Humble Tribute to Chief Judge Judith Kaye

One of the country’s greatest contemporary judges, Judith Kaye, Chief Judge of the New York Court of Appeals, will retire at year-end under the state’s mandatory retirement law. Having served with distinction for some 25 years (15 as Chief Judge), she has earned a deserved reputation for integrity, influence, discernment, very high quality opinion writing—as well as administrative excellence. Notably, Judge Kaye was the first woman appointed to New York’s high court and its longest serving Chief Judge.

In an editorial tribute on December 14, the Sunday New York Times instanced “groundbreaking decisions,” including interpreting the New York Constitution to require the state to provide its citizens with “sound, basic education;" finding certain provisions of a New York death penalty statute unconstitutional; and finding that gay persons enjoy rights to adopt their partners’ children.

In fields closer to my heart and mind, Judge Kaye wrote several important and influential opinions on the common law of contracts, continuing a tradition on her court, whose earlier members include luminaries such as Benjamin Cardozo, Stanley Fuld, and Charles Brietel. Judge Kaye's opinions have made their way into Contracts casebooks, becoming staples of the course.

Judge Kaye’s opinions are likely to increasingly be reprinted in Contracts casebooks. If so, she would join the only other woman, Ellen Ash Peters, former Chief Justice of Connecticut, on lists of judges whose opinions are frequently reprinted, which include the likes of Cardozo, Roger Traynor, Richard Posner and Learned Hand).

One illustration, from Judge Kaye’s early years on the bench, is the classroom favorite, Van Wagner Advertising Corp. v. S&M Enterprises, 492 N.E.2d 756 (N.Y. 1986), where Judge Kaye announced her holding in the opening lines: “specific performance of a contract to lease ‘unique’ billboard space is properly denied when damages are adequate to compensate the tenant . . . .”

The lease ran from December 16, 1981 for three years (with an option to total seven years) covering space on an outside building wall (facing an exit from the Midtown Tunnel so that it was visible to vehicles entering Manhattan). Judge Kaye affirmed lower court interpretations of the contract that rendered the lessor in breach so the principal issue was the remedy.

Judge Kaye’s discussion is exemplary, explaining New York law’s somewhat different approach while engaging fully with historical and contemporary expert discussion of the doctrine. In short, she rejects the lessee’s insistence that the billboard lease, involving real estate, entitles it automatically to specific performance and also rejects the lessor’s assertions that nor should money damagers be awarded because they are too speculative. She begins with this observation in footnote 2:

We note that the parties' contentions regarding the remedy of specific performance in general, mirror a scholarly debate that has persisted throughout our judicial history, reflecting fundamentally divergent views about the quality of a bargained-for promise. While the usual remedy in Anglo-American law has been damages, rather than compensation “in kind” [citing Oliver Wendell Holmes and Grant Gilmore] the current trend among commentators appears to favor the remedy of specific performance [citing Allan Farnsworth, Peter Linzer and Alan Schwartz] but the view is not unanimous [citing Richard Posner and Ed Yorio].

Judge Kaye explained:

Whether or not to award specific performance is a decision that rests in the sound discretion of the trial court, and here that discretion was not abused. Considering first the nature of the transaction, specific performance has been imposed as the remedy for breach of contracts for the sale of real property, but the contract here is to lease rather than sell an interest in real property. While specific performance is available, in appropriate circumstances, for breach of a commercial or residential lease, specific performance of real property leases is not in this state awarded as a matter of course. [Here Judge Kaye’s footnote 3 offers “but see” citations to Arthur Corbin, Samuel Williston, and the Restatement.]

She elaborated:

Van Wagner argues that specific performance must be granted in light of the trial court's finding that the “demised space is unique as to location for the particular advertising purpose intended”. The word “uniqueness” is not, however, a magic door to specific performance. A distinction must be drawn between physical difference and economic interchangeability. [T]he leased property is physically unique, but so is every parcel of real property and so are many consumer goods. Putting aside contracts for the sale of real property, where specific performance has traditionally been the remedy for breach, uniqueness in the sense of physical difference does not itself dictate the propriety of equitable relief.

By the same token, at some level all property may be interchangeable with money. Economic theory is concerned with the degree to which consumers are willing to substitute the use of one good for another [citing Anthony Kronman], the underlying assumption being that “every good has substitutes, even if only very poor ones”, and that “all goods are ultimately commensurable” ( id.). Such a view, however, could strip all meaning from uniqueness, for if all goods are ultimately exchangeable for a price, then all goods may be valued. Even a rare manuscript has an economic substitute in that there is a price for which any purchaser would likely agree to give up a right to buy it, but a court would in all probability order specific performance of such a contract on the ground that the subject matter of the contract is unique.

The point at which breach of a contract will be redressable by specific performance thus must lie not in any inherent physical uniqueness of the property but instead in the uncertainty of valuing it.

After quoting extensively from Professor Kronman, Judge Kaye applied the foregoing principles to conclude that “the value of the “unique qualities” of the demised space could be fixed with reasonable certainty and without imposing an unacceptably high risk of under-compensating the injured tenant.” She explains:

First, it is hardly novel in the law for damages to be projected into the future. Particularly where the value of commercial billboard space can be readily determined by comparisons with similar uses—Van Wagner itself [the lessee] has more than 400 leases-the value of this property between 1985 and 1992 cannot be regarded as speculative.*

Second, S & M having successfully resisted specific performance on the ground that there is an adequate remedy at law, cannot at the same time be heard to contend that damages beyond 60 days must be denied because they are conjectural. If damages for breach of this lease are indeed conjectural, and cannot be calculated with reasonable certainty, then S & M should be compelled to perform its contractual obligation by restoring Van Wagner to the premises. . . .

Judge Kaye’s Van Wagner opinion is characteristically clear, straightforward and informative—and fun and easy to teach. It is but one specimen of how all those with an interest or stake in the output of the New York Court of Appeals have benefited from her considerable contributions and why we will miss her.

* My note: Van Wagner still has hundreds of billboards all around New York City. If readers of this post who are denizens of that town haven't noticed them before, they likely will now.

Posted by Lawrence_Cunningham at 03:53 PM | Comments (1) | TrackBack

"Yet, he ought to pay his rent."

“Yet, he ought to pay his rent,” is a famous legal conclusion from the grand case of Paradine v. Jane evoked by Mark Edwards recently in this blog, a wonderful early specimen in the law denying excuse from contractual obligation due to supervening events. Later chestnuts (like Taylor v. Caldwell to Krell v. Henry) relax the rigid stance denying impossibility, impracticability or frustration of purpose as excuses from contractual obligation, but only if the risks arising from a supervening event (fire, flood, riot, disease and the like) are not allocated, expressly or implicitly, by contract.

The common law’s navigation of these doctrines prompt parties to include in contracts express provisions excusing performance of obligations upon the occurrence or non-occurrence of stated supervening events. Parties can include any sorts of events they wish. A common example of the kinds of clauses that result, often generically described as force majeure clauses, follows:

“If either party to this contract shall be delayed or prevented from the performance of any obligation through no fault of their own by reason of labor disputes, inability to procure materials, failure of utility service, restrictive governmental laws or regulations, riots, insurrection, war, adverse weather, Acts of God, or other similar causes beyond the control of such party, the performance of such obligation shall be excused for the period of the delay.”

