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The Dodd Plan: A Contract Clause Problem?

Section 11 of the Dodd bill seeks to minimize foreclosures by allowing bankruptcy judges to approve Chapter 13 bankruptcy plans that adjust the terms of residential mortgages in the debtor's favor. Any Contract Clause experts willing to weigh in on this provision? There is no doubt that the section is lawful if applied prospectively, that is, to mortgages issued after the law goes into effect. But if it applies retroactively, as surely it is intended to, then creditors can assert a Contract Clause violation. The Supreme Court replaced the flat ban on this type of law with a balancing test during the Great Depression, under similar circumstances. Section 11 would pass the balancing test if interference with creditors' contractual rights is sufficiently limited and/or the government interest is sufficiently great. But, however bad things might be now, we are not in a Great Depression or even (yet) a Mild Recession, and we have very different personnel on the Supreme Court.

As a lawyer:
It's my understanding that the SCOTUS read a three part balancing test into the Contract Clause. And, while the business terms might change, the reformation under this proposal doesn't undermine the purpose of the contract or destroy the purpose of the contract: people will still have to pay for their mortgage just on better terms.

Besides, this type of "reformation" of a contract isn't that unusual. The most obvious example is the prohibition of non-competition clauses in employment contracts in California. Now, I don't know whether there's ever been a Constitutional challenge to that rule, but I doubt that the SCOTUS would say that such a law violates the constitution.
9.24.2008 10:28am
DC:
The Contract Clause is, honestly, new to me. But I have two thoughts:

(1) There is also a bankruptcy clause, and it seems to me that it contemplates debts being entirely discharged, not just readjusted. In practical terms, that may mean you give the creditor a choice to voluntarily split the debt into two parts, one of which will be discharged out. Or, if they refuse to split their loan, you just discharge it out.

(2) Does your working model of the Contracts Clause mean that all retroactive changes in bankruptcy laws (such as those crammed down on debtors a few years back) are invalid? If it's true that every contract silently incorporates the then-existing state of bankruptcy law, there will be a ton of debtors saying "This wasn't the law when I took out this credit card! The attempt to apply new bankruptcy law to me is a violation of the Contracts Clause." Surely the Contracts Clause isn't a one-way street; contracts are about things being a two-way street.

If anything, I thought the contracts clause was about contracts out there in the real world, not in bankruptcy court.
9.24.2008 10:33am
DavidBernstein (mail):
The first problem is that the Contracts Clause only applies to states, not the federal government, and I don't believe there is any precedent applying it to the feds. You can argue that it's an unenumerated right protected by the 5th Amendment's DP Clause, or that, following Bolling v. Sharpe, if the states are obligated, so are the feds.
9.24.2008 10:41am
ejo:
shouldn't the person who took the highest amount of donations from FM/FM and received sweetheart loans from Countrywide be prohibited from offering any nuggets of wisdom on the current mess? go ahead and vote-just keep your vast brain power away. far far away.
9.24.2008 10:43am
Houston Lawyer:
Wasn't it Lochner where the Supreme Court said that the founders couldn't possibly have forseen the great depression and therefore wrote the contracts clause out of the constitution?

If Congress can lower the rate on your mortgage, they could also increase it. The whole idea seems to be that those unworthy of credit should get it on the same terms as those who are worthy. If you increased the interest on all outstanding loans to say 10%, the banks would collect enough interest to cover the losses on all those bad loans.
9.24.2008 10:45am
STB:
My fuzzy recollection is that the Contracts Clause does not apply to federal legislation.
9.24.2008 10:48am
jccamp (mail):
An interesting opinion piece in today's WSJ HERE
which seems to mention some history on the subject.
9.24.2008 10:51am
ReaderY:
As an indication of the low ebb that the Contracts Clause has reached, Deleware passed a law in the 1990s allowing a bank to unilaterally change any term of a revolving credit contract (except increasing the interest rate) without notice (unless required by Federal law), even after closure of the account and regardless of the availability of future credit, and to do this retroactively for agreements reached under prior law. Many other states have copied it.

If such a clause is consistent with the Contracts Clause, then the Contracts Clause's exceptions have so swallowed the rule that there isn't really any substance to the clause left. The provision represents everything the Contracts Clause -- indeed, the 13th Amendment -- was designed to prevent. If this isn't an impairment of contracts for purely private gain in the complete absence of any pretense of a public purpose, it's hard to understand what could be. (It's one thing if the state required or forbid certain provisions for public policy reasons, but a law that calls for unilateral amendment by one party at its sole discretion is something else.)


