Don't Let Judges Tear Up Mortgage Contracts:
Amidst the so-called "credit crisis," there is much talk about how libertarianism is dead, or at least how libertarian first principles are irrelevant. One appeal of libertarianism is that its basic principles are simple and easy to understand. Private property, freedom of contract, self-defense, restitution for rights violations, etc. While some libertarians hold these principle as ends in themselves, all libertarians also believe they lead to good consequences. And the general public is concerned with consequences along with its views of morality. When a public policy debate arises, however, it is not persuasive simply to invoke libertarian general principles. One must know something about the subject at hand to explain how violating these principles is likely to turn out badly.
Libertarian first principles can be analogized to having a cheat sheet of answers to a multiple choice test. While you might know the right answer--which is certainly useful--you won't know exactly why
the answer is right, which is needed to truly understand the subject being tested. And without such an understanding, one cannot explain the "right answer" to others and why it is right.
One of the basic libertarian principles is that persons have a right to enter into contracts of their choosing, and that the government should not intervene to hold such a contract unenforceable. But contract law recognizes valid defenses to a contract that are needed to protect contractual freedom. And contract law has long co-existed with bankruptcy laws. (For a libertarian analysis of bankruptcy laws see here
While libertarians today might instinctively object to letting bankruptcy judges modify existing mortgages, to be persuasive, one needs to know something about both the mortgage market and how bankruptcy proceedings work to know exactly why
this is a bad idea. Co-conspirator Todd Zywicki has an op-ed in today's Wall Street Journal
opposing giving bankruptcy judges the power to modify existing mortgages. His essay well illustrates why libertarian principles alone are not enough to enter into a public policy debate. One also needs knowledge of the subject at hand. You should read the whole thing, but here is an excerpt:
In the first place, mortgage costs will rise. If bankruptcy judges can rewrite mortgage loans after they are made, it will increase the risk of mortgage lending at the time they are made. Increased risk increases the overall cost of lending, which in turn will require future borrowers to pay higher interest rates and upfront costs, such as higher down payments and points. This is illustrated by a recent example: In 2005, Congress eliminated the power of bankruptcy judges to modify auto loans. A recent staff report by the Federal Reserve Bank of New York estimated a 265 basis-point reduction on average in auto loan terms as a result of the reform.
Allowing mortgage modification in bankruptcy also could unleash a torrent of bankruptcies. To gain a sense of the potential size of the problem, consider that about 800,000 American families filed for bankruptcy in 2007. Rising unemployment and the weakening economy pushed the number near one million in 2008. But by recent count, some five million homeowners are currently delinquent on their mortgages and some 12 million to 15 million homeowners owe more on their mortgages than the home is worth. If even a fraction of those homeowners file for bankruptcy to reduce their interest rates or strip down their principle amounts to the value of their homes, we could see an unprecedented surge in filings, overwhelming the bankruptcy system.
Finally, a bankruptcy proceeding sweeps in all of the filer's other debts, including credit cards, car loans, unpaid medical bills, etc. This means that a surge in new bankruptcy filings, brought about by a judge's power to modify mortgages, could destabilize the market for all other types of consumer credit.
There are other problems. A bankruptcy judge's power to reset interest rates and strip down principal to the value of the property sets up a dynamic that will fail to help many needy homeowners, and also reward bankruptcy abuse.
Consider that the pending legislation requires the judge to set the interest rate at the prime rate plus "a reasonable premium for risk." Question: What is a reasonable risk premium for an already risky subprime borrower who has filed for bankruptcy and is getting the equivalent of a new loan with nothing down?
In a competitive market, such a mortgage would likely fetch a double-digit interest rate -- comparable to the rate they already have. Thus, the bankruptcy plan would offer either no relief at all to a subprime borrower, or the bankruptcy judge would set the interest rate at a submarket rate, apparently violating the premise of the statute and piling further harm on the lender.
More worrisome is the opportunity for abuse. [snip]
If Congress wants to deal with the rising number of foreclosures, it should not create a new mess by converting the mortgage crisis into a bankruptcy crisis. Doing so will open the door to a host of unintended consequences that will further freeze credit markets, raise interest rates for new home buyers, and spread the mortgage contagion to other types of consumer credit. Congress needs to reject this plan and look for better solutions.
Read the whole thing here
A defense of mortgage modification in bankruptcy.