Pending in New York court is a claim that a similar sort of clause enables the real estate developer, Donald Trump, and companies he controls, to delay repayment of obligations for borrowed money to Deutche Bank, and a syndicate of other banks. The borrowers want a declaratory judgment that prevailing real estate market conditions are within such a clause and beyond the borrowers' control. Accordingly, they want to lawfully delay repayment of a $40 million installment due last month under a $640 million construction loan. The substantive argument is that sales of condo and hotel units the construction loan supported have failed to materialize as anticipated (only $204 million have closed and $353 million are under contract).

The claim is dubious under New York law, reflected in a leading case, which is also a Contracts classroom standard, Kel Kim Corp v. Central Markets, 519 N.E. 295 (N.Y. 1987). A lessee sought a declaratory judgment to be excused from an obligation to procure insurance on leased premises in light of the liability insurance crisis of the 1980s that made it essentially impossible to buy such insurance. The New York Court of Appeals, affirming both a trial court and intermediate appellate court, rejected the lessee’s common law impossibility and contractual force majeure arguments.

As to the common law impossibility claim, the general rule is that contracting parties agree to perform or pay damages even if unforeseen events make that burdensome. This stance is relaxed under the impossibility doctrine to excuse performance only in a way that reflects the contractual risk allocation the parties manifestly contemplated. This requires such things as destruction of the subject matter of the contract or that the means of performance is “objectively impossible.” It also requires proving that the event could not have been foreseen or guarded against by contract. In Kel Kim, the lessee did not meet these requirements for excuse under the doctrine of impossibility. After all, inability to obtain insurance could have been foreseen and guarded against in the contract.

Nor was the lessee’s claim within the scope of the force majeure clause for similar reasons. Ordinarily, only if an event is expressly within such a clause can it be invoked to excuse performance. The Kel Kim contract’s clause, the one excerpted above, did not specifically list inability to obtain insurance. Listed events deal with day to day commercial operations. The catch all phrase does not expand that class to include insurance. Procuring insurance is not about frustrated expectations in daily operations. It is about the lessor’s bargained for protection of its unrelated economic interest where the lessee continues to operate a particular business at the site posing particular liability risks.

The only way Trump’s claim against Deutche Bank is likely to succeed is if the loan agreement’s force majeure clause contains something like the following revision of the Kel Kim clause (changes in bold):

“If Borrowers shall be delayed or prevented from the performance of any obligation through no fault of their own by reason of labor disputes, inability to procure materials, failure of utility service, restrictive governmental laws or regulations, riots, insurrection, war, adverse weather, Acts of God, material deterioration in the market value of the property constructed using the proceeds of this loan, or other similar causes beyond the control of such party, the performance of such obligation shall be excused for the period of the delay.”

I haven’t been able to find the Trump-Deutche loan agreement and definitive conclusions obviously depend on reading and interpreting it.* It would be shocking, however, if a commercial bank would agree to the allocation of risks manifested in the foregoing language or anything remotely like it. Donald Trump ought to repay his loan as due.

* [As an aside, it would be nice when journalists in the modern era quote from court documents and other materials that may be costly to obtain, to provide a link to enable others access to them at no or little cost.]

Posted by Lawrence_Cunningham at 11:45 AM | Comments (2) | TrackBack

Eighteenth-Century Lessons for Credit Default Swaps

Of late I've been reading Niall Ferguson's The Ascent of Money: A Financial History of the World, and I've been struck again at how similar the rise of the modern CDS market is with the rise of maritime insurance at Lloyd's Coffee House in the early 18th century.

Originally, of course, there weren't insurance companies. Rather, individual merchants and speculators would meet informally at Lloyd's Coffee House in London. Suppose that there was a merchant with a ship that was about to make a voyage to America that he wished to insure against loss due to the perils of the sea. He would arrive at Lloyd's with a written contract promising to pay him so much in the event that his ship went down. He would also arrive with money -- or at least the willingness to pay it. He would then circulate through the coffee house, looking for those who were willing to sign the contract. Suppose that the contract promised to pay out 5,000 pounds in the event that the ship went down. Some people would sign for one pound of liability, some for 100 pounds, some for 1,000 pounds. Each underwriter would, of course, be paid by the merchant for their signature in proportion to the amount of liability that the underwriter took on. In the end, the merchant would have an insurance contract on his ship signed by a pool of investors who in aggregate were paid less than the insured value of the ship. Of course, while he was at Lloyd's the merchant might pick up a bit of money by signing on as an underwriter on another merchant's insurance contract. Before too long there were people who made their living (or at least tried to) entirely with in Lloyd's Coffee House.

Thus maritime insurance started out much like the modern CDS market. It was an entirely over the counter trade. (Literally!) There were no reserve requirements for underwriters, there was a lot of speculation by those who didn't have a clear idea of the risks they were taking on, as well as underwriting by experienced market participants who probably had a very good idea about the perils of the sea. And of course, there was an endemic problem of counter party risk. If an underwriter turned out to be insolvent in the event that a ship did sink off Cape Hatteras, there wasn't much that the hapless owner could do. There was, I suppose, the consolation of debtor's prison and the knowledge that you could drive welshing underwriters and their children into a Little-Dorrit-esque existence.

There was a two fold response to the wild world of Lloyd's. On one side, the common law courts reacted with skepticism if not outright hostility to the contracts written in the smokey coffee rooms. There was a persistent suspicion that these contracts were little more than gambling devices, something disreputable that ought to be suppressed or limited. On the other side, the regulars at Lloyd's realized that they needed to clean up the insurance market. The result was a system of trading within an association to which one could not gain access unless certain basic proofs of reliability were met. In the end, pay-as-you-go was replaced with insurance based on an insurance pool and investment proceeds, which gradually reduced the problem of counter party risk in insurance. (Although it far from eliminated it.)

I actually think that there are some important lessons to be learned from Lloyd's. First, over the long term I think that it is pretty clear that the insurance-as-gambling meme turned out to be a legal dead end. Judicial hostility toward insurance contracts injected legal uncertainty into the mix of other risks, but did little or nothing to deal with the underlying problems of counter-party risk and proper risk assessment. These problems, it turned out, were solved despite legal hostility rather than because of it. Second, a completely decentralized market of spot contracts in pure risk allocation doesn't work horribly well. Regulating the capital requirements of players in the game (or at least insuring their transparency) is absolutely necessary. Better yet is a clearing house system that eliminates counter party risk through asset pooling and the ruthless exclusion of unreliable or undercapitalized players. Not surprisingly, the commercially sophisticated parties at Lloyd's did both of these things long before the courts and parliament managed to sort out a sensible attitude toward insurance. I suspect that the same will be true of the CDS market.

Posted by oman at 12:56 PM | Comments (15) | TrackBack

Australia: A Movie About Contract Law

A few days ago, in a fit of holiday and pre-exam frivolity, I went to see Australia, the latest Baz Luhrmann – Nicole Kidman collaboration. It’s quite different from Moulin Rouge (no singing to speak of), yet it’s still a similar kind of oddball high-kinetic vision, and a lot of fun. The one flaw of the movie (okay, other than the fact that it lacks Ewan McGregor) is that it tries to weave too many strands together – a sense of the beauty of the outback, cattle ranching, business competition, racism, aboriginal rights, WWII, mysticism, a love story. Too much for one movie.

