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.


KipEsquire said...

The idea that "you knew what you were getting into," in other words, can just as easily apply to the lenders as the borrowers.

Creditors certainly know that debtors may default. Every party to every contract knows that the other party might breach. This statement is utterly devoid of any substance -- yet it is the cornerstone of your entire argument. Go figure.

What you're really hinting at, which is outrageous, is the idea that "knowing in advance that you might lose the game denies you the right to protest when the other side seeks to change the rules after the game has begun." You are essentially proposing reducing all contract law to mere suggestions dressed up as "rebuttable preumptions."

What a circular piece of reasoning this whole post is. Your argument, which boils down to little more than, "We should do this because some people ('macroeconomists') think it would be good if we did this..." is not an especially robust basis for abridging, post facto, voluntary contracts entered into by competent consenting adults.

And your tidbit about first-year contracts is particularly insolent. What 1Ls learn is that some contracts might be void or voidable ab initio, that remedies for breach might be forward-looking or backward-looking depending on the circumstances, and that arrangements that aren't really contracts might, for the sake of equity, be treated sorta kinda like contracts on some occasions.

But I am not aware of any law school curriculum that teaches that otherwise valid contracts are or ought be the legal equivalent of Silly Putty -- to be pulled, stretched and knotted (against one or both of the party's wishes) in whatever way some third-party malcontent ("macroeconomist," politician or otherwise) thinks would be neat-o.

egarber said...
This comment has been removed by the author.
egarber said...

But I am not aware of any law school curriculum that teaches that otherwise valid contracts are or ought be the legal equivalent of Silly Putty -- to be pulled, stretched and knotted (against one or both of the party's wishes) in whatever way some third-party malcontent ("macroeconomist," politician or otherwise) thinks would be neat-o.

Banks, etc. acknowledge in very practical terms the risk on their side of the contract -- that's why they project "bad debt" for the books.

So in a way, I think Neil is simply saying that there's a point where "bad debt" in the aggregate can rupture the larger economic system. Put another way, there's a point where lenders' collective inability to manage bad debt bubbles up to become a concern for all of us. For it to get that far implies some level of culpability on the non-defaulting side (lenders, etc.).

In either case -- whether a bank has to write down a loss, or whether the public sector bails out the other side -- the non-defaulting partner is reaping the harm of its own reckless behavior. If it is a big enough failure that it threatens the larger system, imo it's fair to place accountability on the lender side as well (at least morally).

I don't think acknowledging this alters our understanding of contracts -- it's more about mitigating collective risk. And as long as the bar is set high for when big responses are needed, there's ample room for contracts to mean what they always have.

egarber said...

Just to throw out something anecdotally:

A few years ago, when were shopping around for a mortgage, the sales guy gave me an upward loan limit that made my jaw drop. Here's my paraphrased recollection of the exchange:

Me: So you're saying I qualify for a loan at X? And that the payment is Y?

Him: Yes.

Me: Well, that payment is more than my entire take-home income. How can I be approved for that?

Him: Your credit indicates that you're trustworthy. So you're approved on these terms.

That's just nutty. And it serves as proof on some level that those front-line retailers were so eager to sell off loans in the secondary markets that they threw caution to the wind on approvals (back to the fragmented ownership issue). Sure, Wall Street issued "guidelines", but clearly, banks exercised a tremendous amount of license.

Neil H. Buchanan said...

Along the lines of egarber's experience, a friend of mine was working for Wachovia Bank in the 90's when it was absorbing some failed S&L's in Texas. When the files arrived for the commercial loans, the Wachovia people discovered that the files (which were paper, not electronic, at that time) often contained exactly one sheet of paper. On the paper was written the amount of the loan and the borrower, sometimes with a general description of the location of the property being purchased with the proceeds ("10 acres at end of County Road 134"). That's it. When things go crazy, they can go really crazy.

Paul Scott said...

The real problem behind all of this has not been addressed (and likely will never be addressed, since this is the third time this nearly exact situation has come up during my lifetime, every time the government intervening in the simplest way possible and leaving the root problem unchecked).

What we have here is a perverse incentive program. Simplified, the persons making the call are rewarded handsomely for "big wins." They are not, however, proportionately punished for big losses. The result is that while the institution might best benefit (e.g. be most profitable) by taking x% risk for y% gain, where both x and y are not particularly large. The individuals running* the institution are incentivized to take huge risks. If they take those risks and succeed for a couple years, they (and the institution) make huge profits. When, as will ultimately happen, they fail, the institution takes a huge loss, but the individual is really not injured in any substantial way.

Until this is fixed (and I really don't have a good suggestion as to how to fix it that does not come with its own problems), these cycles will continue and institutions and their shareholders (and occasionally the entire country) will continue to suffer.

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