The Home Mortgage Proposal and The Contract Clause

In May of 1987 I bought a condo in the ski area of New Hampshire for a determined amount. That fall the Stock Market crashed. The following summer, 1988, the condo was worth 25% less and the following year it was worth 40% less. I and my fellow borrowers never thought of getting a cram down on the mortgage. I waited seventeen years to sell the condo at almost the same price I paid when I bought it. If I sold it earlier I would loose money, and that was the risk of my venture into real estate, and in fact into any transaction in life.

The Constitution has a clause called the Contract Clause and it reads:

"Article I Section. 10. Clause 1: No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility."

In the infamous Blaisdell Case, HOME BLDG. & LOAN ASS'N V. BLAISDELL, 290 U.S. 398 (1934), which was the Roosevelt Court that abrogated the Contract Clause, the Chief Justice, Justice Hughes, states the words of Justice Marshall uttered more than a hundred years earlier:

"The occasion and general purpose of [290 U.S. 398, 428] the contract clause are summed up in the terse statement of Chief Justice Marshall in Ogden v. Saunders, 12 Wheat. 213, 354, 355: "The power of changing the relative situation of debtor and creditor, of interfering with contracts, a power which comes home to every man, touches the interest of all, and controls the conduct of every individual in those things which he supposes to be proper for his own exclusive management, had been used to such an excess by the state legislatures, as to break in upon the ordinary intercourse of society, and destroy all confidence between man and man. This mischief had become so great, so alarming, as not only to impair commercial intercourse, and threaten the existence of credit, but to sap the morals of the people, and destroy the sanctity of private faith. To guard against the continuance of the evil, was an object of deep interest with all the truly wise, as well as the virtuous, of this great community, and was one of the important benefits expected from a reform of the government.""

Justice Marshall knew very well that a persons word was their bond. Agreements mean something, words mean something, contracts mean something. If the Government comes in and abrogates an agreement that means something, it means that agreements may have no value. It is the beginning of the end of an economy. It stops trade. All one has to do is look at Genoa in the 7th century and see how the early letters of credit started the expansion of Mediterranean trade, slowed during the Muslim dominance, and then recaptured from Venice.

In the current Administration plan it recommends:

"Institute Clear and Consistent Guidelines for Loan Modifications: Treasury will develop uniform guidance for loan modifications across the mortgage industry, working closely with the bank agencies and building on the FDIC’s pioneering work. The Guidelines will be used for the Administration’s new foreclosure prevention plan. Moreover, all financial institutions receiving Financial Stability Plan financial assistance going forward will be required to implement loan modification plans consistent with Treasury Guidance. Fannie Mae and Freddie Mac will use these guidelines for loans that they own or guarantee, and the Administration will work with regulators and other federal and state agencies to implement these guidelines across the entire mortgage market. The agencies will seek to apply these guidelines when permissible and appropriate to all loans owned or guaranteed by the federal government, including those owned or guaranteed by Ginnie Mae, the Federal Housing Administration, Treasury, the Federal Reserve, the FDIC, Veterans’ Affairs and the Department of Agriculture."

The unintended consequences may very well be the total collapse of new credit. Why deal with any financial institution with a nexus to the United States if the terms of any loan can be summarily changed by the US Government.

The plan we suggested was quite different and one would have assumed more compliant with the Administration. It was the recreation of the Federal Home Loan Bank. To repeat:

1. Deal only with "qualified" borrowers. Let that definition be as with the current Administration proposal.

2. Pay off the existing mortgage with a 20-25% haircut. That most likely puts cash into the system, and eliminates risk. The latter is more important. The payout may be over some period of time and an interest consistent with Government bonds could apply. Thus it would cost the Government a large sum but it would be spread over a ten year period.

3. Issue new mortgages to the homeowners for the same face amount but for 40 years at 3%, for example. The Government could finance the payments to the original holders with these assets.

4. If the borrower sells the house at less than the face value of the loan after a minimal holding period, say three to four years, the Government eats the loss. If the house is sold for more than the loan value the Government gets 25% of the upside.

5. No Contract abrogation.

The main advantages of this proposal are:

1. Eliminates Bank balance sheet uncertainties.

2. Is financeable because of the Federal underwriting, in effect a swap like structure.

3. Avoids violating what little is left of the Contract clause thus maintaining the integrity of the markets.

4. May even be profitable!

Just a few thoughts for the day. The advantage of the new Administration is that it allows for new thoughts every day. That is an improvement in itself.