Aside from all these themes, I perceived that Baz Luhrmann wanted ... to make a movie about contract law. When Lady Sarah (Kidman) arrives in Australia, the dominating cattle baron, King Carney, offers her a lowball price for her cattle ranch. If she can succeed in driving her cattle to the port of Darwin, she will win the contract for supply of the army, thereby undercutting Carney’s monopoly. The climax of the first part of the movie (the first movie?) involves whether the army officer will sign Carney’s proffered contract before Lady Sarah rides into town with the cattle.

Unfortunately, the army officer does sign the contract before Lady Sarah arrives. But then the officer tells Lady Sarah that the contract is only binding upon delivery of the cattle to the ship. A race then ensues to load the cattle first. Who knew that the UCC could be so much fun?

So, there you have it. The epic of Australia is really a movie about contract law.

[Cross Posted at ContractsProf]

Posted by Miriam_Cherry at 09:35 PM | Comments (1) | TrackBack

A Modest Proposal to Completely Restructure American Housing Policy

Among the hopeful things that Obama has done (other than his audacity and change that we can believe in and all the rest) is bring Larry Summers on to his economic team. I hope that he'll heed Larry's suggestion that we should ultimately privatize Fannie and Freddie. The half-way house of "publicly sponsored" institutions is, we have seen, a recipe for moral hazard and financial disaster. Anyone who thinks that we should simply nationalize these behemoths needs to spend some time contemplating François Mitterand's France and the long-term gloire of the state-owned banking sector.

Of course, if Fannie and Freddie are ultimately chopped up and sold off, who will be in "the American Dream business"? How will the government continue to facilitate home ownership? The answer, of course, is that we can continue to do all sorts of things to subsidize home-mortgage debt. The death of Fannie and Freddie wouldn't end the home-mortgage interest deduction or all of the other financial goodies that the feds hand out to indebted homeowners like myself. And this is why Larry's privatization proposal doesn't, in my opinion, go far enough.

Oddly enough, this is not the part of the post where I say "let the market take care of the housing market thank you very much." (Although I sometimes have those moments as well.) I actually subscribe to the home-ownership-is-good-for-communities school of thought. There are positive externalities to home ownership that are, I think, worth subsidizing. I've lived in neighborhoods full of renters and I've lived in neighborhoods full of homeowners. There is a difference. On the other hand, I am increasingly convinced that our entire approach to subsidizing home ownership is fundamentally wrong.

To put it bluntly, we subsidize home ownership by subsidizing home mortgage debt. The result is more home debt in the economy, but also more leverage by homeowners and an accompanying brittleness in household finances and the performance of home mortgages. In other words, the government is in the business of increasing the amount of mortgage debt flowing through the financial system and in increasing the risk associated with that debt. It's not such a great system, as we have seen over the last year or so.

The solution, if we want to subsidize home ownership, is to subsidize equity rather than debt. This would also help families into homes, but it would do so in a way that encouraged them to be less leveraged, making household finances -- and incidentally the performance of home mortgage loans -- less brittle in the face of outside shocks or drops in asset prices.

The problem with subsidizing equity, however, is that it would force both policy makers and home owners to fess up to what they are doing. Policy makers would have to put an actual line in the budget where they voted x billions of dollars in transfer payments to home buyers. There would be a stipulated sum of money for which they would be accountable to the voters. Tax exemptions and GSEs allow the government to goose up home purchasing in a way that is complex enough that most voters yawn. On the home owner front, subsidizing equity would require middle-class citizens like myself to fess up to the fact that when we recline under our vine and fig tree we're on the government dole as well.

None of this will happen, of course, but as we shake our fists at the obfuscation and dishonesty of high finance, I can at least dream about a little honesty between politicians and the virtuous middle class.

Posted by oman at 11:10 AM | Comments (6) | TrackBack

I Can’t Believe I Sent it to the Whole Listserve

A recurring theme on the ever-fabulous AALS contracts list-serve involves pressing “reply to all” accidentally. The list is a fabulous resource, yet over the years it has seen its share of embarrassments (because it automatically replies to all when you hit reply, leading many to conclude that maybe that default rule should be changed, yet somehow it remains reply to all, despite the fact that everyone on the list is teaching contracts law and thus understands default rules and should realize that this is a penalty default, with too much information seemingly forced from us and onto the entire listserve, nonetheless we all have to live the consequences of this particularly onerous penalty default, including this horrible run-on sentence).

We all have experiences with the accidental reply, and I can speak about this personally. That law firm associate who accidentally hit “reply all” when responding to the inquiry about workload? That would be me, informing everyone at the law firm that I indeed was satisfied with my current work assignments (hey, it could have been worse). But sometimes it seems that people “reply all” strategically. They *want* everyone to know something good that they did. So someone sends an email out to an entire list, making public their donation to the homeless shelter. Other times, someone wants to embarrass the person who sent an email by picking apart some mistake in the original email. It’s framed as a private reply, of course, but it goes to everyone. Of course the author, if asked, will try to play it off as a mistake. “Ooops, sorry, didn’t mean for that to go the whole list.” Sure, sure, we believe you…

What’s the best / worst example of “reply y’alling” that ya’ll can think of?

[cross-posted at ContractsProf]

Posted by Miriam_Cherry at 04:08 PM | Comments (8) | TrackBack

Exposing Your Inner Socialist

You've probably heard, or maybe even taken, the Implicit Association Test relating to racial bias. Now comes an IAT for policy, and specifically views on regulation and markets. I took the test, and was surprised to find that I'm not quite as pro-market as I thought. According to the test,

"Your IAT score is 0.24, which suggests a slight automatic preference for Regulations compared to Markets."

At least it wasn't a moderate preference! Anyway, this is an interesting test -- if well-designed, it would seem to be another way to excavate underlying policy preferences, roughly supporting the cultural cognition project's work. (A correlation between c.c. measures and IAT results would be neat.)

That said, I am a little unhappy with the specific measures the study uses. In particular, as you will see if you take the test, the proxies for regulation are exceedingly general - Congress, statutes, etc. -- and for markets sometimes more specific - stock exchange. There are a few salient problems. First, right now might be a bad time to use "stock exchange" in a test. Why not something more innocuous and wholesome: farmers' market; e-bay, etc.? Second, when people think about regulation, I don't think they think about Congress: they are much more specific. I made tons of errors on the test, because I had some difficulty associating the test's general measures with either markets or regulation. Or to put it another way, at no point could I just relax and hit the keys. I had to focus and concentrate the whole time.

(H/T: The Situationalist)

Posted by hoffman at 12:52 PM | Comments (3) | TrackBack

Statutory Poetry

Those who are subscribers to the AALS listserve will not be surprised to see another example of Sid Delong's (Seattle) razor-sharp wit, but it was still a surprising amount of fun to see him take on the topic of “statutory poetry” in a short essay appearing in the Journal of Legal Education.
I had no idea that anyone could find poetry in the Model Rules of Professional Responsibility, 1.17, comment 13, yet Sid apparently has:

This Rule applies ot the sale of a law practice by representatives of a deceased, disabled, or disappeared lawyer.

