CONTENTS INTRODUCTION I. THE EXISTENCE AND IDENTIFICATION OF BUBBLES A. Definitions 1. Judgment 2. Low-Quality Trader 3. High-Quality Trader 4. Bubble-Like Price Behavior 5. Bubble a) Definition b) Comparison to Alternative Definitions of Bubbles 6. Bubble Contract B. Existence of Bubbles 1. Evidence from Experimental Economics 2. Evidence from Empirical Finance Research 3. Evidence from Descriptive Observation 4. Bubbles and the Efficient-Capital-Markets Hypothesis 5. Conclusion C. Identification of Bubbles 1. Market Indicators a) Boom-and-Bust Price Behavior b) Volume Increase c) Increased Use of Leverage 2. Actor Characteristic Indicators a) New Participants b) Increase in Speculative Motives c) Increase in Net Sales from More-Experienced to Less-Experienced Traders 3. Irrationality-Inducing Environmental Factors a) Hype b) New-Era Stories 4. The Role of Arbitrage 5. Ex Post and Ex Ante Identification of Bubbles D. Negative Consequences of Bubbles 1. Malinvestment 2. Price Volatility 3. Fraud 4. Bailouts 5. Summing Up: The Negative Consequences of Bubbles II. BUBBLES AND FREEDOM OF CONTRACT A. The Two-Step Structure of Exeusing Doctrines 1. Capacity 2. Mistake 3. Misrepresentation B. Bubbles and the Capacity Doctrine--Step One C. Bubbles and the Mistake and Misrepresentation Doctrines--Step One 1. Bubbles and Mistake 2. Bubbles and Fraud D. Bubbles and the Possibility of a "Gestalt" Response E. Bubbles and Individual Proof at Step One F. Bubbles and Excuse--Step Two 1. The Setting of Step-Two Analysis 2. The Utilitarian Approach to Step Two 3. Nonutilitarian "Contractarian" Approaches to Step Two III. RESOLVING BUBBLE CONTRACTS A. The Argument Against Case-by-Case Analysis of Care B. Rescinding Bubble Contracts 1. Rescission and Stock-Market Bubbles 2. Rescission and Real-Estate Bubbles 3. Rescission and Deterring Bubbles C. Equitable Adjustment of Bubble Contracts CONCLUSION INTRODUCTION
The decrease in U.S. housing prices----often called the "end of the housing bubble"--has brought about a tremendous increase in mortgage foreclosures and defaults. That in turn has spawned an ongoing controversy about what, if anything, the government should do to intervene in this situation. One of the major questions has been under what circumstances the political branches should alter private contracts, such as mortgage loan agreements and the agreements that govern the servicing of securitized mortgage loans. (1) Ad hoc interventions, such as legislative changes to servicing agreements that shield servicers from liability for making loan modifications-justified as they may be in a foreclosure crisis--raise troubling questions of fairness and rent-seeking behavior, as well as legal issues. (2)
But apart from the issue of whether and how the political branches should rewrite contracts in the latest financial upheaval, there is another question raised by what appears to be the second asset-bubble deflation in a decade: Is there any significance to the existence and persistence of asset-price bubbles from the perspective of contract law? As the government exercises its general regulatory power to rewrite some private contracts and not others---depending inevitably on political considerations to make the distinction--less attention is devoted to whether these contracts ought to be enforced under contract-law principles in the first place.
Asset-price bubbles have been analyzed only to a limited extent in legal scholarship, and the work that has been done mostly takes a regulatory perspective: What rules might governments, acting directly through the political process or through administrative agencies, adopt to control asset bubbles, assuming that transactions made during a bubble will be enforced? (3) Scholars have not examined what is arguably the antecedent question of how asset-price bubbles interact with private ordering on a fundamental level. That question lies within the domain of contract law:
This Article presents the first such examination, taking as its premise that we ought to take bubbles seriously. It asks what happens if contract law takes seriously the widely embraced (though disputed) proposition that financial markets are given to bubbles--bouts of mania when poor-quality traders drive up prices--that can be identified with confidence only after the fact. It answers that courts might order rescission or equitable adjustment of bubble contracts, because the reasons generally given for supporting private ordering do not apply to bubbles.
