Modification-proof contracts boost commitment and can help overcome
information problems. But when such
rigid contracts are ubiquitous, they can function as social suicide pacts,
compelling enforcement despite significant externalities. At the heart of the current financial
crisis is a hyper-rigid contract: the
pooling and servicing agreement (PSA), which governs residential mortgage
securitization. PSAs are designed
to preclude both their own modification, and the modification of underlying assets,
such as mortgage loans. In the
mortgage context, PSAs’ rigidities fuel foreclosures, with spillover effects
for homeowners, communities, financial institutions, financial markets, and the
macroeconomy.
This Article situates PSAs in the context of theoretical and policy
debates about contract rigidity and bond contract modification. The Article proposes a typology of
contract rigidities, and draws on New Deal jurisprudence for strategies to
overcome them. These include
narrowly tailored legislation that renders the problem contract terms
unenforceable on public policy grounds, backed up with administrative
restructuring mandates. Despite their
past prominence, these strategies have received scant attention in the current
crisis.
Rewriting hyper-rigid PSAs will not resolve the current financial crisis. Yet voluntary foreclosure prevention initiatives are unlikely to succeed for as long as contract rigidities persist. The experience with PSAs holds an important lesson for the future: widespread contract rigidities can unleash catastrophic social consequences, even where rigidity makes perfect sense for the contracting parties. We argue that a viable mechanism for contract modification is essential for financial stability.
Comments
3 responses to “Rewriting Frankenstein Contracts”
There is way too much jargon in this post. I have a much simpler view. The federal government has the power to retroactively impair contracts; the only restriction is that under the Fifth Amendment it must do so via due process and pay just compensation for the taking of the contract right. What is the value of an individual debtholder’s right to veto a contract modification approved by say 2/3 of similarly situated debt holders? Not a lot; it might be less than the legal fees to prove it, and it would be offset socially by reduced bankruptcy court expenses. Passing a law that permits debt contracts to be modified on 2/3 vote of the principal would be a much cheaper solution than many of the alternative programs being proposed to address these problems. In RMBS, CMBS, ABS and corporate debt agreements generally.
The author assumes the existence of something that has proven to be non-existent in the realm of loan modifications – good will on the part of the participants.
I’m reminded of John Godfrey Saxe’s poem of the blind men and the elephant.
Each come to the experience with their own preconceived notions and upon discovery of a part of the elephant ascribes some explanation of that part to what an elephant is like. Fortunately in Saxe’s story, none of them take it upon themselves to kill the others as a result of their experience. When it comes to financial issues, the apparent stance is one of “death to the loser means life to the winner.”
But contract rigidity isn’t the real issue; sorry, but when you boil it all down cash flow is what counts. You ask an average CFO and you’ll find that happiness is a positive cash flow.
The solution is to devise a way for cashflows to satisfy or at least placate those at the table – with the understanding that not participating in the solution means zero cash flow.
Mr. Homeowner, you’re going to have to show you can put up $x every month because the servicer has to put up $y every month because the trustee has to pay out $z to the bondholders. And, oh, by the way, the bondholder thought they were going to get $z++++, but guess what, the duplicitous or utterly stupid rater fooled them too so I hate to say it, in that case they’re screwed. They decided to play at the tables. They bought tickets to ‘Vegas, booked rooms at the hotel, were fully aware of where they were and what they were there for.
There has been no shortage of coverage of the abusive lending practices in subprime lending. Anyone touching those investments had plenty of warning.
Yes, the simple loser in that equation is the RMBS investor.
And who should they turn to?
Well, if they could prove they were brain damaged and couldn’t read, they should turn to the people who are being largely ignored – the raters they relied on.
Until they’ve exhausted that remedy, trying to re-mold the judicial system for their benefit should be off-limits.
What is preventing the modification of the contracts?
My understanding is that a common law contract such as this, is never precluded from mutual modification.