Academic

Gelpern & Levitin on Frankstein Contracts

By Lawrence Solum

Anna Gelpern and Adam Levitin (Rutgers Law School - Newark and Georgetown University - Law Center) have posted Rewriting Frankenstein Contracts: The Workout Prohibition in Residential Mortgage-Backed Securities on SSRN.  Here is the abstract:

At the heart of the current financial crisis are two kinds of contracts rife with negative externalities. The first is the residential mortgage contract, which is problematic because too many homeowners cannot pay what they owe, yet cannot modify their debts in bankruptcy. Their contracts end in foreclosures, which decimate communities, drive downward housing price spirals, and destabilize financial markets. The second is the pooling and servicing agreement (PSA) that governs the management of securitized mortgage loan pools. The PSA is problematic because as a legal and practical matter, it often precludes the modification of unsustainable mortgages and fuels uneconomic foreclosures. The mortgage contract has drawn the bulk of policy attention to date; we focus instead on the PSA and related agreements that form the contractual framework for residential mortgage securitization.

Like Frankenstein's doomed masterpiece, securitization contracts combine mundane elements, such as the requirement of unanimous bondholder consent to change payment terms, mandated by the Trust Indenture Act and common in corporate bonds, with magical features of financial alchemy, such as bankruptcy remoteness, tranching, and resecuritization. The result is a world of hyper-rigid contracts that boost commitment in good times, but function as suicide pacts in bad times.

Our Article catalogues standard policy responses to rigid contracts and recent proposals to deploy them to stem residential foreclosures. These range from modern-day corporate bankruptcy to Depression-era foreclosure moratoria, and include all manner of fiscal and regulatory incentives.

We argue instead for narrowly tailored legislation that renders the offending contractual language unenforceable on public policy grounds. This simple proposal draws on New Deal jurisprudence upholding legislative revision of private contracts to help the United States come off the gold standard, restructure public utilities, and stem farm foreclosures.

We do not claim that eliminating contractual limits on mortgage loan modification will resolve the financial crisis. But as long as these limits in place, voluntary modification and government refinancing initiatives are doomed to failure.

Full post as published by Legal Theory Blog on January 07, 2009 (boomark / email).