclosure, and instead they are modified, cured, or paid off by refinancing or sale. Mortgages that do end in foreclosure are different from those that do not; foreclosed homes are disproportionately located in lower-income neighborhoods. This pattern holds even when comparing similar loans on similar properties, held by similar borrowers, suggesting that servicer behavior drives this difference. Given the high costs of foreclosure, both to the parties and to local neighborhoods, I estimate that servicers’ discretionary behavior is redistributing more than $500 million from poor to rich neighborhoods every year.

This is just one example of standardized contracts being enforced differently for different populations. A growing literature in consumer contracts has shown that the “real deal,” or the value a contract creates for an individual, differs greatly from the “paper deal” that can be gleaned from written contract terms. The paper deal is weighted heavily in favor of companies, created by an imbalance in bargaining power and resulting in few rights for borrowers. The real deal may be significantly better for privileged consumers who can negotiate with companies, but those benefits do not extend equally to all customers.

In related work on retail returns, Meirav Furth-Matzkin finds evidence that black retail customers are disproportionately held to strict written terms, relative to white customers. Similarly, Arka Bandhyopadhyay shows that mortgage forbearance benefited white borrowers disproportionately during the COVID-19 crisis.

Despite these pervasive patterns, there is little information about contract performance and few legal mechanisms that can help bring this phenomenon to light. Policymakers need further data to address concerns about equity and to minimize inefficiencies that these patterns create.

Unequal treatment during contract performance can cause consumers to distrust companies, which is then exacerbated by the inability of firms to commit to cooperative behavior. For instance, many low-income minority borrowers avoid banks and formal financial services providers, and they choose instead to work with check cashers and other alternatives. One reason may be disadvantaged borrowers’ rational expectation that banks will treat them more stringently compared to their privileged peers. In theory, banks can choose to waive fees for privileged customers but not disadvantaged ones. But my work demonstrates that no legal mechanism requires banks to treat all customers equally.

Inequalities in contract performance, however, are not necessarily all bad. As research by Susan Cherry and coauthors shows, companies sometimes use their discretion to help individuals in acute need of funds by allowing them to delay or skip payments for a period of time. When these benefits accrue disproportionately to disadvantaged populations, they can act as a mechanism for progressive redistribution of wealth. Moreover, by decreasing the chance of negative outcomes such as foreclosure, targeted benefits can improve the efficiency of markets for contracts.

Therefore, the first step is to understand the scope and magnitude of inequalities in contract performance, with special focus on the treatment of disadvantaged consumers. To do so, companies must disclose data on choices they make during performance, at least to regulators and sophisticated parties. Information on bank fee waivers, or on debt servicer forbearance, linked with consumer characteristics, would help regulators and scholars understand whether companies are engaging differently with certain classes, such as people of color, and falling afoul of anti-discrimination law. On the other hand, the data may reveal that some companies have targeted their performance in favor of disadvantaged populations, which could help their reputation.

Importantly, data on consumer contract performance would fill a gap in information between companies and their customers. Companies are repeat players that have access to credit scores and datasets about customers’ social media use, friend network, and advertisement preferences, which help them predict how each consumer will behave. Consumers know much less about companies’ standard business practices, when and how to negotiate, and how their experience compares to that of other consumers.

Disseminating information to regulators and to consumers through informed intermediaries can generate more productive relationships between companies and their customers, no matter the written terms of the contract.

Manisha Padi is a professor at the University of California, Berkeley, School of Law.