Contracts: Credit Cards, Mortgages and Chrysler

A recent piece I wrote on credit cards turned out to be rather controversial. To defend the regulation being imposed on credit card companies, some dissenters argued that the companies do not follow through with their contracts. They say "arbitrarily" changing terms, such as interest rates and fees means the original contract is not honored. This raises a question. Is strengthening contracts Congress' desired end when imposing financial regulation?

Before examining this question, I need to note that this argument regarding credit cards actually misses the mark. If credit card companies were violating contracts, then they could (and commonly would) be sued for doing so. The contracts and disclosures they provide to customers include language that allows them to make these changes. They've got dozens of lawyers who make certain of that. As a result, the argument would be better if it focused on getting those disclosures to be more transparent, which I wholeheartedly support, and which some leaving comments correctly pointed out.

But let's assume that Congress holds the same misconception, and that this, and other, regulation they are only beginning to impose on the financial industry is really about upholding contracts. Could this possibly be the case?

First of all, I think contracts are pretty important. I would even assert that the strength of a free-market economy is only as strong as its contracts. If courts and legislators fight to uphold contracts, then freedom of exchange can thrive. If not, then the economy will have a hard time flourishing, because businesses and individuals will be uncertain if their agreement will be upheld.

So if Washington's intent in additional financial regulation is to strengthen contracts, then I would be in strong support. Unfortunately, given a few of Washington's recent actions, I find this motive doubtful.

First, let's consider mortgages. The Obama administration's homeowner bailout can hardly be said to have strengthened contracts. Through the Treasury's plan, mortgage contracts of underwater homeowners are modified by banks so that they can more easily afford payments. This means the original mortgage contracts are being altered.

Some might argue that it is in the best interest of the banks/investors holding those mortgages to make these modifications, because they would lose more money by forcing the homeowners to foreclose. If both parties agree to change a contract, then that's perfectly acceptable.

This argument is pretty clearly flawed. If it were in the best interest of banks to modify these mortgages the way in which the government program demands, then they would not need the program to prompt them to do so. Banks having received bailout funds would also not need to be coerced to participate.

But even more striking is the so-called "cramdown" of mortgages that many in Washington are fighting for. This would allow bankruptcy judges to re-write mortgage contracts in whatever way necessary so that the troubled homeowner could afford them. There has never been as serious a suggestion by Washington in as long as I can remember that would deliver as fatal a blow to the sanctity of a contract as cramdowns. This measure has so far failed to gain traction in Congress, despite the Obama administration's support. But the battle continues.

Another striking example is the recent Chrysler bankruptcy. Megan blogged about this earlier in the month:

It's all very well to say that most of the senior lenders are going along, but of course, the leading senior lenders are doing this because the administration has them over a barrel.

And others have also pointed out that, rather than honor bankruptcy law regarding the contracts in place, the Obama administration strong-armed creditors to accept unfavorable terms so that the unions would have a verdict in their favor.

In both of these instances, it's easy to see that Washington cares far more about satisfying portions of their consistencies than contracts. That's why I become wary when I hear the power in Washington spewing rhetoric about financial regulation strengthening contracts. In reality, it only cares about contracts when convenient.

While some regulations, like clearer disclosure language may strengthen contracts, others may actually stifle the freedom to contract. That's why rhetoric should be ignored, and each regulation's effect on contracts should be carefully examined on a case-by-case basis.