Sanctity of Contracts: Mortgages and Credit Cards

Momentum is building in Washington for a large-scale housing bailout. It is virtually certain something will happen. The big questions are how large will the package be and will it be designed to help homeowners or to bailout out the banks?

The latter question will be determined primarily by whether the government steps in to try to prop up bubble-inflated housing markets in places like California, Florida and the East Coast cities. While the government may be able to play a useful role in stabilizing house prices in depressed markets like Detroit, Cleveland and Atlanta, the main effect of bailouts in the bubble markets will be to reduce the banks' losses on their mortgages.

In these markets, prices must still fall 20 percent to 40 percent to get back in line with fundamentals. If the government were to guarantee new mortgages at near the current market prices, it will just be allowing the lenders to cut their losses.

Since prices will continue to fall, homeowners will not accumulate any equity and the taxpayers are likely to have to make good on the mortgage guarantees. Furthermore, homeowners will be paying far more than necessary for housing costs each year that they live in their house, draining money away from health care, child care and other necessary expenses.

There is a simple and costless alternative policy that could be applied to these bubble areas. We can temporarily change the foreclosure laws to allow moderate-income homeowners facing foreclosure the option to stay in their homes as renters paying the fair market rent.

This would guarantee homeowners some security, since they could not just be thrown out on the street. If they like the house, the neighborhood, the school for their kids, they would have the option to stay. More importantly, since the banks will not want to become landlords, this policy will give banks a real incentive to negotiate terms that allow homeowners to stay in their house as owners. It is likely this would be the more common outcome from this policy.

I have been pushing this "own to rent" plan for more than half a year. Many people from across the political spectrum have embraced the proposal as the most realistic way to help homeowners facing the loss of their home. However, there has been one widely voiced objection that seems to carry considerable weight in policy circles. This plan would interfere with the sanctity of contract since it would be changing the rules for enforcing payment on mortgages and could cause lenders to involuntarily end up as landlords.

This objection is interesting because there seemed no concern whatsoever for the sanctity of contract when Congress went in the opposite direction with the bankruptcy law reform passed in 2005. In that case, Congress established much stricter rules for bankruptcy, which made it far more difficult to use bankruptcy to discharge debt.

What makes the bankruptcy reform analogous to the own to rent proposal is Congress applied the new bankruptcy rules retroactively. In other words, people who had accumulated credit card or other debt under the old set of bankruptcy rules were suddenly subject to a new set of bankruptcy rules.

Presumably, both the banks and credit cardholders understood the bankruptcy rules that were in place when loans were issued prior to the bankruptcy reform. Banks would have charged an additional premium because debt was harder to collect under the old bankruptcy laws.

However, Congress had no qualms whatsoever about just ignoring these contracts when it decided to tighten the rules to make it easier for the banks to collect. Congress could have written the law to just apply to debts incurred after the passage of the new bankruptcy bill, but apparently this route was never even considered.

Given this recent history, it seems strange there is such great concern now about the sanctity of contract. The only obvious difference is this legislative change would benefit borrowers, while bankruptcy reform benefited lenders. Does anyone smell a double standard?