5 Del Cd. 2224 Amendment of Agreement

(a) Unless the agreement governing a revolving credit plan otherwise provides, a licensee may at any time and from time to time amend such agreement in any respect, whether or not the amendment or the subject of the amendment was originally contemplated or addressed by the parties or is integral to the relationship between the parties. Without limiting the foregoing, such amendment may change terms by the addition of new terms or by the deletion or modification of existing terms, whether relating to plan benefits or features, the rate or rates of periodic interest, the manner of calculating periodic interest or outstanding unpaid indebtedness, variable schedules or formulas, interest charges, fees, collateral requirements, methods for obtaining or repaying extensions of credit, attorney's fees, plan termination, the manner for amending the terms of the agreement, arbitration or other alternative dispute resolution mechanisms, or other matters of any kind whatsoever. Unless the agreement governing a revolving credit plan otherwise expressly provides, any amendment may, on and after the date upon which it becomes effective as to a particular borrower, apply to all then outstanding unpaid indebtedness in the borrower's account under the plan, including any such indebtedness that arose prior to the effective date of the amendment. An agreement governing a revolving credit plan may be amended pursuant to this section regardless of whether the plan is active or inactive or whether additional borrowings are available thereunder. Any amendment that does not increase the rate or rates of periodic interest charged by a licensee to a borrower under § 2216 or § 2217 of this title shall become effective as determined by the licensee, subject to compliance by the licensee with any applicable notice requirements under the Truth in Lending Act (15 U.S.C. §§ 1601 et seq.), and the regulations promulgated thereunder, as in effect from time to time. Any notice of an amendment sent by the licensee may be included in the same envelope with a periodic statement or as part of the periodic statement or in other materials sent to the borrower.



Note: The law explicitly adopted the narrowest possible interpretation of the Truth in Lending act, explicitly saying that various interest rate changes would not constitute an increase triggering a notice requirement. For example:


(c) For purposes of this section, the following are examples of amendments that shall not be deemed to increase the rate or rates of periodic interest charged by a licensee to a borrower under § 2216 or § 2217 of this title:

(1) A decrease or increase in the required number or amount of periodic installment payments;
...
(4) A change from a variable rate plan to a fixed rate, or from a fixed rate to a variable rate plan so long as the initial rate that would result from such a change, as determined on the effective date of the change, or if the notice of the change is mailed or delivered to the borrower prior to the effective date, as of any date within 60 days before mailing or delivery of such notice, will not be an increase from the rate in effect on such date under the existing plan;



So for example, a bank that offers monthly payments at 10% with a default rate of 30% can perfectly legally unilaterally decrease the number of payments to 1 and/or move up the due date without telling the customer and impose the 30% default rate when full payment wasn't made on the unknown new date. Similarly, a bank could move from a fixed rate to a variable rate based on index of its own choosing, perhaps one it knows is likely to increase soon or even one designed for such a purpose. (Although the mailing of a notice permits a bank to move up the effective date, no notice is required if the interest rate isn't deemed increase)

And all this in the face of the Contracts Clause.
9.24.2008 11:21am
Larry Rosenthal (mail):
In my copy of the Constitution, the Contracts Clause limits only the States. Moreover, my copy has a Bankruptcy Clause, which has long been understood to permit bankruptcy courts to modify or even discharge contractual obligations. The nation's bankruptcy lawyers would be awfully surprised to learn that the Bankruptcy Clause was limited by the (nonexistent) federal Contracts Clause.

Larry Rosenthal
Chapman University School of Law
9.24.2008 11:22am
Casper the Friendly Guest:
If the mortgage holders signed on to the deal, that would eliminate any contract clause problem. It shouldn't be that hard to obtain their agreement: the investors benefiting from the bailout could just refuse to use that new cash to buy any new mortgages from lenders who don't sign on. No secondary market means no new mortgages, which severely cuts down on profits. So the creditors will sign on if forced to.
9.24.2008 11:31am
A.S.:
Why isn't the contemplated limitation on executive compensation a Contracts Clause problem? The executives are paid (mostly) based on employment or severence contracts with their firms. Wouldn't the bailout bill (assuming it has some limitation on executive compensation) interfere with those contracts?
9.24.2008 11:43am
MartyA:
I'm certain your concern can be covered in the details. What is more important here, however, is how they arrange Dodd's cut on each such transaction to be secretly paid to him. And, then, of course, there is Countrywide that has funded Dodd for many years with it's VIP program; they'll need to be taken care of.
9.24.2008 11:43am
Kate S (mail):
OK some background here first, I have a law degree and work in contracts for the government but this is not my area of expertise. Can someone tell me how that fact that most of these mortgages, the original contract, were packaged and sold as derivatives affects contract rights? If you cannot determine who the legal holder of the mortgage is, how do you protect their contract rights, and were those rights fully transferred when the investment was sold?
9.24.2008 11:45am
Oren:
Kate, that is precisely the problem that Dodd is attempting to mitigate. The mortgage holder, if he could be properly found/represented, would rationally prefer to negotiate terms than to let it lapse into foreclosure. Since the bundling makes this difficult, the market cannot make the changes that all parties would rationally consent to. Hence, an imperfect intermediary (a bankruptcy judge) ought to step in and correct an obvious market failure.

