Sunday, March 15, 2009

Gamma: Some Contracts Are More Equal Than Others

GG writes:

The Obama administration is focusing on the short-term pain of families losing their houses and neglecting the long-term costs of undermining the integrity of contracts.

This mischaracterizes what the foreclosure plan does.  First, it allows millions of homeowners to refinance.  Second, it uses TARP funds to provide liquidity to lending markets.  Third, it sets guidelines for modification of sub-prime loans.  Now this portion of the plan does require payment reduction and caps on monthly payment amounts, but these mandatory guidelines apply to institutions that receive assistance from the federal government.  If you're a lender that doesn't want renegotiate your sub-prime loans - fine: stop taking taxpayer money.  Seems like a reasonable quid pro quo.

But GG's primary beef is with loan modification as part of a bankruptcy proceedings, then he just doesn't see eye to eye with the framers of the constitution.  Article I, Section 8 of the Constitution gives Congress the power to establish uniform bankruptcy laws throughout the United States.  This explicit grant of power is in the same section of the Constitution that give Congress the power to coin money, organize and provide for a military, and declare war.  From this, one can infer that the Constitutional Convention found the provision of national debtor protection laws was less controversial that say, the freedom of expression, religious freedom, or freedom of the press. 

Since then the US has had a long history enacting pro-debtor laws that have benefited not only individuals, but also large corporations.  In fact,  lenience for corporations with debt problems is one of the hallmarks of American bankruptcy law.  This tradition is codified in Chapter 11 of the Bankruptcy code and is called reorganization.  While not unique to the US, the idea that a debtor can hold on to its assets, renegotiate credit terms, and continue to operations without the immediate threat of liquidation or foreclosure is a truly American legal tradition.  Under Chapter 11, if the creditors and the debtors can't find mutually agreeable terms for restructuring the debt, the Court may step in and create terms that would allow approval of the restructuring plan. 

Therefore, for at least the last 125 years, commercial lenders have always entered into lending agreements with the understanding that a court could rewrite the terms of the loan agreement.  Yet American credit markets have grown through these years and America's companies have been able to borrow plenty (perhaps too much).  Thus there is ample evidence credit markets can function and grow, even with the threat that a bankruptcy judge may not honor the "integrity" of the original contract.

Now, over the years, Chapter 11 reorganization has been available only to companies and high net worth individuals.  The average person couldn't file for bankruptcy and hope to hold on to their home.  The Obama administration means to change this by providing all Americans with the same protections afforded to corporations and the rich.  Of course, if the debtor is unable to meet its restructured obligations, all bets are off and the lender can foreclose.

Ironically, the absence of any means for an individual to renegotiate home loan terms in bankruptcy may have created a moral hazard wherein lenders (using the faulty assumption that home values would always rise) could offer sub-prime mortgages with little or no risk.  Lenders could extend credit with confidence knowing that if the borrower did default, they could quickly foreclose on the house and never have to deal with the borrower again.

With this change to the bankruptcy laws, lenders will have to be more cautious in lending with the knowledge that the terms may have to be renegotiated and that easy foreclosure is not an option.  

What is hypocritical here is that just months ago, GG was demanding that the Big Three be placed in bankruptcy so that a judge could rewrite the terms of union and labor contracts.  Apparently, there is no need concern ones self with the "integrity" of contracts when average working folks are the ones getting the shaft.  But God forbid using the same laws for the benefit of average working folks if it means lenders may have to renegotiate terms of some of their more boneheaded loans.  



friedmanite said...

I felt compelled to respond to this, as it seems lately that my head has been swimming in bankruptcy law. I'm somewhat familiar with personal bankruptcy law, not so much as with corporate. When you say "the Court may step in and create terms that would allow approval of the restructuring plan", does that mean that both parties can either approve or deny the terms? If so, that would be different than what is being proposed, as it would force lenders to accept terms set by a judge.

In general, there will always be trade-offs with deciding how to write bankruptcy law. As you make it more lenient, you increase the cost of borrowing for everyone else. For example, in Memphis, where the bankruptcy laws are very lenient, businesses will not accept out of state checks, and auto dealers require a down payment of at least the wholesale value of the car. Those are the second order effects of allowing people to escape their debt commitments too easily. On the other end of the scale, you'd have no bankruptcy protection, which would provide the cheapest borrowing rates for all of society (as lenders wouldn't have to account for the costs of bankruptcy protection), but you wouldn't have some of the benefits of bankruptcy. These include encouraging some level of risk taking, plus the moral issue of allowing people a second chance in life.

So regardless of what side you are on, you should acknowledge that there are costs and its a trade-off between the cost and the benefits.

You also have to deal with people gaming the system, which obviously happens when you look at the numbers of bankruptcy filings based on the leniency of the bankruptcy law. For example, right before a law change in 2005, half a million people filed bankruptcy in a two week period. Only 650k filed the entire following year. People who game the system are stealing from all of us, as the costs of their benefits are spread among all other consumers.

Also, there is bankruptcy protection for individuals that allows them to keep their home. Its Chapter 13 bankruptcy, where your wealth is protected, but your future income is not. So the bankruptcy agreement in Chapter 13 might include a payment plan, wage garnishments, etc. That's opposed to Chapter 7, which protects your future income, but not your current wealth.

Allowing judges to write-down the values of their mortgages will incur some costs.

First, there is a value in stability of law. When the rules of the game don't change very often, there is a high degree of certainty in how the state will act, and businesses and individuals can proceed with confidence. When the rules change all the time, everyone has to account for the possibility of change at any moment. That means businesses will have to include in their potential costs unforeseen changes in the rules, which cause higher prices. It also scares away investment. It reminds of me of looking at property to buy in Belize, where I didn't have a high confidence that the property laws would stay as-is, so I chose not to invest. Scaring away investment is not good for the economy.

Businesses and individuals expect a certain level of protection in bankruptcy. For mortgage lenders, it means that if you don't meet your obligations, they can always take your house. Now we're talking about a drastic change, where a judge can write the terms however he sees fit and the lender doesn't have the ability to take the house.

Contract law is a bedrock of a prosperous society. Courts are there to execute the terms of the contract, not change them. I'm ok with bankruptcy courts serving as a mediator, but they shouldn't be able to force changes in terms. That goes for corporate, personal, etc. If this is occurring in other forms of bankruptcy, my opinion would be that that's where the problem is, those laws should be changed to respect the terms agreed upon by both parties. Lets not spread the problem further.

Last, I don't see how lenders have "moral hazard" as you state it. Moral hazard means they are protected from risk somehow that causes them to behave differently than if they were fully exposed to their risks. How does offering better loan terms assuming a rise in house prices a moral hazard? As long as the lender has to eat the loss when the house goes down, there is no moral hazard. Its simply a bad business strategy. The only moral hazard would be if there is some third party taking some of the risk off the lender.

Restless Native said...

Howd on, dere, Friedie. The moral hazard when real estate booms is to write someone a loan you know he's good for for a couple of months and NO MORE. You collect his monthly payments until such time as he skee-daddles for greener pastures. You keep the payments, the property and the capital gain, again, assuming that real estate, like every other asset class, can only go up.

Dude, you're a lot smarter than me. How does that one escape you?

friedmanite said...

Ok RN, I'll let Wikipedia settle it:

"Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions."

What you describe might be considered shady deal making, but its not moral hazard.