Rewriting Frankenstein Contracts: The Workout Prohibition in Residential Mortgage-Backed Securities

Abstract

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 contract designed to be hyperrigid: the pooling and servicing agreement (“PSA”), which governs residential mortgage securitization. The PSA combines formal, structural, and functional barriers to its own modification with restrictions on the modification of underlying mortgage loans. Such layered 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, bond contract modification, and contractual bankruptcy. We propose a typology of contract rigidities, ranging from formal prohibition on amendment (formal rigidity) to extreme collective action problems (functional rigidity). We then draw on New Deal jurisprudence for strategies to overcome each type of rigidity. These strategies include narrowly tailored legislation that renders the problematic terms unenforceable on public policy grounds, administrative restructuring mandates, and special bankruptcy regimes.

The New Deal experience highlights the spillover effects of widespread contract practices, the limits of voluntary modification, and the utility of targeted government mandates to rewrite problematic terms. It also reveals the limits of such mandates. When different kinds of rigidity combine in a complex web of contracts, a comprehensive mechanism like bankruptcy may be necessary, if not always sufficient, to break the logjam.

Rewriting PSAs will not resolve today’s financial crisis. Yet voluntary foreclosure prevention initiatives are unlikely to succeed as long as contract rigidities persist. The continuing foreclosure epidemic also holds an important lesson for the future: even where contract rigidity makes perfect sense for the parties, pervasive rigidities can have catastrophic consequences for financial stability and for society.

Keywords: securitization, mortgages, foreclosure, servicing, PSA, pooling and servicing agreement, gold clauses, New Deal, public utility holding company act, Frazier-Lemke Act, contract, collective action, workout, modification, externalities, MBS, RMBS, CMBS, bankruptcy

JEL Classification: G33, K12