As between rescission and equitable adjustment, rescission has the advantage of sending a clear signal that should help prevent bubbles. Equitable adjustment is more flexible and avoids potentially high remedy administration costs from rescinding large numbers of bubble contracts.
Applying an ex post remedy to financial bubbles avoids a fundamental problem that underlies regulatory suggestions that have been advanced to address the issue: the fact that regulators may not on average have foresight superior to that of market participants. (4) This supports either approach.
This Article proceeds in three Parts. The first argues that outbreaks of poor judgment that drive up asset prices very likely do exist and can be identified, even if only after the fact. It also argues that bubbles are likely to be destructive. This assertion requires some preliminary exposition of how bubbles should be defined and what it means to identify them. The second Part argues that the distinctive characteristics of bubbles make them inappropriate for private ordering, drawing on the contract doctrines of incapacity, mistake, and misrepresentation. The third Part discusses the remedies of rescission and equitable adjustment and sketches how they might work in the context of stock-market and real-estate bubbles.
THE EXISTENCE AND IDENTIFICATION OF BUBBLES
I start by adopting and defending definitions of key terms. Bubbles are defined in different ways by different authors. The different definitions all capture the same or similar phenomena, but they raise different issues of identifying and proving the existence of asset bubbles. For example, a definition based on fundamental asset values raises the question of how to measure fundamental value in the real world. A definition based on price behavior--such as "any fast rise and sudden crash of prices is a bubble"--raises the question of whether it makes sense to treat all such price patterns identically. I propose a definition based on the characteristics of traders and the effect of those characteristics on financial markets.
The idea of judgment is central both to the definition of a bubble that I adopt and to the contract-law doctrines I discuss. This concept apparently has received less attention than it deserves from legal academia; (5) in this context, I refer to the reasonableness of the trader's conception of future outcomes. (6)
The type of poor judgment that is most relevant to this Article is unreasonable optimism--not the optimism that an economist would call "irrational," (7) but optimism that is unreasonable. (8) For example, if a person flips a coin, and he or she believes that the coin is eighty percent weighted to heads, there is no way in advance to say that this belief reflects poor judgment. If, after one thousand flips, the coin flipper maintains this belief after the coin comes up heads 501 times and tails 499 times in a thousand flips, he is probably exercising poor judgment. (9) Poor judgment cannot be proven with absolute certainty, but it can be inferred. (10)
The concept of judgment is not limited to situations involving an explicit conception of probabilities. It applies to any scenario in which the actor underweighs or disregards bad outcomes. When a person decides not to wear a seatbelt while driving, that person is in all likelihood exercising poor judgment by believing that "I won't be in an accident," even if the person has no conscious concept of the probabilities involved and, if asked, would not say that the probability of being in an accident is zero percent.
The qualification "in all likelihood" reflects the possibility that our seatbelt-free rider may find seatbelts especially uncomfortable, enjoy the risk of injury or death, highly value the relief that comes from taking such a risk without being injured, and so forth. The arguments requiring us to qualify the seatbelt example with "in all likelihood" are analogous to arguments often made about asset bubbles, namely that they cannot be distinguished from changes in the actor's risk preference or preference for current versus future consumption. (11) In both cases, it is very difficult to establish poor judgment with certainty, but poor judgment nevertheless can exist and the law can take account of this. The law requires seatbelts even if the requirement harms some people who are not exercising poor judgment, such as risk-lovers who simply enjoy not wearing seatbelts and do so with full knowledge and appropriate understanding of the possible consequences.
Apart from the reasons for not wearing seatbelts just discussed (those arising from the person's subjective preferences), we can imagine another possibility. Perhaps the driver, who otherwise acts as though she correctly anticipates the probability of an accident, believes that important technological developments will have occurred since the last time she ventured out, and that the other cars she encounters are likely to feature automatic accident-aversion systems that radically reduce the probability of an accident. (12)
If this turns out not to be the case, can we say for sure that the person exercised poor judgment? No. Our driver might have correctly assessed the probability that the improvements would materialize. It might simply have been bad luck that they did not. But poor judgment seems to be a more likely explanation of the situation. This example...