Monday, August 18, 2008

Two to Tango: Mortgages and Contract Law

-- Posted by Neil H. Buchanan

Here on Dorf on Law, I recently discussed the problem of abusive credit card practices, suggesting that the discussion of whether and how to rein in certain controversial practices by credit card issuers will be distorted by absolutist rhetoric about contracts. "But they agreed!" is likely to be the retort to any suggestion of legal relief for people who signed or clicked through contract provisions that they now wish to avoid.

I noted briefly in that posting that this absolutist language of contract carries over to debates about the loan contracts at the center of the current mortgage crisis. Again, the argument is that grown-ups must be held to their agreements, making any provision to modify or set aside contract terms now viewed as onerous a dangerous and paternalistic response. The presumption in any system of contract must surely be that agreements will be honored. That part is easy.

What we often seem to forget is that no system of contract law -- and certainly not ours -- ends at the beginning. The mortgage crisis, in fact, offers a particularly rich set of lessons in how and why some contracts should appropriately be re-written after the fact. (I do not propose to discuss here recent legislation that has been enacted in response to the mortgage crisis. Whatever else one might say, it is safe to assume that recent Congressional action on this issue will not be the last word on this ongoing crisis.)

As a macroeconomist by training, the natural place for me to start is to look at the aggregate picture. When the economy at large is threatened by a problem, averting greater damage is much more important than any particular contract. Just as it is appropriate to take action to prevent the catastrophic failures of large financial institutions ("too large to fail"), it can be necessary to take action to prevent the downward spiral that can come from widespread mortgage defaults ("too many to fail"). Policymakers, of course, will worry about whether the actions that they take today will set a bad precedent for future actions, but a doctrinaire hands-off response to these crises is, thankfully, no longer the end of the story.

The question remains, though, why it is appropriate to ask the non-defaulting party to take a hit in a crisis when it seems to have done nothing wrong. One simple answer is that, sometimes, losses need to be spread around to prevent greater damage. The more interesting answer, though, is that often non-defaulting parties should share in the losses, both because of what they knew when they entered into their contracts and what they did during the contracting process.

A borrower who cannot make loan payments when due is in default. The natural response is to say, "When you entered into the contract, you knew that you had to pay back the loan. You accepted the lender's money in consideration, and now they have a right to a remedy for your breach."  Again, as a starting point, this is fine. What we rarely hear, however, is a reminder of what lenders knew when they entered into these mortgage contracts. There are two sides to every contract, it is true, and both sides' actions need to be considered.

In the case of mortgages -- even mortgages that are not sub-prime -- the "negotiation" between the parties takes an odd form. It is true that mortgages are not "take it or leave it" contracts of the type that we see in the credit card market, with the terms of contracts (especially the interest rate, but also the length, the possibility of penalties for early repayment, etc.) the subject of direct negotiation. In many states, in fact, the buyer must be represented by legal counsel in purchasing a home.

Still, the mortgage process is deliberately set up in a way that makes the borrower a passive participant in the most important part of the process: loan approval. The borrower submits all kinds of confidential personal information to the lender, who takes that information and issues a one-word answer -- approved or denied -- to the applicant.

Note that the potential borrower is now an "applicant," waiting for a considered judgment from an authorized expert. Applicants know that their loan will not be approved unless they have enough income or assets or if they fail to qualify on some other objective ground. When they are approved, therefore, there is reason for celebration. "We can afford the house!" The lender has set itself up as having greater expertise (a quite reasonable notion, in the eyes of a borrower), and it has said that the loan is acceptable.

The idea that "you knew what you were getting into," in other words, can just as easily apply to the lenders as the borrowers. Mortgage lenders tell borrowers that their loans are accepted, which a borrower reasonably takes to mean that they will be able to afford the loan. The borrower could have done more to make sure that this was true, but so could the lender. To the borrowers, we often say: "If you didn't want to pay back the loan, you shouldn't have borrowed the money." To the lenders, we must sometimes say: "If you didn't want this borrower to default, you shouldn't have lent them money."

This perspective does not reverse the presumption that loans will be repaid but rather makes that presumption rebuttable. It is a delicate matter to try to figure out how and when contract terms must be voided, altered, or enforced -- so delicate, in fact, that every law school in the world forces its first-year students to study just those issues for at least a full semester. Working out when and how to provide relief to over-extended borrowers is never easy, and the easy answer that they never deserve relief is the least satisfying approach of all.