February 8, 2008
Holmes and Homes
The blogosphere is aglow as opinionators wage battle over morality and contract in the context of the mortgage crisis. Early in contracts courses, students become acquainted with Oliver Wendell Holmes's position on contracts -- that is, a contract is a promise to either perform or to pay damages in case of compensable harm resulting from the breach. They also struggle with their moral instincts that pacta sunt servanda -- one ought to keep one's promises.
In the commercial context, the Holmesian perspective predominates in large part because commercial parties can protect themselves against the risk of breach. Indeed, rudimentary economic principles suggest that in some cases, breach might be preferable from the perspective of overall efficiency. It seemed obvious to me that in the case of mortgage agreements, clearly we are in the realm of commercial agreements and no stigma should attach to borrowers who "walk away" from their mortgage obligations other than whatever stigma is associated with the terms drafted and enforced by the lender.
Here, as in so many other areas, I have been proved wrong -- or at least ignorant -- by my colleague Alan White, who has directed me to numerous postings suggesting that we ought to feel (and vent) moral outrage directed at the borrowers on whom those poor, credulous, trusting, caring, unsuspecting lenders are foreclosing. For example, note the tone of these readers' comments on CNN's Money Blog.
Such outrage at borrowers is not confined to anonymous (or semi-anonymous) blog posters. George Will, for example, points out that freezing adjustable mortgage rates "amounts to a revision of perhaps hundreds of thousands of contracts" and will not help "scruplous borrowers who have scrimped and sacrified to fulfill the obligations of their contracts." Is that right? I think it probably will preserve my property's value if my neighbors are not forced into default.
Kevin Funnell of the Bank Lawyer's Blog doesn't see it that way. How would you feel, Funnell asks, if your "deadbeat" neighbor gets the benefit of a loan rate reduction? According to Funnell, in an economic climate that rewards such malingerers, those of us who honor our commitments and pay back the money we borrow when and on the terms agreed to are "SUCKERS." On Mish's Global Economic Trend Alnalysis, Mike (Mish) Shedlock criticizes "60 Minutes" for "legitimizing" walking away -- that is, the practice of defaulting on one's loan payments rather than re-financing.
Mish's criticism of 60 Minutes seems unfair to me, since the people featured in the 60 Minutes story could not refinance. Their property had declined in value to such an extent that no lender would have them. That is why government intervention such as that denounced by Will seems to make some sense. Even Will concedes that the voluntary freeze plan endorsed by President Bush will benefit not only borrowers but also people who own mortgage-backed securities. And that's presumably a good thing, since people who invested in mortgage-backed securities weren't engaged in irresponsible speculation, were they?
In defending lending practices denounced as predatory, Will asks whether lenders expected "the borrowers upon whom they supposedly preyed to default." The question is intended to be rhetorical, but the answer is obviously "yes." Mortgages are securitized as a risk-spreading device precisely because the lenders expect that a certain percentage of the loans will end in default. That does not mean that the lenders were engaged in predatory practices, but they were undeniably aware that default was going to occur in a certain percentage of these sub-prime mortgages. Where borrower and lender were both engaged in commercial ventures that entail recognizable risk, it seems to me inappropriate to condemn the defaulting party. Indeed, in almost all cases in which a borrower defaults, the lender is better positioned to assess the risk of default and thus well-positioned to protect itself.