I would prefer if the holders of MBS's could get together and somehow delegate the relevant authority to make these negotiations officially, but since the market structure makes that impossible, this solution seems good.
9.24.2008 11:53am
Andy Freeman (mail):
> If the mortgage holders signed on to the deal, that would eliminate any contract clause problem. It shouldn't be that hard to obtain their agreement: the investors benefiting from the bailout could just refuse to use that new cash to buy any new mortgages from lenders who don't sign on. No secondary market means no new mortgages, which severely cuts down on profits. So the creditors will sign on if forced to.

Huh? The investors holding the mortgages are the ones harmed by govt-mandated contract changes. (If they weren't harmed, it wouldn't be necessary to force them to accept the changes.)

If you tell mortage holders that they can't buy new mortgages unless they agree to make their current mortgages less valuable, they'll simply decline to buy more and invest their money elsewhere. This might not be fatal to the secondary market, because folks who don't hold mortgages might decide to start buying, but they don't have the ability to consent to changes in contracts owned by other people. However, it will require finding folks to replace the current players in the secondary market, folks willing to walk into a "govt wants to change the terms retroactively" situation.
9.24.2008 12:03pm
Larry Rosenthal (mail):
I'll try again, this time with the Supreme Court, in case anyone is interested in what it has to say about the (in)applicability of the Contracts Clause to federal legislation, This is from Pension Benefit Guaranty Corp. v. R.A. Gray Co., 467 U.S. 717, 732-33 &n.9 (1984):

"[I]t is suggested that we apply constitutional principles that have been developed under the Contract Clause, Art. I, § 10, cl. 1 (“No State shall ... pass any ... Law impairing the Obligation of Contracts ...”), when reviewing this federal legislation.FN9 See, e.g., Energy Resources Group, Inc. v. Kansas Power &Light Co., 459 U.S. 400, 103 S.Ct. 697, 74 L.Ed.2d 569 (1983); Allied Structural Steel Co. v. Spannaus, 438 U.S. 234, 98 S.Ct. 2716, 57 L.Ed.2d 727 (1978). We have never held, however, that the principles embodied in the Fifth Amendment's Due Process Clause are coextensive with prohibitions existing against state impairments of pre-existing contracts. See, e.g., **2720 Philadelphia, B. &W.R. Co. v. Schubert, 224 U.S. 603, 32 S.Ct. 589, 56 L.Ed. 911 (1912). Indeed, to the extent that recent decisions of the Court have addressed the issue, we have contrasted the limitations imposed on States by the Contract Clause with the less searching standards imposed on economic legislation by the Due Process Clauses. See United States Trust Co. v. New Jersey, 431 U.S. 1, 17, n. 13, 97 S.Ct. 1505, 1515, n. 13, 52 L.Ed.2d 92 (1977). And, although we have noted that retrospective civil legislation may offend due process if it is “particularly ‘harsh and oppressive,’ ” ibid. (quoting Welch v. Henry, 305 U.S. 134, 147, 59 S.Ct. 121, 125, 83 L.Ed. 87 (1938), and citing Turner Elkhorn, 428 U.S., at 14-20, 96 S.Ct., at 2891-2894), that standard does not differ from the prohibition against arbitrary and irrational legislation that we clearly enunciated in Turner Elkhorn.

FN9. It could not justifiably be claimed that the Contract Clause applies, either by its own terms or by convincing historical evidence, to actions of the National Government. Indeed, records from the debates at the Constitutional Convention leave no doubt that the Framers explicitly refused to subject federal legislation impairing private contracts to the literal requirements of the Contract Clause:“MR. GERRY entered into observations inculcating the importance of public faith, and the propriety of the restraint put on the states from impairing the obligation of contracts; alleging that Congress ought to be laid under the like prohibitions. He made a motion to that effect. He was not seconded.” 5 J. Elliott, Debates on the Federal Constitution 546 (2 ed. 1876). See 2 M. Ferrand, Records of the Federal Convention of 1787, p. 619 (1911).

Larry Rosenthal
Chapman University School of Law
9.24.2008 12:07pm
Brad Ford:
If they are going to let the bankrupt people force lenders to take a writedown on mortgages, why shouldn't solvent people (who have had their houses depreciate dramatically) be able to obtain the same deal?