Sid comments: “[D]isappeared lawyer.’ What poignancy lies in that phrase! The image triggers a flood of allusion: Judge Crater, the Chesire cat. And consider the prosodic significance of the alliterative series ‘deceased, disabled, or disappeared.’ One cannot help but wonder what additional alternatives the poet considered and rejected: dissipated, diseased, demented, despondent, depressed, degenerate, dejected, defunct.”
In the rest of the essay Sid has fun with the UCC and the bankruptcy code, noting that some of his poetry analysis “confirms what many have long suspected: Revised Article 9 was drafted not by human beings at all, but by non-English speaking robots[.]” The whole Essay is highly recommended (apparently not online except for the table of contents, but free in a faculty mailbox near you) especially if you are feeling in a mood that is either curmudgeonly or poetic (or both).

[cross-posted at ContractsProf]

Posted by Miriam_Cherry at 04:49 AM | Comments (0) | TrackBack

Law Talk: Judith Maute on Contracts, Scholarship, and Movie Making

It's been a while since I have been able to put together a Law Talk episode, but I still hope to keep this podcast going with two new episodes. The first new episode is simply a collection of the Battlestar Galactica interviews conducted by Dan, Dave, and Deven a couple of months ago. Enjoy all you affianados of law and science fiction!

My second new episode is an interview with Professor Judith Maute of the University of Oklahoma. As far as I know, Professor Maute has the distinction of being the only law professor who has ever had one of her law review articles turned into a movie. In this case, the movie is the recently released documentary "The Ballad of Willie and Lucille," which looks at the iconic contracts case of Peevyhouse v. Garland Coal & Mining Co. The film was recently given the "Chris Award" by the Columbus Film Fesitival, and in our interview Professor Maute talks about teaching, historical research, movie making, judicial bribery, and the importance of a lawyer's appreciation for facts. Enjoy!

You can subscribe to "Law Talk" using iTunes or Feedburner. You can also visit the "Law Talk" page at the iTunes store. For previous episodes of Law Talk at Co-Op click here.

Posted by oman at 04:48 PM | Comments (0) | TrackBack

Can Financial Innovation Save us From Financial Innovation?

Robert Shiller of "Irrational Exuberance" fame is coming in for some well-deserved kudos for calling the housing bubble a bubble back when it was still a bubble. If you haven't heard it yet, I strongly suggest listening to the most recent episode of the EconTalk podcast where Russ Roberts interviews Shiller about the mortgage crisis. I was surprised to hear Schiller talk about solutions to the subprime mortgage problem, particularly in light of how I've seen Shiller cited as an authority by the financial-innovation-is-a-scam-for-the-benefit-of-Wall-Street variety pundit.

At least on the EconTalk podcast, Shiller was frankly willing to admit the virtues of subprime lending and refused to excoriate asset securitization. Indeed, he was celebratory about the benefits of bundling and selling mortgages. Rather, he advocated what he called a continuous work-out mortgage in which the payments are tied to the index of housing prices. (The creation of such a reliable index is actually a fairly recent phenomena and one for which Shiller deserves credit.) The effect of such a mortgage loan would be to shift much of the risk of shifting home prices from borrowers to lenders. It seems to me that the predictable result of such a move would be to increase interest rates and price a lot of folks out of the home market. Perhaps this is not such a bad idea if we think that housing bubbles represent some sort of recurrent economic risk requiring a systemic response.

This, however, is not what Shiller seems to want. Rather, he suggested that salvation lies in a thick housing futures market, something that does not currently exist. The creation of such a market would allow lenders to hedge against the risk that Shiller's continuous work-out mortgage would assign to them. In the happy version of the story, the buyers get a house and the lenders get paid and all of the risk of asset prices is diversified away into global capital markets. Of course, Shiller's proposed future market in housing is not a straight-out credit derivative like the credit-default swaps that brought down AIG (or at anyrate that brought in the feds), but they are awfully close. Rather than betting against borrower default one would be betting against a shift in asset prices that would effect the value of the payment stream from a borrower.

I've no idea if Shiller is right or not, but I did find it striking that in the midst of the excoriation of derivatives, the prophet of many a market basher sees financial innovation as the solution rather than the problem.

Posted by oman at 08:25 PM | Comments (2) | TrackBack

The Loophole that Became a Wormhole: Why the Fed Had to Bail out AIG

Many explanations have been offered for the "why" of the Fed found it necessary to bail-out AIG, mostly centering around uncertainty and risk. It's not exactly that AIG was "too big to fail," but rather that no one could say, with any certainty, that its failure wouldn't lead to a real market crash of enormous scope. That is, AIG is a good example of the precautionary principle in action. Maybe so. But I still am a little unclear why AIG is so exceptional in that regard.

Back in the Spring, when Bear failed, I asked my colleague Jonathan Lipson to offer a set of observations about Bear's bailout. (Check out also Ribstein's response to Lipson here.) Based on a recent correspondence with him about AIG, I thought it would make sense to share with you his unique & very interesting perspective on the problem.

Why did the Fed bail out AIG but not Lehman?

The conventional answer—which is true but incomplete—is that AIG was too big to fail. But that begs two questions: Too big how? And why?

In part, AIG was too big to fail because it could owe an astronomical amount—allegedly about $300 BN—on credit default swaps issued to support mortgage-backed securities.

The problem, however, is not just the amount AIG owes, but the fact that these obligations are not like other obligations. They occupy a series of loopholes that make them unusually dangerous. Perhaps the greatest loophole of all came in the 2005 amendments to the Bankruptcy Code. Although designed ostensibly to “get tough” on profligate debtors, those amendments also made certain that CDS holders would get special treatment in bankruptcy—special treatment that may have made the Fed bailout inevitable.

Credit Default Swaps and AIG

Credit default swaps (CDS) function much like insurance on another party’s debt. So, for example, investors that purchased a mortgage-backed security issued by, say, Lehman Brothers may also have purchased a credit default swap issued by AIG that would pay if Lehman defaulted on its bonds (e.g., by going into bankruptcy).

Credit default swaps are essentially unregulated insurance contracts. Not technically securities, they do not have to be registered with the SEC. Not technically insurance, their issuance by AIG was not overseen by state regulators.

Among other things, this meant that AIG was apparently not required to disclose the full extent of its liability, or to hold reserves against these contingent liabilities, as they would for the life insurance policies their (currently) healthy subsidiaries write. So, when the rating agencies threatened to downgrade AIG, it is not surprising that the counterparties to these contracts would have required AIG to pony up more collateral.

This, AIG could not do.

Thus, a liquidity crisis.

Chapter 11

Ordinarily, when an ostensibly healthy company (e.g., AIG) faces a liquidity crisis, it seeks protection under chapter 11 of the U.S. Bankruptcy Code. In chapter 11, the company benefits from, among other things, a temporary stay of collection actions, the exclusive opportunity to propose a reorganization plan, and the power to discharge debts.

So, if AIG merely had $300 BN in bonds that it could not pay because it found itself in a cash crunch, bankruptcy might be a sensible strategy. Bondholder collection actions would halt, and the company would be able to catch its breath and right the listing ship, or at least sell its parts for more than scrap value. Imagine Lehman Brothers, but to a higher order of magnitude.

