Let me start by saying I am not a lawyer and I do not aspire to be a lawyer. But these days it is hard to be in the mortgage business and not be pretty savvy on the legal aspects of our industry.
Recently, I was talking with an associate at a title company who works on his firm’s international title insurance operations. I learned that one of the most important factors when they are deciding where to issue title insurance is to look for countries with a strong “rule of law.” This got me thinking about what exactly is the rule of law? A simple definition is: “A legal system in which rules are clear, well understood and fairly enforced, including property rights and enforcement of contracts.”
Put simply, the rule of law is a governmental and judicial system in which a society adopts or maintains a set of just and fair laws that govern contracts and criminal codes. When we think of corrupt societies around the world, we often think of places where people are jailed with no due process. But, I have learned that it isn’t just the criminal code that causes oppression and keeps certain countries from achieving economic stability. It is their lack of even and fair enforcement of contract law.
Stability necessitates the assurance that the judicial system will evenly enforce the terms of a contract, using only the law and the terms of the contract as their guide. In many underdeveloped countries, the enforcement of contract law often includes emotional factors such as personal whim or gain, or their belief that they must bow to political pressures. Governments will intervene to adjust or invalidate laws as it suits their political agendas.
As mentioned earlier, companies prefer to have the rule of law as the rock upon which they can build business and rely for their business contracts. And fortunately for us, the United States is the gold standard for the rule of law fostering economic growth and prosperity.
A mortgage is a contract
As a veteran of the mortgage industry I am intimately familiar with two contracts: the mortgage, or deed of trust, and the note. The note is a legal contract where the lender agrees to loan the borrower money and the borrower agrees to repay the money on a certain schedule with interest. The mortgage is a legal contract by which the owner, i.e., the buyer, gives to the lender a lien interest in real estate to secure the repayment of a debt, evidenced by a note.
Under the rule of law, these contracts are simple. If you don’t pay back the money as agreed to in the contract, you agree to forfeit your ownership and vacate the home.
Most experts will likely say that the various programs implemented over the past few years ultimately will benefit the investors and the economy as a whole, but I am not an economist so I don’t have an educated opinion on the long-term economic effect of these programs.
But one thing is obvious to everyone: We have had unprecedented levels of intervention in private-sector business. We have seen changes in mandated judicial processes and a backlog of foreclosures for years. So while they may eventually enforce the contract law via foreclosure, the years of backlog make it almost an infeasible option.
These delays could be considered similar to what we find when attempting to do business in underdeveloped nations, where delays in processing by local courthouses are often adjusted by the clerks based upon your political alliances.
How about the eminent domain debate? Eminent domain is the right of a government to expropriate private property for public use, with payment of compensation. Historically, this has been used to seize land for public facilities, highways and the railroad. Under proposed plans, a city will force the purchase of residential properties from the banks, then write down the loan and refinance the homeowners into a new loan.
In short, these cities are setting aside the contract between the borrower and the bank and rewriting the rules.
Principal reductions
What about principal reductions? There has also been a significant debate over the moral hazard of principle reduction. Under these programs, borrowers who are underwater will have the debt amounts lowered to the present day value of their homes. The thought is that borrowers who are underwater will be less motivated to pay their mortgage. The detractors of principal reductions argue that this will create more strategic defaulters, making it difficult to differentiate between those borrowers who need assistance and those who have stopped paying in order to get their loan written down for free.
We could have a reasonable debate with many valid views about the moral hazard of principal reduction.
But I think the questions we should be asking are: What is the moral hazard in the message we are sending to an entire generation of homeowners? Are we telling them that if a transaction leaves them upside down, “Don’t worry, someone will step in and fix it for you?”
Are we telling them that they don’t need to worry about contracts they sign, because they will only be enforced as long as the contract still is perceived as a good value to the borrower.
I mentioned before that I am not a lawyer, but I am pretty sure the rule of law doesn’t say anything about a contract only being enforced as long as it is still a good deal. Finally, why is it that we are suggesting only principal reduction for homes? What about automobiles? My father always told me never to buy a new car because “it drops in value the minute you drive it off the lot.” Why isn’t there a principal reduction program for my truck?
Why not? Because I signed a contract and, put simply, our economy is built on people doing what they say they are going to do, enforced by the strongest rule of law in the world.