Morally, if anyone should get a "good" deal out of this mess, it should be people who didn't borrow irresponsibly.
9.24.2008 12:09pm
Steve:
Larry, has the Supreme Court discussed the subject in terms of a taking issue rather than a Contracts Clause issue? As a matter of pure logic, it seems to me that if I have a vested right under some contract to receive $1000, and the federal government nullifies the contract retroactively, they have deprived me of $1000 and ought to compensate me. I can imagine ways to distinguish that argument, but have they ever confronted it?
9.24.2008 12:20pm
Jon Roland (mail) (www):
Congress would need to create a new Chapter in the Bankruptcy Code for a streamlined, fast track processing of mortgage contracts, a variant on Chapter 11 reorg, but limited to a few things like TRO or injunction against foreclosure or rate resets. It would also need to fund and perhaps allow more appointments and courts to handle the workload.
9.24.2008 12:21pm
You say buy us, I say by us:
So Brad, how would you confirm which bankrupt person was snookered by a bank, mortgage agent, etc and which one was a scumbag speculator or someone who lied on their paperwork. Or someone who was told by their mortgage agent to lie on their paperwork?
9.24.2008 12:24pm
justaguy (mail):
Doesn't the change to the bankruptcy law simply give those holders of mortgage securities a claim against the Government? The claim could arguably be for all losses in the security if held to maturity- giving the Government incentive to be the holder.
9.24.2008 12:33pm
Larry Rosenthal (mail):
Steve: Although the Court has never confronted a Takings Claim claim precisely like the one that might be fashioned against the Dodd Amendment (to my knowledge), the case law is pretty clear that Congress has broad power to rebalance liabilities among private parties without running afoul of the Takings Clause. E.g., Connolly v. Pension Benefit Guaranty Corp., 467 U.S. 211 (1986). A takings claim would be additionally complicated by the difficulty in establishing the current market value of the security interest that is "taken" through some sort of write-down as part of the bankruptcy process. My guess is a Court would conclude that given the uncertainty of the value of these mortgages and the complexity of the current situation, Congress could reasonably conclude that bankruptcy workouts would be unlikely to reduce the fair market value of mortgage rights and hence did not constitute a taking.
9.24.2008 12:52pm
A. Zarkov (mail):
During the Great Depression Minnesota granted relief to homeowners in foreclosure. One would thinks that was a direct violation of the Contracts Clause but the Supreme Court said otherwise-- Home Building &Loan Association v. Blaisdell,290 U.S. 398 (1934). SCOTUS thought the Depression was a "emergency" and Minnesota could use its "police powers" to fashion a remedy. No only that, the Contracts Clause does not apply to the Federal Government. There is no constitutional problem with the Dodd Plan. So investors beware.
9.24.2008 1:00pm
byomtov (mail):
If they are going to let the bankrupt people force lenders to take a writedown on mortgages, why shouldn't solvent people (who have had their houses depreciate dramatically) be able to obtain the same deal?

That's what happens in bankruptcy. Lenders take losses.
9.24.2008 1:05pm
Steve:
Thanks for the answer, Larry, very interesting.
9.24.2008 1:10pm
Just Saying:
Professor Posner,

I'd like to direct your attention to Lewis v. United States Dep't of Educ. (In re Lewis), 506 F.3d 927 (9th Cir. 2007).

A very similar argument was made, and the court found no conflict with the contract clause. Excerpts:

Appellant James Lewis seeks review of a final judgment issued by the United States District Court for the District of Idaho in favor of appellee United States Department of Education ("Department"). The bankruptcy court held and the district court affirmed that a congressional amendment to the law governing the dischargeability of a student loan obligation in bankruptcy may be retroactively applied to an obligation incurred prior to the date the law was changed. Whether the district court correctly ruled that the retroactive amendments govern appellant's student loans is the single issue of law before this court on appeal. Appellant's central argument is that he had a right to rely on the statute of limitations in effect at the [**2] time he incurred his obligation because (a) the statute of limitations was an implicit term of the contract he signed, (b) his contract created a property right to discharge his student loans after the prescribed statutory period, and (c) any government action to impair his contractual right violates his Fifth Amendment right to due process. 1

Congress has sought progressively to limit the instances in which student loan debts may be discharged in bankruptcy. In 1998, Congress amended 11 U.S.C. § 523(a)(8)(A), which had provided that student loans in repayment for seven years were eligible for discharge. 5 See Higher Education Amendments of 1998, Pub. L. No. 105-244, § 971, 112 Stat. 1581, 1837 (1998). The 1998 Amendments repealed the safe harbor provision "with respect to [student loans in bankruptcy] [**6] cases commenced under Title 11, United States Code, after the date of enactment of this Act." Id. at § 971(b). The only remaining exception to nondischargeability is through a showing of undue hardship, which is not at issue in this case. Lewis filed a petition for voluntary bankruptcy discharge under Title 11, Chapter 7 on November 30, 2003.

