The new foreclosure crisis reveals the shocking unfairness in how the law treats struggling homeowners.

Commentaries on economics and technology.
Nov. 7 2010 8:24 AM

One Law for the Rich, One Law for the Poor

The new foreclosure crisis reveals the shocking unfairness in how the law treats struggling homeowners.

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A foreclosure sign. Click image to expand.
The foreclosure crisis has revealed flaws in mortgage law.

The mortgage debacle in the United States has raised deep questions about "the rule of law," the universally accepted hallmark of an advanced, civilized society. The rule of law is supposed to protect the weak against the strong, and ensure that everyone is treated fairly. In America in the wake of the subprime mortgage crisis, it has done neither.

Part of the rule of law is security of property rights: If you owe money on your house, for example, the bank can't simply take it away without following the prescribed legal process. But in recent weeks and months, Americans have seen several instances in which individuals have been dispossessed of their houses even when they have no debts.

To some banks, this is just collateral damage: Millions of Americans—in addition to the estimated 4 million in 2008 and 2009—still have to be thrown out of their homes. Indeed, the pace of foreclosures would be set to increase—were it not for government intervention. The procedural shortcuts, incomplete documentation, and rampant fraud that accompanied banks' rush to generate millions of bad loans during the housing bubble has, however, complicated the process of cleaning up the ensuing mess. To many bankers, these are just details to be overlooked. Most people evicted from their homes have not been paying their mortgages, and, in most cases, those who are throwing them out have rightful claims. But Americans are not supposed to believe in justice on average. We don't say that most people imprisoned for life committed a crime worthy of that sentence. The U.S. justice system demands more, and we have imposed procedural safeguards to meet these demands.

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But banks want to short-circuit these procedural safeguards. They should not be allowed to do so.

To some, all of this is reminiscent of what happened in Russia, where the rule of law—bankruptcy legislation in particular—was used as a legal mechanism to replace one group of owners with another. Courts were bought, documents forged, and the process went smoothly. In America, the venality is at a higher level. It is not particular judges who are bought, but the laws themselves, through campaign contributions and lobbying, in what has come to be called "corruption, American-style."

It was widely known that banks and mortgage companies were engaged in predatory lending practices, taking advantage of the least educated and most financially uninformed to make loans that maximized fees and imposed enormous risks on the borrowers. (To be fair, the banks tried to take advantage of the more financially sophisticated as well, as with securities created by Goldman Sachs that were designed to fail.) But banks used all their political muscle to stop states from enacting laws to curtail predatory lending.

When it became clear that people could not pay back what was owed, the rules of the game changed. Bankruptcy laws were amended in 2005 to introduce a system of "partial indentured servitude." An individual with, say, debts equal to 100 percent of his income could be forced to hand over to the bank 25 percent of his gross, pre-tax income for the rest of his life, because the bank could add on, say, 30 percent interest each year to what a person owed. In the end, a mortgage holder would owe far more than the bank ever received, even though the debtor had worked, in effect, one-quarter time for the bank.

When this new bankruptcy law was passed, no one complained that it interfered with the sanctity of contracts: At the time borrowers incurred their debt, a more humane—and economically rational—bankruptcy law gave them a chance for a fresh start if the burden of debt repayment became too onerous.

That knowledge should have given lenders incentives to make loans only to those who could repay them. But lenders perhaps knew that, with the Republicans in control of government, they could make bad loans and then change the law to ensure that they could squeeze the poor.

With one out of four mortgages in the United States under water, there is a growing consensus that the only way to deal with the mess is to write down the value of the principal (what is owed). America has a special procedure for corporate bankruptcy, called Chapter 11, which allows a speedy restructuring by writing down debt, and converting some of it to equity.