Posted by Randy Barnett:
Don't Let Judges Tear Up Mortgage Contracts:
http://volokh.com/archives/archive_2009_02_08-2009_02_14.shtml#1234536544
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 [1]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 [2]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 [3]here.
References
1. http://mises.org/journals/jls/1_4/1_4_2.pdf
2. http://online.wsj.com/article/SB123449016984380499.html
3. http://online.wsj.com/article/SB123449016984380499.html
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