Why Constitutions MatterExamining the legal root of the financial crisis

RICHARD A. EPSTEINThe current financial meltdown has exposed the myth that our nation’s sophisticated, multilayeredscheme of government regulation immunizes us from systemic failure. We are realizing that shocks, fromboth home and abroad, will exact their toll. What is less commonly appreciated is that the very politicalinstitutions on which we depend count as a structural cause of much of our current distress. In manycases, the root of our problems lies in the legal restrictions that block the movement of prices and wagesin financial markets. It is just this sort of folly that has embroiled the Obama administration in testydisputes with bankers who are desperate to return their TARP money. These banks cannot afford to bleedtalent to foreign and start-up companies that operate (for the moment at least) free of Obama’s egalitariancompensation-control shackles.That said, at least some portion of the current malaise comes from a more prosaic source: We don’t honorthe straightforward moral imperative that promises must be kept. Our modern crisis has been brewingsince the Supreme Court started inexorably casting aside protection for property and contract in an effortto cope with economic tumults from Roosevelt’s 1930s through Reagan’s 1980s. On this score, ourflawed constitutional framework suffers from two related mistakes, both of which are endorsed byacclamation today. The first is the notion that the government may be permitted to disrupt financialtransactions between private parties in ways that frustrate the unambiguous expectations of the parties.The second is the idea that the government need not honor its own promises in dealing with privateindividuals.These two propositions are stated at a level of abstraction that is likely to draw yawns of indifferencefrom anxious policy wonks who fixate on the latest twists in the fortunes of AIG or Citibank. But thesedramatic financial struggles play out against a background of weak contract and property rights — asystem that drives political operatives into high gear in times of economic stress.The legal stability of private agreements offers one powerful bulwark against these mischievousgovernment activities. Once people know that courts will enforce their agreements as made, they have noincentive to beg for government favors to improve their contractual positions. One avenue of politicalintrigue is closed down. The stabilization of contractual arrangements will not of itself stop all politicalhijinks, but it will go a long way toward incentivizing firms to focus on creating wealth, or onrenegotiating their existing agreements that have turned bad. These business workouts are not sterile.They increase the total wealth of the parties, and they create additional business opportunities forstrangers to the basic deal. As the circle of contracts expands, so does the economy. One good idea,applied numerous times, generates tremendous benefits.The same logic applies to deals between government entities and ordinary citizens. The principle of rational expectations still holds. Any government can euchre its citizens once. But if everyone knows itcan renege on its commitments at will, it can’t pull the same stunt twice. People will steer clear of doingfurther business with government, which then loses one key tool — voluntary agreement — that it

desperately needs to address today’s plethora of economic ills. Everyone stands back, leaving coercion,not cooperation, as the dominant form of government action.In the modern era, state interference with private contracts began, most tellingly, with mortgageforeclosures during the Great Depression. In Home Building & Loan Association v. Blaisdell (1934), theU.S. Supreme Court had to decide whether Minnesota law could delay a bank’s foreclosure of real estatesubject to unpaid mortgages. The answer was Solomonic, but wrong: Minnesota could not kill thelender’s right, but it could alter the lender’s remedy; the change had to be reasonable, but what wasreasonable was to be decided by the state on a case-by-case basis, with the legislature acting “primarily”as the judge.Demographically, we should expect the debtor interests to have prevailed in those early legislative tussles.It is a brute fact that a smallish number of banks made loans to a large number of local businesses andresidents. When large groups of debtors exerted pressure, state legislatures responded with mortgagemoratoria. Postponing debt collection in turn put pressure on banks as borrowers from their owndepositors, which eventually led to a nationwide collapse of the banking system. The world would havebeen a very different place if the state had been forced to pay from public funds to forestall mortgageforeclosure — a prospect that would have generated far less political support. Then the cost of itsforgiveness would have fallen on the public balance sheet, and voters would in all likelihood havedecided the price was too steep.I am no fan of this system of public relief, because it lets some citizens impose obligations on others; butits shortcomings are small compared with those of a system of state-mandated loan forgiveness. The latteris a form of “off-balance-sheet financing” that lies under the social radar, since it is so hard to monetizethese contract modifications in ways that make clear their costs. Worse, these modifications ignore theimpact of the delay in payment on the bank’s position. Then, as now, banks often accepted demanddeposits or short-term notes. Once the mortgage payments are postponed, bank failures become morelikely as antsy depositors clamor to withdraw funds in a flight to safety. The short-term fix for borrowersopens up a gaping hole for the lending banks, who themselves have borrowed. The Depression bank failures and the Roosevelt bank holidays were the inexorable consequence of this credit squeeze.Today, the power over mortgages has passed from the states to the federal government — but the oldhabit still exerts a powerful influence. The Obama administration is keen on postponing the collection of loans, by ordering workouts that block foreclosure and extend the life of the mortgage. The rulesinfluence not only those who are already in default, but those who are behind in their payments or whomay choose to default. The shakiness of home mortgages spread rapidly throughout the system as theinitial loans were sliced and diced. As repackaged, these loans worked their way through the system, sothat other financial institutions came under stress, including our two government bankers, Fannie Mae andFreddie Mac.The numbers are impressive. Over 2.3 million homes went into foreclosure in 2008, and the first twomonths of this year racked up over 500,000 additional ones. Most critically, the current dislocations don’tcome solely from the properties in foreclosure. They also come from the perceived increased riskiness of homes not in foreclosure. This forces a downward revaluation of all the securitized packages now on themarket, which in turn imposes enormous pressure on banks and other entities to liquidate their holdings tomeet their various regulatory and contract requirements.