Credit Default Swaps in Bankruptcy

That logic fails in the strange world of credit default swaps. Swaps are not like other debts. The 2005 amendments to the Bankruptcy Code were the culmination of a series of amendments which began in the 1980s, and which assure that CDS will essentially be untouched by the bankruptcy of any party to the swap.
Most important, the bankruptcy stay will not halt collection efforts by swap counterparties. Unlike other creditors, CDS counterparties may “net” their “positions”—claims—against the company. This simply means that if you were lucky enough to hold a swap issued by AIG, you would be able to enforce it even if AIG went into bankruptcy. If you were a bondholder, you wouldn’t.

For AIG, this presented a serious problem, because it meant bankruptcy could not realistically protect the company. Given the way the Bankruptcy Code treats CDS, an AIG bankruptcy would (likely) create a cascade of defaults, with all of AIG’s counterparties “running” the company to collect. Because the bankruptcy stay would not protect AIG, the CDS counterparties would simply be able to take their collateral and leave. With private lenders unwilling to lend, and bankruptcy off the table, this left only a Fed bailout as a viable alternative.

Is AIG a Disguised Lehman Bailout After All?

Last March, I put up some paranoid posts about the Fed’s bailout of Bear Stearns. I argued that chapter 11 of the Bankruptcy Code could solve problems like those presented by Bear’s failure.

I was suspicious of the motives to keep Bear out of bankruptcy. Who was being protected? The executives? The hedge fund managers? The folks on Wall Street and the Fed, however, believed that a Bear bankruptcy would have catastrophic results. It, too, was too big to fail.

The Fed’s resistance to a Lehman bailout was thus curious. Wouldn’t a Lehman bankruptcy be even more catastrophic than a Bear bankruptcy?

So far, the answer would seem to be: No. The stock market rose the day after Lehman’s bankruptcy. If the reaction to Lehman is any indication (and of course it may not be), in hindsight, a Bear bankruptcy may not have been so bad either.

Not so for AIG. After the AIG bailout was announced, the market plunged.

Why? One possibility is that the AIG bailout really isa disguised Lehman bailout. If Lehman’s bondholders purchased, say, $85 BN of AIG-issued CDS insuring against a Lehman bankruptcy, perhaps they are the ultimate beneficiaries of the Fed’s largesse. Perhaps no one cared when Lehman itself filed because insiders knew (or hoped) that the real money was coming from AIG. Then the only question was: Where would AIG get it?
This is rank speculation, of course. We may never know the relationship between the AIG bailout and the Lehman bankruptcy because—being unregulated—the general public has no idea who issues or holds CDS, in what amounts, or against whom.

The Real Problems—Selective Socialism and Deregulation

Ultimately, there are two problems here, one of regulation, the other of policy.

The regulatory problem is that once the Fed bailed out Bear, it created a new grade (tranche?) of moral hazard. Why wouldn’t every anxious Wall Street executive plead for a meeting with the Fed? If they did it for Bear, they might do it for Merrill, or Lehman, or Wachovia, or WaMu, or AIG.

But this was the worst of all possible regulatory strategies (and I use that word generously), because it is opaque, unpredictable and unfair. It’s selective socialism. It gave Wall Street nothing but an incentive to keep begging rather than doing the hard work of deleveraging.

If Bear had gone into bankruptcy, it may have caused some pain. But perhaps that pain would have prevented the much larger pain we see today. Bailing out Bear may simply have forestalled the day of reckoning.
Which, by the way, may still have yet to come.

The policy problem involves the choice in the 1970s to embark on a massive program to deregulate many industries. It is difficult to point to many success stories here. With the possible exception of certain telecom sectors (i.e., cell phones), few of the promised benefits of deregulation materialized. Electricity is more expensive, cable television is (generally) pretty lame, and transportation hasn’t exactly improved. And, while lightened regulation has been good for executives and hedge fund managers, average investors aren’t doing nearly so well. And they’re likely to do a lot worse in the near term.

The CDS Loophole: The Wormhole Cometh

The story of the CDS exemption under the Bankruptcy Code is part of this deregulatory story, which has seen Bankruptcy Code loopholes for all sorts of special interests. Swaps are not the only specialized financial contracts that are immune from bankruptcy. Among others, repurchase agreements and commodity contracts also get special treatment.

The difference is that those are generally regulated in other ways, whether by federal securities laws, by the Commodities Futures Trading Commission, under Federal Reserve Bank regulation, or state securities or insurance law. The decision to exempt those contracts from bankruptcy may not be ideal policy, but may also not be so harmful because those contracts get some regulatory reality check at some point. Not so for credit default swaps.

No one stops to think about the role that obscure and technical amendments to the Bankruptcy Code play in larger debates about regulatory policy. But here, the decision to exempt swaps from the ordinary operation of the Bankruptcy Code may have been the greatest deregulatory mistake of all. It may have helped AIG to become too big to fail in any way short of a massive Fed bailout. It may be the loophole that became a wormhole, sucking all value out of the financial space-time continuum.

Posted by hoffman at 09:48 AM | Comments (3) | TrackBack

On the Uses of Greed and the Current Finacial Mess

How useful is it to think about our reactions to the current financial meltdown in terms of greed? It seems to me that there are two questions here. The first is positive. To what extent can I use greed as a concept to explain the current implosion in the markets?. The second is normative, namely to what extent does greed help us understand how to best deal with the crisis?

First to the positive question. Greed as an explanation posits that we are in this mess because the single-minded pursuit of profit by financial speculators, irregardless of its wider consequences has caused our problems. On this view, the problem is that we have been suffering some sort of a unique spiritual crisis that has come to a head at this moment with dire consequences. The question then becomes cultural. Why did we suddenly become greedy now in such a way as to create this problem?.

Frankly, I'm skeptical. Rather, it seems to me that what we are seeing is a classic bubble caused by sharply rising asset prices. Was the rise in prices fed by greed? No doubt in part, but a better candidate is, I think, the Fed's loose monetary policy. In effect, we had a huge, government-sponsored intervention in the price mechanism that resulted in a massive misallocation of resources. Now that misallocation is getting unwound. Indeed, if the speculators were greedy, they were also stupid and many who were greediest -- those who leveraged themselves the most and for the longest periods -- are now the one's most likely to lose their shirts. My point here is not that investors, brokers, and other players in the financial markets are all saints. There is more than enough greed to go around, I'm sure. Rather, my point is that I think that there are other causal factors that are more important.

What about in terms of our possible regulatory responses? Is greed a useful concept here? Again, I am skeptical. One response would be to somehow make people less greedy. Frankly, I am not sure how public policy can be usefully deployed to work such a spiritual regeneration. Alternatively, we could pass laws to prohibit or punish greedy behavior. This only makes sense, however, if greed turns out to be a major causal factor in the meltdown.

Consider, for example, the problem of no-doc loans, which probably contributed to the subprime mess. This seems a pretty clear example of greed to me. You have mortgage brokers paid on commission who were writing loans on an the basis of insufficient information in order to make fees off of the sale of the loan. Likewise, you had borrowers who got easy money -- at least until the ARM kicked in -- by in effect lying about their employment and income, lying that was facilitated by the broker. Lots of greed to go around. The financial problem with the no doc loans, however, was not that they were conceived in the original sin of avarice. Rather, the problem was that there was insufficient monitoring of the levels of risk associated with the loan. What we have is a failure of information. To be sure that failure was caused by a set of practices and misaligned incentives that encouraged the greedy to behave in deceptive ways. Yet it seems to me that it was this set of misaligned incentives -- coupled with the asset bubble -- that is the cause of the problem. The solution is to realign the incentives and avoid creating asset bubbles through unwise monetary policy. Notice, however, that greed doesn't have much to say one way or another about the policy solutions. We can have lots of debates about how to best align incentives or structure monetary policy to be sure. These are thorny and difficult questions about which reasonable people will disagree. On the other hand, moral outrage about greed will be of limited analytic usefulness.