Appellant argues that the Fifth Amendment due process clause imposes essentially the same restraint on the impairment of contracts as does the Contract Clause 8 (citing Northwestern Nat. Life Ins. Co. v. Tahoe Regional Planning Agency, 632 F.2d 104, 106 (9th Cir. 1980)). The district court held that while that may be true in some instances, the enacting legislation under the Bankruptcy Clause, Art. 1, § 8, cl. 4 of the U.S. Constitution controls in this instance. Relying on Wright v. Union Central Life Ins. Co., 304 U.S. 502, 516, 58 S. Ct. 1025, 82 L. Ed. 1490 (1938), [**11] the district court reasoned that Lewis' student loan contract "was made subject to constitutional power in the Congress to legislate on the subject of bankruptcies impliedly written into the contract between Lewis and the original lender." Dist. Ct. Op. at 3.

This court, reviewing the district court's decision de novo, applies the presumption of constitutionality accompanying congressional acts to the 1998 Amendments. 9 To overcome the presumption, appellant debtor must show a violation of a constitutionally protected right or privilege. In re Simon, 311 B.R. 641, 645 (citing In re Golden, 16 B.R. 585, 587 (Bankr. S.D. Fla., 1981)). In this case, appellant alleges a violation of his Fifth Amendment right to due process. The questions we must answer are whether Congress has the power to impair appellant's contractual obligation through its power to legislate on bankruptcies and whether appellant has a superseding right to discharge in bankruptcy.


As noted by the district court, pursuant to authority under [**13] the Bankruptcy Clause, Congress may pass laws that impair contractual obligations. The court noted that in fact, discharge in bankruptcy necessarily impairs or modifies the rights of the creditor by eliminating the personal liability of a debtor to a creditor. While appellant argues that contemporaneous laws are read into contracts as if they were expressly referred to or incorporated in its terms, he fails to take into account that HN8"essential attributes of sovereign power [are] also read into contracts as a postulate of the legal order." Wright, 304 U.S. at 516 (quoting Home Bldg. &Loan Ass'n v. Blaisdell, 290 U.S. 398, 435, 54 S. Ct. 231, 78 L. Ed. 413 (1934)). Appellant signed his promissory note subject to this congressional authority to impair his contractual obligation.

The district court further found that Congress may impair appellant's contract retroactively. As the district court noted we have previously rejected arguments against retroactivity similar to those made by appellant. In Matter of Reynolds, 726 F.2d 1420 (9th Cir. 1984), this court retroactively made nondischargeable certain support obligations. As the district court also noted, HN9the Supreme Court recently upheld retroactive application of [**14] a change in the law permitting the Department to administratively offset delinquent student loans against Social Security benefits for loans incurred prior to the time the government could do so. Lockhart v. U.S., 546 U.S. 142, 126 S. Ct. 699, 163 L. Ed. 2d 557 (2005). Although not addressing precisely the same issue, Lockhart is "nonetheless a powerful indication that the Supreme Court would not adopt the position advanced by Lewis. . . ." Lockhart applied law as it existed at the time of the decision rather than laws at the time the student loans were made. Applying laws existing at the time of this decision, we hold that Congress has the authority to impair appellant's contractual obligation, and did so appropriately through the 1998 Amendments.
9.24.2008 1:14pm
David Schwartz (mail):
So Brad, how would you confirm which bankrupt person was snookered by a bank, mortgage agent, etc and which one was a scumbag speculator or someone who lied on their paperwork. Or someone who was told by their mortgage agent to lie on their paperwork?
I think his point is that it doesn't matter. Even people who told the truth on their paperwork still took the same kinds of losses from the same kinds of sources -- the market collapsed.
9.24.2008 1:15pm
Oren:
Larry, thanks for the great post.
9.24.2008 1:22pm
trad and anon:
As others have mentioned, the Contracts Clause by its terms only applies to the states and SCOTUS has declined to reverse incorporate it. I'd think the Fifth Amendment would be a much more significant problem. I don't know anything about the Takings Clause in this context (my Property prof wanted to talk about regulatory takings) but retroactively reducing the amount of past or existing executive compensation arrangements sure looks like a taking, especially if it's of existing property. Or: is there any chance the Bill of Attainder Clause could be a problem?

Couldn't Congress create some new retroactive civil violations designed to hit these people though? Or, could they adjust the 2008 tax code to impose an extremely high windfall profits tax on individual income and capital gains earned by financial executives whose firms lost money on mortgage-backed securities?
9.24.2008 1:40pm
Avatar (mail):
Actually...

