George Cohen on the Financial Meltdown and the 'Forgotten' Law of Contracts

Courts could do more through contract law to help Americans facing mortgage foreclosures, University of Virginia law professor and contracts expert George Cohen says in a new paper.

Cohen recently discussed his paper, "The Financial Crisis and the Forgotten Law of Contracts," with the Law School.

What is your paper's central argument?

Contract law has a number of doctrines that courts could use to provide relief to homeowners burdened by underwater mortgages and threatened with foreclosure. Using these doctrines, courts could impose efficient modifications — that is, modifications involving principal reduction that make both homeowners and investors in mortgage-backed securities better off, but are not happening now in sufficient numbers. This result would be consistent with the economic approach to contract law, which argues for putting unanticipated risks on the party better able to control them.

How did you become interested in this topic?

In the spring of 2008, I did consulting work for a hedge fund that invests in mortgage-backed securities. I learned a great deal about what was happening in the financial markets just as the crisis was starting to hit. Because of my background in contract law, I was very interested in how the various contracts were structured and interpreted.

Late in 2008 and early in 2009, I was involved in an effort to draft legislation proposed by my friend and colleague, Susan Koniak of Boston University, and John Geanakoplos, an economics professor at Yale. The basic idea of the proposed legislation was to remove the modification decisions in securitized mortgages from the hands of conflicted mortgage servicers and place those decisions in the hands of community-based, government-appointed trustees, recruited from the banking industry, who would be "blind" to information about securitization pools. Instead these trustees would make decisions about whether modifications, including writing down principal, would bring in more money than foreclosure. The idea was to recreate the traditional mortgage relationship between homeowner and community banker without having the modification decision distorted by securitization. We were optimistic about the proposed legislation because this was the time that President Obama was about to be inaugurated and we thought there would be an openness to creative ideas for dealing with the financial crisis.

Although the proposal found some sympathetic ears, it ran up against substantial objections from Obama's advisers. One of the main concerns expressed was that our proposed legislation unlawfully interfered with existing contracts. I found those arguments unconvincing, because I viewed the proposal as supporting contract rights, not abrogating them. That led me to start thinking about how contract law would apply to mortgages in light of the financial crisis. Unfortunately, President Obama and his advisers opted for a much less ambitious approach to modifying mortgages and addressing the rising foreclosure mess, which turned out to be ineffective. We're still living with the consequences of those decisions today.

You suggest that lawyers and courts could use contract law to address the high number of residential foreclosures and underwater mortgages, which continue to weigh down the economy. Can you elaborate?

One example I discuss in the paper is the law of assignment. The securitization process begins with the assignment of mortgages into a securitization pool. Although there has been a lot of discussion about procedural defects with these assignments, less attention has been paid to the rules of assignability. Contracts are generally assignable, so long as there is no extra burden or risk imposed on the person whose contract rights are assigned. In a traditional mortgage, assignment does not increase the risk for the homeowner because it does not matter to whom the homeowner writes the monthly check. Securitizations did, however, increase risks to the homeowners by making efficient modifications much more difficult to achieve. In my view, that violation of assignment law opens the door to court modification of the contracts. Similarly, the law of contract modifications and restraint of trade can be interpreted to allow courts to refuse to enforce unreasonable restrictions on contract modifications, such as those imposed in securitization contracts.

I also argue that the excuse doctrines of mistake, impracticability and unconscionability could be interpreted to support court-imposed efficient modifications under the circumstances of the financial crisis. The main point here is that the financial crisis was no accident, but resulted from deliberate actions by the financial industry that exacerbated risk. Contract law supports putting the responsibility for unanticipated risks on the party better able to foresee, control, diversify and protect against these risks. In the current circumstances, the financial industry is, in my view, the superior risk bearer.

Why do you think contract law has not really been a part of conversations about the financial crisis, even though, as you point out, failed contracts were at the center of the meltdown?

Given the scope of the crisis, the focus has naturally been on legislative solutions. I have been surprised, however, that there has been so little discussion of contract law. As far as I can tell, the reason seems to be that many lay people, as well as lawyers, judges and academics, take a very strict view of contracts. A deal is a deal, according to this view. Otherwise, we undermine contractual certainty and economic stability. Even when I presented my paper at a workshop here, a number of my contract law colleagues found many of the arguments far-fetched. Although many courts do interpret contracts strictly, especially those between sophisticated parties, contract law has always contained escape hatches for unusual and extraordinary circumstances.

My point is that we should not forget this other side of contract law, and that the current crisis is exactly the kind of situation that these escape hatches are meant to address. Contract law as I view it can enhance economic stability by countering and deterring the destabilizing tendencies of the financial industry.

What practical outcome would you like to see occur with regards to your arguments about contract law and the financial crisis?

I don't harbor any illusions that lawyers and courts are going to read my paper and rush en masse to make or adopt the arguments I suggest. But if a few bold lawyers made some of these arguments and a few bold courts accepted them, or even if a few academics started debating them, that could change the political conversation and open up possibilities that are not now being considered, including legislative possibilities.

Do you believe the legislative response to the financial crisis has been sufficient? If not, what legislative changes would you advocate?

I believe the legislative response to the foreclosure mess has been woefully inadequate. Many individuals and communities are suffering, not to mention our national economy, yet we seem to lack the political will to take necessary action. At the very least, we should not be giving the financial industry immunity from liability of the kind I'm advocating, immunity the industry is apparently pushing for in the ongoing negotiations with state attorneys general. The legislative action we need is a program to require financial institutions to write down principal to reduce the number of underwater mortgages. Once people have equity in their homes, they tend to make every possible effort to pay, and costly foreclosures tend to be averted. There are a variety of ways this goal could be achieved, but modifications that reduce principal should be the key objective.

What will you be researching next?

I am currently reading David Graeber's book, "Debt: The First 5000 Years," which I find fascinating. Graeber is an anthropologist who takes many accepted economic ideas about debt and completely upends them. Although Graeber does not focus so much on law, I think his insights have a lot of relevance to contemporary debates about contract law. I am interested in exploring these implications.

Faculty Q&A Archive