We can’t, moreover, dig our way out of this hole by following the 1930s policy of repayment delay. Thesecuritized packages have to take those losses into account today. And their valuations will reflect thegrisly fact that today’s distressed borrower is likely to fail tomorrow, when the property is worth evenless. Remember: Many defaults come from borrowers who paid little or nothing down on their mortgages,and who did little to build up their equity in the property before defaulting. To act as though these recentbuyers were landowners with an indissoluble bond with the soil is to glorify their status without warrant.In contrast, many debtors back in the Depression had made large down payments, only to be savagedfinancially by the steep deflation that forced them to default when they were unable to repay their debtswith more expensive dollars than they had borrowed. Fortunately, Fed chairman Ben Bernanke has notrepeated the mistake of the 1930s, when government tolerated a massive contraction of the money supplythat deflated the currency, implicitly increasing the real amounts of all debts, and thus driving borrowersinto unnecessarily deep holes that only a reinflation of the currency could have cured.Today’s constant efforts to rig mortgage markets frequently have a different unpleasant consequence:They tax prudent borrowers in the hopeless quest to stave off financial ruin for the imprudent, who arelikely to default a second time down the road, when the underlying real estate is worth even less. It isbetter to get the process over with quickly and have the original owner return to the rental market, whileletting new buyers purchase the property out of foreclosure at low prices, with clean title and littlefanfare. This trend is starting, and we need to do everything we can to accelerate it. Unfortunately, thecurrent willingness to meddle with mortgages blocks that cleansing process in a second way. There is ahuge glut of houses on the market that were placed there by people who want to sell before they gounderwater. We thus face this genuine paradox: Lenders are eager to lend, and there seems to be an ampleamount of cash at low rates; there are often competent buyers waiting for these houses; yet the buyerssimply cannot arrange financing.Why do we have, simultaneously, falling prices and a small number of sales? Much of the price fall canbe explained as a contraction of the bubble; the market has yet to reach a new equilibrium. And doubtlessmuch of the hesitation is in response to the current uneasy economic climate, which is in part attributableto the risks of higher taxes and new regulatory schemes. That said, one part of the mix is the continueduneasiness over the risks of further interference in mortgage markets down the road. Investors and banksknow that the government has disrupted private transactions to the detriment of creditors once, and fearthat it will do so again.Of course, Congress could swear on a stack of seven Bibles that it would never behave as it did the lasttime around. But who will believe them now that the state’s power is construed so broadly as to allow thegovernment to reshape lending markets in whatever fashion it sees fit? The situation infects not only theresidential-home market, but larger transactions to build office complexes and apartment houses. Thefancy footwork of debtor relief may help some borrowers, but it won’t encourage wary lenders to returnto the market if they lack confidence in our current institutional arrangements. David Hume alwaysstressed the “security of possession” in dealing with property arrangements. Our cavalier attitude towardprivate transactions has already done enough mischief to prove that he was right.A parallel story explains the decline in confidence in contracts that government makes with privateindividuals. Of all contracting parties, government has the obligations that should be the most secure —because states do not have financial constraints that block them from discharging their contracts. But the