I keep hearing that the securitization of the mortgages makes re-negotiation difficult, that the mortgages are bundled and sold off to firms who then sell various layers of bonds backed by those mortgages.

But wait... all those CDOs are bond sales, not equity sales, right? Buying a bond doesn't transfer ownership rights of the assets of the issuing corporation, it's just a form of loan. The managing companies who own the mortgage bundles, er, they still own the mortgage bundles; they're the assets to balance the liabilities of the issued bonds.

So what's the problem? I don't see where, at any point, a fraction of -an actual mortgage- is sold to any party. The bond-holders don't get any say in how the managing company deals with an individual mortgage (other than the effect on the market price... but it's not like anyone's buying those bonds NOW, right?)

There's also the practical issue - the bond-issuing company's just a paper shell and doesn't actually have people to negotiate WITH, though certainly they could hire some people to do the negotiating. I mean, if the opposing party can't be arsed to retain representation or show up, they have to accept whatever the judge gives them, right?
9.24.2008 1:50pm
Gabriel McCall (mail):
The mortgage holder, if he could be properly found/represented, would rationally prefer to negotiate terms than to let it lapse into foreclosure. Since the bundling makes this difficult, the market cannot make the changes that all parties would rationally consent to. Hence, an imperfect intermediary (a bankruptcy judge) ought to step in and correct an obvious market failure.

If I buy into a bundle of mortgages with no way to identify, contact, or negotiate with the people who's debt I'm investing in, that's not a "market failure", that's a personal failure of my intelligence and due diligence. The fact that lots of investment bankers have exhibited exactly that sort of personal failure- inspired to irrational exuberance by Greenspan's artificially low interest rates- still doesn't equate to a market failure. If you buy a pig in a poke, you've got nobody to blame but yourself when you find out what's inside.
9.24.2008 1:52pm
Nibbles:

The mortgage holder, if he could be properly found/represented, would rationally prefer to negotiate terms than to let it lapse into foreclosure. Since the bundling makes this difficult, the market cannot make the changes that all parties would rationally consent to. Hence, an imperfect intermediary (a bankruptcy judge) ought to step in and correct an obvious market failure.


The solution would seem to be: Create a new GSE (like Freddy or Fannie), force the holders of mortgage backed securites to sell them to the GSE in return for stock in the GSE.

The GSE can then sort things out, and if necessary re-negotiate mortgages.
9.24.2008 2:25pm
anon:
Avatar,
Most securitizations are structured as sales rather than financings. By tradition the securities created are called "bonds", but they are usually mortgage pass-through certificates that represent actual ownership of the underlying mortgages. It gets more complicated because for tax purposes these securities are treated as debt.

The problem with partial discharge for underwater homeowners is it would be unfair to lenders: real estate goes up, the borrower wins; real estate goes down, the lender loses. If borrowers could get partial discharge from a bankruptcy court, every underwater borrower in the country will have an incentive to file bankruptcy.
9.24.2008 2:35pm
Gabriel McCall (mail):
Create a new GSE (like Freddy or Fannie), force the holders of mortgage backed securites to sell them to the GSE in return for stock in the GSE.

Force them to sell? You're going to nationalize the entirety of the MBS market of the United States? Do we get to take over the steel factories next? Power to the proletariat!

The GSE can then sort things out

Because our previous experience with GSEs shows how good they are at that sort of thing?
9.24.2008 3:19pm
Nibbles:

Force them to sell? You're going to nationalize the entirety of the MBS market of the United States? Do we get to take over the steel factories next? Power to the proletariat!


Not really nationalized, because it will have private stockholders.

The problem is that no one knows what these securities are worth. So the solution is to repackage these securities into a rational structure whose value can be assesed and then sold off back into private hands. The profits will then be divided amongst the shareholders (i.e. the people who currently own these securites).

But it looks like in order to repackage these things you'll have to force the sale, because if the guy who owns some bit of some tranche holds out it won't work.
9.24.2008 3:41pm
EIDE_Interface (mail):
The answer is to reset the whole financial system, and start another pyramid scheme.
9.24.2008 4:47pm
Gabriel McCall (mail):
you'll have to force the sale, because if the guy who owns some bit of some tranche holds out it won't work.

Da, tovarisch, we must not let a little thing like an individual's property rights in the assets he has purchased be allowed to interfere with the grand plans of the enlightened economic leadership.

Why is it that when central economic planning fails, as it inevitably does, so many people clamor for yet more of it?
9.24.2008 4:56pm
Curious Passerby (mail):
A process server who covers a large part of mid Florida and says they always have a stack of foreclosures to serve that is 5 feet high says that 60% of the people in foreclosures they serve are investors.