Todd’s Wall Street Journal op-ed makes many good points but it doesn’t address the main argument for bankruptcy reform. The basic problem posed by the housing crisis is that millions of people find themselves with negative equity and rationally abandon their homes. Banks have trouble seizing, maintaining, and selling these houses, and bankers will tell you (anyway, they’ve told me) that the rule of thumb they use is that a foreclosed house will lose fifty percent of its value. I am unaware of any studies that prove that this figure is correct but the anecdotal evidence is powerful. In some communities, abandoned houses become havens for drug dealers and squatters who strip away wiring and whatever else might be valuable in the house. The derelict houses reduce the value of neighbors’ houses, who then can be plunged into negative equity themselves, causing them to abandon their houses as well, leading to further degradation of the neighborhood, in a vicious spiral.
From a theoretical perspective, there are really two problems. First, bankers and mortgage holders are unable to negotiate contracts that provide for an automatic mortgage modification in the event that the value of the house falls below the debt. An optimal, complete contract would provide for such a debt adjustment, but it seems likely that bankers fear that any such provision could be too easily gamed, and so they prefer to renegotiate ex post if necessary or simply swallow the costs by having a policy of automatic foreclosure. Second, bankers and mortgage holders have no incentive to take into account the possible negative effects of mortgage default on neighbors.
As I have argued in earlier posts, the solution to such a problem in principle is mortgage modification. A banker does better by voluntarily reducing principal and interest than by foreclosing; however, big banks have traditionally refrained from renegotiating, perhaps because the transaction costs are high (smaller banks have traditionally agreed to renegotiate, by contrast). In the current climate, big banks are rethinking their earlier policy, but in any event it is hard to renegotiate with someone who has abandoned his house and disappeared.
If people can strip down their mortgages in Chapter 13, they will be less likely to abandon their houses, and this will have positive effects on their neighborhood. It is possible that such a rule could increase the cost of credit, as Todd argues, but the opposite effect is just as likely. On the one hand, banks might be reluctant to extend credit if they know that, in effect, repayment amounts will be reduced if housing prices decline, or banks will raise interest rates to cover this risk. On the other hand, if the result is a reduced incidence of foreclosure, then banks will do better rather than worse, and so interest rates should fall. If the right to modify the mortgage is limited to cases of financial crisis (which is not in the current bills), then the positive or negative effect on the cost of credit will be correspondingly smaller, minimizing a risk of disruption in the mortgage market.
We have learned from this crisis that every mortgage imposes potentially serious negative externalities on third parties. When someone defaults and abandons his house, he causes harm to others. The law currently does not punish that person or try to deter him from what is essentially a kind of pollution (like abandoning a car in the street); any attempt to do that would be impractical. So in a second-best world in which wrongdoers cannot be punished for the harm they cause others, restrictions on the contracts that bring about this state of affairs may well be justified. That is what bankruptcy law has always done; mortgage modification is a further development in bankruptcy law that would be justified in crisis (and possibly even normal) conditions.
Libertarian Stop Signs:
Blogger BK Drinkwater
has a reaction to my post yesterday analogizing libertarianism first principles to a cheat sheet for a multiple choice exam:
I’ve always found libertarianism to be an attractive political philosophy. But since I’m a pretty bad political philosopher—in fact, I suck at philosophy generally—the libertarian perspective has a couple of traps. The trap Barnett describes is a particularly tough one to get out of: once seduced by a libertarian idea, like “goods and services are produced & distributed more effectively when markets are not interfered with by coercive agents like government”, it’s apparently obvious correctness turns it into a sort of semantic stop sign.
I went through a phase where if, say, education or healthcare policy came up in conversation, I’d say “Markets! Markets markets markets! MARKETS!” I found these conversations astonishingly unproductive, but I didn’t think to blame myself.
Truth is, I didn’t know much about education or healthcare policy. The semantic stop sign—“Markets!”—shut down my own investigations into these matters. I was frustrated that I couldn’t convince conservatives, social democrats, and socialists to come round to my view. To myself, I blamed their intransigence. In terms of Barnett’s analogy, I had the “right answer”, but I couldn’t explain why it was right, and so I didn’t truly understand the subject being tested.
I’m slowly maturing. I’ve learned more about education & healthcare policy. What I’ve learned has moderated my beliefs a little, but I still claim that our schools and healthcare would benefit from a policy that lets markets do more of the heavy lifting than they’re currently able. I’m just better able to argue it now.
I still don’t argue it well—I still don’t know enough. But I’ve run the stop sign, and I’m no longer stalled. On this issue.
Where are your stop signs? Be honest.
You can comment on his blog post here