Corporate & Securities Law

Zywicki on Judicial Modification of Mortgage Contracts

Earlier this week, I argued that courts should resist the urge to modify what turn out to be improvident commercial contracts. An unintended consequence of rewriting such contracts, I asserted, is that negotiated agreements would become unreliable, which would raise the risks associated with, and thereby discourage, wealth-creating exchanges. And real wealth creation — not just wealth redistribution — is what we desperately need right now.

In an op-ed in today’s Wall Street Journal, Josh’s GMU colleague (and Volokh conspirator) Todd Zywicki offers a similar analysis of proposals to modify mortgage contracts. He cites the following unintended consequences of permitting judges to rewrite such contracts:

* Mortgage costs will rise, as the risk of judicial modification increases the risk of lending, resulting in higher interest rates and/or upfront costs;

* Bankruptcy filings will increase as homeowners see bankruptcy as a means of getting out of a bad mortgage without foreclosure (Todd notes that there were 800,000 bankruptcies last year and that five million homeowners are currently delinquent on their mortgages);

* Because “a bankruptcy filing sweeps in all of the filer’s other debts, including credit cards, car loans, unpaid medical bills, etc.,” the increase in bankruptcies resulting from the ability to rewrite mortgage contracts will also “destabilize the market for all other types of consumer credit”;

* At least under the leading pending proposal, homeowners could act opportunistically at the expense of lenders, filing for bankruptcy to get the mortgage principal written down and then pocketing much of the appreciation if the home eventually appreciates in excess of the written-down principal amount.

In addition, Todd notes a number of systematic adverse effects of permitting judicial modification of mortgages (e.g., effects on mortgage-backed securities, which “provided no allocation of how losses were to be assessed in the event that Congress would do something inconceivable, such as permitting modification of home mortgages in bankruptcy”). Go read the whole thing.

Full post as published by Truth on the Market on February 13, 2009 (boomark / email).