Don't get me wrong. I actually like denunciations of greed. I think that sermons on the subject are good for the soul. I've taught Sunday school classes in which I exhort kids to learn how to live within their means and make sure that the pursuit of wealth is never at the center of their lives. A life structured around greed is ultimately an impoverished one. On the other hand, as natural and justifiable as our revulsion to greed is, I'm skeptical of how useful it is when thinking about systemic causes and solutions.

(Image source: Wikipedia)

Posted by oman at 01:08 PM | Comments (4) | TrackBack

I am Irving Fisher

"You are a perverse soul," my office-suite mate told me this morning after I expressed my glee at the fall of Lehman Brothers and the imminent death-by-merger of Merril Lynch. Perhaps, I am just Irving Fisher. Of course, my office-suite mate and I have differing time horizons. She is not that far from retirement and is in that stage of life where every twitch, hiccup, and nose-dive of the market ripples through one's 401(k). I'm decades from cashing out my retirement savings, and I have to confess that the fall of a major financial institution puts me in a down right jaunty mood.

Sure, the markets already have lost 3%, but what makes me happy is the news that Lehman Brothers threw itself at the knees of the Fed and the Treasury Department over the week end, and Berneke and Paulson looked on in stoney indifference. At last, it would seem, capitalism is going to do what capitalism is supposed to do: Punish those who make bad investment choices. Hopefully, we are in for a bit of short term pain while markets find their bottom and the dead and dying are taken out behind the barn to be shot. On the other hand, once the carnage is over those with money to loan, invest, and spend -- and there are lots of them -- will come out from hiding in their bunkers with the knowledge that we've unwound the risk, and a market that has learned something about the valuation of credit derivatives can move forward. To be sure, the landscape will be utterly changed, but that had to happen any way. Better this way than through a long, slow, expensive process of bailing out the super-rich. This is bad for the financial markets and the real economy may take a hit as well. It is good, however, I think for the long-term political health of capitalism.

I am also frankly skeptical about the notion that we are facing a crisis that will call for New Deal-esque responses. Just a quick reality check: When the New Deal was being put together we had near 25 percent unemployment, roughly 50 percent of all home-mortgages in default, and the GNP contracted by over 13 percent in a single year. This simply IS NOT the second coming of the Great Depression. This is an enormous financial crisis, but one that -- as Dave notes in the Greenspan quote in his post -- has been having less than catastrophic effects on the economy. It is a big nasty problem, to be sure, but I do not think that it is an apocalypse. Gordon is right, however, that the big question is going to be what will be the regulatory response. This is undoubtedly a bigger event economically than Enron, and the regulatory response to that problem does not give me a great deal of confidence going forward. What I fear is less the markets, than what Congress is likely to do in response. It is the sort of thing that we might want to ask our Presidential hopefuls about, although the chances of a productive discussion on this between now and election day are ... low.

Posted by oman at 10:25 AM | Comments (5) | TrackBack

Invasion of the Credit Cards

It is pretty easy to find dire statistics about credit cards in America. Frankly, the financial puritan in me likes it when I see another news story denouncing over-leveraged American consumers and the sad erosion of thrift and delayed gratification. Bring on the jeremiads! On the other hand, I realize that there is an important sense in which these statistics are misleading.

This week in my Article 9 class we went over the rules governing security interests in consumer purchases. The interesting thing about this material is that the standard hypothetical -- I buy a refrigerator on credit from the department store -- is an anachronism. Today, if I am going to finance the purchase of a big-ticket consumer good, I don't get a loan from the J.C.Penny finance department. I charge it. Indeed, even if Target or Home Depot wants to finance my purchase I don't go to the lending office at the back of the store. I get a Target credit card. Of course, some of these charge cards -- I am told -- claim a security interest in the goods purchased with them. On the other hand, I suspect that the Walker-Thomas days of a retailer who repos the cross-collateralized big stereo sets are as obsolete as, well, big stereo sets. In other words, we now have more credit card debt in part because credit cards have replaced virtually all other forms of consumer finance.

This, of course, makes economic sense as well. The biggest benefit of secured credit does not come from the reduction of risk. Miller and Modigliani long ago taught us to be skeptical of this story. The unsecured creditors ought adjust their interest rates to accommodate the risk created by secured creditors and the over all effect on the cost of capital will be a wash. Of course, this is far from entirely true -- there are non-adjusting creditors like tort victims and trade creditors. On the other hand, I'm skeptical that secured credit exists mainly as a vehicle for lowering financing costs through increases in risky behavior.

Rather, the story on secured credit is that it reduces monitoring costs by providing a legal technology that reduces the need for creditors to constantly watch their debtors' every move. Credit cards are also based on monitoring technology, but in their case the technology is . . . well . . . technology, in particular, computers, low-cost credit reporting, and the law of large numbers. In other words, the information technology of credit cards is a substitution for the legal technology of secured credit, and on many fronts it seems that legal technology is losing the race. Hence -- at least in part -- the rise in credit card debt.

It would seem, however, that credit cards may be moving in to replace not only the old consumer finance departments, but now ordinary commercial lending as well. According to the NYT:

Just as the slowing economy has made access to cash a higher priority for a lot of small businesses, banks have become more reluctant to extend traditional lines of credit to those businesses, experts say. But banks have been offering “small business” credit cards.

Bank cards and lines of credit both offer money when it is needed, but there is a fundamental difference: lines of credit have low, fixed interest rates or slow-moving, variable ones, while interest rates on credit cards can jump unpredictably.

Hardly an encouraging trend, although I suspect that the unpredictability of credit cards can be overstated. To be sure, if you miss your payments regularlly the combination of changing interest rates, penalty fees, and the like gets very bewildering very fast. On the other hand, if you are a good credit risk that subprime-spooked banks just won't lend to, then credit cards may not be a horrible way of providing short term liquidity. Longer term credit card loans, however, get my inner puritan fired up.

Posted by oman at 11:08 AM | Comments (0) | TrackBack

Soothsayer Law

According to the WashPo, St. Johnsbury, Vermont has decided to make the plunge and legalize soothsaying. It turns out that a number of jurisdictions still have anti-fortunetelling statutes on the books. Contemporary Pennsylvania law, for example states:

A person is guilty of a misdemeanor of the third degree if he pretends for gain or lucre, to tell fortunes or predict future events, by cards, tokens, the inspection of the head or hands of any person, or by the age of anyone, or by consulting the movements of the heavenly bodies, or in any other manner, or for gain or lucre, pretends to effect any purpose by spells, charms, necromancy, or incantation, or advises the taking or administering of what are commonly called love powders or potions, or prepares the same to be taken or administered, or publishes by card, circular, sign, newspaper or other means that he can predict future events, or for gain or lucre, pretends to enable anyone to get or to recover stolen property, or to tell where lost property is, or to stop bad luck, or to give good luck, or to put bad luck on a person or animal, or to stop or injure the business or health of a person or shorten his life, or to give success in business, enterprise, speculation, and games of chance, or to win the affection of a person, or to make one person marry another, or to induce a person to make or alter a will, or to tell where money or other property is hidden, or to tell where to dig for treasure, or to make a person to dispose of property in favor of another. (18 Pa.C.S.A. § 7104 )

The law apparently dates back to an 1861 state statute. A quick Westlaw search reveals reported cases dealing with anti-fortunetelling statues in California, Illinois, Maryland, New York, Washington, and other states.