I wonder what percentage nationwide are actually losing their home.
9.24.2008 5:15pm
MarkField (mail):

The solution would seem to be: Create a new GSE (like Freddy or Fannie), force the holders of mortgage backed securites to sell them to the GSE in return for stock in the GSE.

The GSE can then sort things out, and if necessary re-negotiate mortgages.


I kind of like this idea, though I'd like to do it with voluntary sales rather than forced ones. As I understand it, the sellers would get stock of the new GSE in return for the MBS, etc. Their share of the total GSE stock would be proportional to the payout value of the MBS, as Paulson wants. This clears the books of the sellers, and they make do with their other assets and liabilities.

As the mortgages pay out (or don't), the GSE (subsidized by the Treasury) would pay out the losses and receive the gains. If the GSE lost money over the long term, the sellers would have a reduced stock value when the GSE wound up. If it made money, so would the stockholders. IOW, this way the ones who caused the mess take the long term risk and reward. In the meantime, liquidity is back in the system because the Treasury is taking over assets which can't now be traded.

I have to think more about this, but it has potential.
9.24.2008 5:20pm
Nibbles:

Da, tovarisch, we must not let a little thing like an individual's property rights in the assets he has purchased be allowed to interfere with the grand plans of the enlightened economic leadership.


All you're forcing someone to do is exchange a nearly worthless scrap of paper for another scrap of paper which at least has the potential of being worth something someday.

Far better than the alternative, which involves the IRS forcing uninvolved people to give up their money for nothing in return.
9.24.2008 5:32pm
MarkField (mail):
Hm, ok, my description above only works if there's an overall profit. If there's an overall loss, there's no actual cost to the sellers. There has to be a way to force at least some loss, so maybe we're back to some form of Dodd's equity security plan.
9.24.2008 5:47pm
Gabriel McCall (mail):
Are those really the only two alternatives? How about we don't force anybody to do anything except take the losses they've voluntarily exposed themselved to?
9.24.2008 5:49pm
Nibbles:

Hm, ok, my description above only works if there's an overall profit. If there's an overall loss, there's no actual cost to the sellers. There has to be a way to force at least some loss, so maybe we're back to some form of Dodd's equity security plan.


My idea is that the sellers get stock in the new GSE in return for their MBS. No Treasury backing, except for some money to pay for operating expenses which it in turn gets shares for. Profit or loss is entirely determined by what those shares are worth.

The GSE then has a portfolio of actual mortgages, can asses the value of those actual mortgages, divulge good information about them to prospective buyers and sell them off for a realistic price. It might take 5 years or so to unwind all this crap, but at the end the GSE buys back its shares and disappears.
9.24.2008 6:22pm
Nibbles:

Are those really the only two alternatives? How about we don't force anybody to do anything except take the losses they've voluntarily exposed themselved to?


What about the innocent bystanders who get caught up in the credit crunch? My employer pays me every two weeks, but gets paid by clients at much longer intervals. If the credit markets go tits up I don't get paid, regardless of the fact that my employer has nothing to do with dodgy mortgages.
9.24.2008 6:27pm
Anony Moose (mail):
IRS gets to count debt relief as a gain. This is a whole new source of gov funding!
9.24.2008 6:54pm
Oren:

If I buy into a bundle of mortgages with no way to identify, contact, or negotiate with the people who's debt I'm investing in, that's not a "market failure", that's a personal failure of my intelligence and due diligence.
When two parties would voluntarily agree to a transaction but cannot effectuate it for whatever reason that is the definition of a market failure, even if that failure is directly attributable to one or both of them setting up their finances in an ass-backwards way.

They created the market failure, sure enough, but we are all going to suffer if the credit markets freeze (just think of every business that has a revolving line of credit, paid on time but will be ****ed).
9.24.2008 7:16pm
Xrlq (mail) (www):
This post is Exhibit A for the notion that group blogs are a bad idea. By its terms, the Contract Clause says that "No State shall ... pass any ... Law impairing the Obligation of Contracts." How, pray tell, could the federal government (which, last time I checked, was not a state) violate this clause even if they wanted to?
9.24.2008 8:20pm
Oren:
Xrlq, you make your point quite well. Read up for Larry's post (including Supreme Court precedent!) on that point.
9.24.2008 8:30pm
Augustus (mail):
If this nutty Dodd idea gets passed there will no longer be loans available for first time home buyers, or very few others either. It will be necessary for individual borrowers to make 50% downpayments. That way the security will be there and the payments will be reasonable.