Witchcraft and cursing, of course, were crimes at common law on the straight-forward theory that they were a method of harming others that ought to be suppressed. One may dispute the metaphysics behind this crime, but as a normative matter it seems simple enough. One might even object to love potions as a kind of officious intermeddling. The suppression of fortunetelling -- along with other forms of beneficent magic like peering in stones to find lost treasure -- however, rests on a more subtle calculation, some of it less than pretty.

From the reported cases that I glanced through, it seems that in the early twentieth century these laws were used mainly against Gypsies or immigrants of Eastern or Southern European extraction, suggesting a definite ethic bias at work. In the nineteenth century, the concern was with home grown American conjuring. Folk magic, of course, was an important part of life among the rural poor in the 19th century. Village rodsman and glass peepers would hire themselves out to find water, lost objects, or buried treasure. To local elites, of course, this stuff was the vilest -- and most embarrassing -- superstition, which had to be suppressed. In some cases the argument was fraud, although often the customers of local magicians were not the one's pressing charges. The real impetus was the suppression of superstition.

There is also a religious element here. I found a 1927 Pennsylvania case holding that faith healing and trafficking in biblical predictions did not come under the statutory definition of "fortune telling." In the early 19th century, however, there was little -- if any -- distinction among the rural poor between "magic" and "religion," Indeed, the category of magic was in large part the creation of (Protestant) anthropologists in the late 19th century who wished to distinguish respectable "religion" from mere "superstition."

So is there a case to be made for the prohibition of fortune telling in the modern world? One can certainly imagine cases of fraud, but it is also not unreasonable to simply impose a rule of caveat emptor on those that purchase magical services and leave it at that. There are also, it seems to me, potential first amendment concerns. I am not free speech expert, but it seems to me that the suppression of fortune telling necessarily involves a content-based speech restriction. Of course, this is commercial speech, but in at least some cases it is bound to be truthful, and even predictions that turn out to be mistaken need not be fraudulent. It is difficult to cast a horoscope properly and sometimes astrologers make innocent mistakes. There is also the free exercise claim. If fortune telling can be characterized as religion, then it seems to me that there is a very strong free exercise argument here. This is not a neutral or generally applicable law. The Pennsylvania, statute, for instance is aimed directly at fortune telling itself.

Needless to say, I await the cert petition.

(Image source: Wikicommons)

Posted by oman at 05:42 PM | Comments (4) | TrackBack

I Want a Court of My Own

At times I envy professors who get to teach courses with courts. It may seem an odd complaint from a law professor. After all, I teach contracts -- one of the last bastions of the more-or-less pure common law in our curriculum -- and commercial law, which while structured by the code has plenty of cases. Neither of these subjects, however, has its own court that one can track, gossip about, and teach from.

For example, those teaching federal subjects ultimately have the U.S. Supreme Court. This allows them to follow the development of precedent over time, introduce students to a more or less stable cast of judicial characters, and even provides them with "big" cases pending before the Court to talk about. Biz orgs profs get to play a similar game with the Delaware Chancery and Supreme Courts.

Contracts, by contrast, occurs everywhere and nowhere. It doesn't really make sense to track, say, the Virginia Supreme Court when teaching the subject. To be sure, we end up having a cast of judicial characters -- Holmes, Cardozo, Traynor, Posner, etc. -- but it is much harder to teach and study the subject against a single institutional background. (English contracts scholars are in some sense better off. They can just watch the House of Lords.) There is a real pedagogical advantage, I think, to a subject that operates within a unitary court system, or at least has a dominant court. It certainly makes it easier to illustrate how precedent shifts over time and from case to case.

Hence, odd as it sounds, I have court envy.

Posted by oman at 09:13 PM | Comments (2) | TrackBack

The Real Face of Shar'ia

Generally speaking, when Americans hear about shar'ia it conjures up images of bearded and turbaned Taliban executioners gleefully stoning women to death in an Afghan soccer stadium. It is an unfair stereotype of a great legal tradition, and it is also one that misses some of the most important issues that shar'ia raises for the modern world. As usual, if you want to find the real action follow the money.

In a nutshell, there is a lot of money sloshing around the Islamic world. 20 percent of the world's population is Muslim and at least part of the population sits atop oil fields that churn out an enormous amount of cash every day. What is an observant Muslim, one who cares about Islamic strictures against usury to do? Islamic law forbids the taking of interest, but certain transactional structures that allow some return in exchange for tying up capital are allowed. For example, a straight out purchase-money loan with interest secured by a mortgage on a the purchased house would violate Islamic injunctions against usury. On the other hand, if the bank buys the house, leases it to the resident for a period of years, followed by the resident's purchase of the house at the expiration of the lease for a nominal sum, it does not violate the injunction. The game in Islamic finance is to come up with ways of structuring transactions so as to generate an attractive rate of return for investors without running afoul of the strictures of shar'ia. The result has been a cottage industry of banks and lawyers experimenting with various transactional structures and then rushing to find a reputable Islamic legal scholar willing to issue a fatwah validating the deal for Muslim investors.

The Economist just put up a rather good briefing article detailing some of the growing pains that the industry is facing. At least part of this problem is legal. To give one example that interests me, UCC 9-109 states that the Article 9 governs "a transaction, regardless of form, that creates a security interest in personal property . . . by contract." The rule is aimed at precisely the kind of sale-and-lease-back transactions that are used in Islamic finance, a transactional gimmick that has also been tried as a way of avoiding the strictures of the UCC. The result of the rule, however, is that despite their best efforts parties may be forced, legally speaking, into an interest bearing loan. There is also the simple problem of complexity and the associated transaction costs. Still, according to the Economist:

None of these tensions need derail the growth of Islamic finance just yet. There is plenty of demand, whether from oil-rich investors, the faithful Muslim minorities in Western countries or the emerging middle classes in Muslim ones. There is lots of supply, in the form of infrastructure projects that need to be financed, Western borrowers looking for capital and ambitious rulers eager to set up their own Islamic-finance hubs. The industry is innovative; new products keep expanding the range of shar'ia-compliant instruments. And as in conventional finance, the economics of the Islamic kind improve as it gains scale.

If they are right, then Islamic finance is likely to be the real face of shar'ia in the modern world. In 2007, for example, over 150 new Sukuk (essentially a form shar'ia compliant bond) funds were launched with a value of nearly $50 billion. Given the less than inspiring ethical performance of certain aspects of the American lending market of late, a dose of financial puritanism from the desert might not be such a bad thing.

(Image source: Wikipedia)

Posted by oman at 10:11 AM | Comments (10) | TrackBack

Debtor Friendly Legislation and Unintended Consequences

The rate of home foreclosures in the current mortgage crisis has not been evenly distributed. Some states -- such as Nevada, California, and Florida -- have seen many more foreclosures than others, and not simply because some of them are big states. Take California, where in some localities the foreclosure rate has been as high as 25 percent. What gives here? Are California home buyers and mortgage brokers just much more irresponsible than the rest of the nation? Is there some California specific economic shock that accounts for this? I don't pretend to know the ultimate answers to these questions, but I think that at least part of the blame for California's high foreclosure rates needs to be laid at the feet of California's debtor friendly home mortgage law.

According to California Civil Code section 580b:

No deficiency judgment shall lie in any event after a sale of real property or an estate for years therein for failure of the purchaser to complete his or her contract of sale, or under a deed of trust or mortgage given to the vendor to secure payment of the balance of the purchase price of that real property or estate for years therein, or under a deed of trust or mortgage on a dwelling for not more than four families given to a lender to secure repayment of a loan which was in fact used to pay all or part of the purchase price of that dwelling occupied, entirely or in part, by the purchaser.

What this means is that virtually all purchase-money home mortgages in California are non-recourse. In other words, in the event of default the bank can foreclose on the house but cannot come after the debtor personally for repayment of any debts left unsatisfied by the foreclosure sale. The result is that if buyers are left underwater on a loan, owing more than the house is worth, they can walk away from the house without any debt.

Obviously, this means that mortgage lenders in California necessarily bear more of the downside risk for home price fluctuations, and they ought to lend accordingly, demanding larger equity cushions to limit their exposure. (The homeowner, of course, is still left with the upside if prices rise.) Hence, we needn't shed too many tears for the banks and secondary investors who lost money on the homeowners who left the keys on the kitchen counter and walked away. Likewise, the borrowers have gotten a pretty good deal in that they received large amounts of money that they will not have to repay. Rather the down side of this law, its seems to me, comes from the costs that it imposes on neighbors keep their homes.

A natural effect of the law will be to increase foreclosure rates at the margin. There is less incentives for homeowners to hunkerdown, hang on to their homes and hope for a brighter future. Easier to simply cut your losses and walk away from the house and any future risk associated with it. There is also less of an incentive for homeowners who are leaving to spruce up the house, maximize its value, and sell it themselves. It doesn't matter -- except perhaps to your future credit rating -- how far underwater you are on the loan because your personal liability once you leave the house will still be zero. The result will be lots of foreclosure sales in which lenders -- who are poorly positioned to transform themselves into real estate brokers -- sell off a lot of foreclosed homes for less than they would otherwise realize.

The problem is that the appraised value of a home hinges in large part on the comps. If all of the homes that have sold recently in your neighborhood had been selling cheap, you will have a hard time demanding more if you sell your house. Hence, all of the homeowners who remain on the street with three foreclosure sales take a hit because of those sales. In a neighborhood where the non-recourse law is helping to fuel foreclosure rates as high as 25 percent that can be a very big hit.

There is also the question of foreclosures' communal costs. I tend to think that foreclosure is providing homeowners with a very important signal, namely that they borrowed too much money and bought too much house. The best thing to do is to heed that signal and get yourself into housing that you can afford. On the other hand, there is real value in having communities with rooted residents, and that is something that home ownership at least potentially can provide. Hence, while I am against the notion that we always need to keep homeowners in their homes and keep the big bad banks from foreclosing, I don't think that we want a policy that affirmatively encourages foreclosure in the marginal case. Yet that is exactly what California and other non-recourse states are doing.

Posted by oman at 10:48 AM | Comments (10) | TrackBack

Some new papers on contracts (and their limits)...

A quick shout-out for two papers of interest to contracts geeks and their fellow travelers.

The first is from my one-time classmate Dan Schwartcz (University of Minnesota) entitled "The British Approach to Consumer Financial Disputes." Here's the abstract:

Much of insurance law and regulation is concerned with compensating consumers who have been wrongly denied coverage. But policyholders nonetheless have relatively few realistic options for challenging an insurer's adverse coverage determination. Litigation is often too slow and costly for those who have recently suffered significant financial loss. Meanwhile, the alternative dispute resolution options that do exist - such as the mediation services that insurance regulators offer or the existing variants of insurance arbitration - are generally either ineffective or unavailable for most disputes. This Article proposes a new way forward by looking to the United Kingdom's innovative Financial Ombudsman Service, which operates in parallel to the British regulatory agency and is devoted solely to resolving consumer financial disputes. It argues that the comparative success of the Financial Ombudsman Service is attributable primarily to the ways in which it blends elements of the individual, uncoordinated insurance ADR schemes that are used in America. As such, the Article concludes that American lawmakers can significantly improve insurance compensation by strategically rethinking the institutional architecture of insurance dispute resolution. It also sugges pts that the British Financial Ombudsman Service may offer a model for improving consumer dispute resolution in realms beyond insurance.

The paper is a good piece of comparative work, in effect showing how the Brits arrangement familiar ADR devices in some useful and unexpected scheme. The other piece by Jeff Lipshaw (Suffolk) is at the opposite end of theoretical spectrum, offering Jeff's response to Seana Shiffrin's foray along the fault lines of contract and promise. Here is his abstract for "Objectivity and Subjectivity in Contract Law: A Copernican Response to Professor Shiffrin":

This is a response to Seana Shiffrin's recent and important contribution to the continuing debate whether there is a universal moral or economic truth at the heart of contract law. Her most significant advance toward a general theory of promise and contract is not, however, her analysis of the divergence of morality and contract, but instead her identification of the critical moment at which the interposition of the public in a private matter occurs or is contemplated. This essay carries that theme forward, suggesting that a universal justification for contract law is not possible because the law, by its very nature, objectifies (publicly or with that implicit threat) what was heretofore a private relationship.

I always find Jeff's work on contract theory interesting, although unlike Jeff -- and most scholars of contract I might add -- I am less pessimistic about the prospects for explaining and justifying contract law, even if I don't contemplate anything so grand as a "universal justification for contract law."

Enjoy!

Posted by oman at 10:26 PM | Comments (0) | TrackBack

Prediction Markets and the Palin Pick

Palin is McCain's VP pick, but the inTrade markets seem to have been caught flat footed. Here is the graph of her contract's performance over the life of the speculation:

Notice that she never seems to have traded at above 20 and immediately before the announcement she was trading in the single digits. I've had an on-going discussion with some friends about the value of inTrade numbers, and the anti-inTrade voices have been crowing this afternoon that Palin's pick shows the bankruptcy of prediction markets. "I argue against putting too much weight on prediction markets," one friend said, "which I think are interesting but not of tremendous political value or somehow more predictive that good polling data."

So does this show that the inTrade is bunk and we ought to rely on expertise?

It's hard to say. I can think of a couple of different stories that one might tell here. First, you could -- as I think my friend does -- assume that inTrade numbers are driven by essentially uninformed speculators responding to momentary fluctuations in the flow of information from the 24-hour news cycle. Better to ignore the noise and go with thoughtful experts who base their analysis on reasoned elaboration. The failure of inTrade to pick Palin is just a case in point.

There, is however, another story that we could tell. "Prediction market" is actually a misnomer. inTrade is not a predictor but rather an aggrega