Having the RE as collateral IS worth something to the lender. Credit evaluation is most important. When all else fails the lender can get the collateral, unless now this nutty Dodd idea passes. A lender making a home mortgage loan will doing about the same thing as giving the borrower a $400,000 unsecured credit card line. Good luck getting that done in hard times or good times.
9.24.2008 10:10pm
Dick King:
Just a dumb question ... won't adding the possibility of a cramdown make resale of existing MBS's even more difficult? With the cramdown possibility, even after the dust has partially settled and foreclosing on a nonperforming mortgage becomes reasonable again, the debtor gets a get-out-of-jail-free card at the expense of the creditor.

-dk
9.25.2008 3:20pm
Adam Levitin (mail) (www):
It might help if this discussion were informed by actual law.

A couple of centuries of Supreme Court decisions have made clear that there is no contracts clause issue with retroactive application of bankruptcy laws.

They have also made clear that there is no takings clause problem applying bankruptcy laws retroactively to unsecured creditors. Cramdown does not affect a secured claim's treatment--secured claims get paid in full under cramdown. Instead, cramdown determines the extent to which a claim is secured. If the claim is greater than the value of the collateral, that difference is unsecured (and therefore retroactive modification is not a problem).

If anyone wants to look at the actual law, the cases to see are:

Louisville Joint Stock Land Bank v. Radford, 295 U.S. 555, 588-589 (1935) and United States v. Sec. Indus. Bank, 459 U.S. 70 (1982)

The most relevant language is Justice Brandeis' in the Radford case:

"It is true that the position of a secured creditor, who has rights in specific property, differs fundamentally from that of an unsecured creditor, who has none; and that the Frazier-Lemke Act is the first instance of an attempt, by a bankruptcy act, to abridge, solely in the interest of the mortgagor, a substantive right of the mortgagee in specific property held as security. But we have no occasion to decide in this case whether the bankruptcy clause confers upon Congress generally the power to abridge the mortgagee's rights in specific property. Paragraph 7 declares that "the provisions of this Act shall apply only to debts existing at the time this Act becomes effective." The power over property pledged as security after the date of the Act may be greater than over property pledged before; and this Act deals only with preexisting mortgages. Because the Act is retroactive in terms and as here applied purports to take away rights of the mortgagee in specific property, another provision of the Constitution is controlling." (Emphasis added)

Query: does the "solely in the interest of the mortgagor" language imply a public interest exception (not unlike in contracts clause jurisprudence)? That is what Charles Warren argued in "Bankruptcy in United States History," still one of the leading sources on the history of bankruptcy law. Warren's book was published in 1935...at the height of the last housing crisis.
9.28.2008 11:44am
A. Daniel Feldman (mail):
My recollection is that the Constitutional Convention put the bankruptcy power in the Constitution because Govenour Morris was insolvent and needed relief. He got it, so what is the contract clause problem. Even an originalist should understand that, unless, of course, Scalia, as someone you know has said, wants to do more historical reseaarch of the kind done in law offices.

And while we're at it, how about a claw back statute for the new bailout. The bankruptcy power has always included the power to set aside preferences. A preference is a payment which benefits one creditor more than another. Emplayees and officers were creditors.

Putting a claw back into the bankruptcy act would be a problem, because the whole idea is for these firms to dump their bad paper and avoid bankruptcy...that is what restarts liquidity. But you don't have to put a claw back in the bankruptcy act; the bankruptcy power does not have to be exercised soley in statutes titled "Bankruptch Act."

So how about a "financial joy and elixir act", which acts as a sort of virtual bankruptch act? It could say that if an entity avails itself of the new Resolution Trust entity and dumps paper, any employee of officer who was paid or got option worth more than $1 million in the prior five years is deemed, if the entity was more probably than not, going to have assets less than liabliliies within the next year, to have received a preference and has to pay helf of it back.

To increase the likelihood of the entity dumping its bad paper despite the personal risk to its officers, one could add a provision that any entity that did not dump its paper and became insolvent in the next three years could sue its officers, former officers and employees, etc, for the entire emount they had received as salary or options in the preceeding eight years, on a showing of lack of prudence.

As Miss Mentschikoff used to say, there is nothing wrong with using both a carrot and a stick, and what is the power to make rules of decisions for federal cases all about, anyway.
9.29.2008 12:26pm
JK in Santa Monica (mail):
Seems to me Larry Rosenthal struck the most convincing blow -- and I would like to see a full-dress argument on behalf of both the state (assuming it enacted a Blaisdell-type statute for this obvious emergency and for the feds (who have abundant power under the Bkcy to do what it takes to deal with the crisis for those facing foreclosure).
And while you're at it, how about a dialogue on Blaisdell? It's not a very convincing opinion; repetitious invocations of "emergency" so clamorous you have to squint hard at the arguments ("emergency" often being invoked as an alibi for sound justification, a la Ashcroft).
9.29.2008 4:51pm

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