Zywicki on Judicial Modification of Mortgage Contracts

Thom Lambert —  13 February 2009

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.

Thom Lambert


I am a law professor at the University of Missouri Law School. I teach antitrust law, business organizations, and contracts. My scholarship focuses on regulatory theory, with a particular emphasis on antitrust.

2 responses to Zywicki on Judicial Modification of Mortgage Contracts


    It seems that the major problem is that local brokers bundled mortgages and the bundling agreements prevent the local broker and the homeowner (or homeborrower, really) from privately negotiating a write-down. I am hesitant to suggest that Congress legislate against a contractual obligation on a wide basis, but the unintended consequences that have arisen from these restrictions may warrant some action. Since the mortgages are so difficult to trace through the financial system, the transaction costs of unilateral scrapping of these provisions seems unlikely. Congressional action here might be a good way to overcome the transaction costs and help prevent foreclosures via private negotiations.


    The analysts who hold a negative view of cramdowns offer few solutions to the problems that arise when borrowers (i) lack the incentive to pay their mortgages because the value of the underlying homes is substantially less than the principal balance of the debt secured by them, or (ii) lack the ability to pay their mortgages due to unemployment, or, increasingly, underemployment.

    Whatever the reason, foreclosure has at least three adverse consequences that concern more than delinquent borrowers. Borrowers removed from their homes may leave permanently, limiting the possibility for recovery in those areas and leaving them with the problems of empty, physically declining residences; this dislocation in turn may cause overcrowding and increased stress on areas less touched by the downturn. Unbalanced housing supply sustained by increased foreclosure lowers the values of all homes, thereby decreasing generally household wealth and, presumably, vital consumer spending. Finally, continuing to foreclose on homes as in the past guarantees that lenders will lock in losses at market bottoms with no hope for recovery.

    The need to address these issues outweighs the concerns of those who complain loudly about cramdowns. Two modifications to the general cramdown practice could offer borrowers some necessary relief, address the adverse consequences above and allow lenders to recoup some losses. They are:

    1. Instead of a cramdown to the current market value of the collateral, the cramdown could be a value between the mortgage balance and the value. A projected value, a tax value or a flat percentage (say 115%, to vary with region and market conditions) of the current value could be used. Lenders have the potential to benefit from any increase in property values, and borrowers could be given the right to revisit the cramdown value periodically if values continue to decline.

    2. At the request of a borrower or lender, a bankruptcy court judge could modify interest payments to a level equal to market rent. Lenders would be required to accept the payments and forego foreclosure for two years. At the end of two years, the borrower could resume its obligations under the mortgage, refinance or allow the lender to sell the property in or out of foreclosure. In other words, borrowers and lenders would essentially have a two-year standstill period to “wait and see” what happens. Borrowers and lenders would share equally the costs and the benefits of the waiting period.

    Clearly, either of these alternatives would be available only to borrowers who had the ability to sustain reasonable installment payments. In addition, bankruptcy filings are not undertaken lightly by most borrowers, and bankruptcy has significant adverse future consequences. While the proposals above would be factored into a decision whether to file bankruptcy, any increase in filings likely would be offset by the number of filings avoided by lenders’ willingness to accommodate temporarily distressed borrowers caused by the possibility of court-ordered modification.

    The alternatives discussed are intermediate steps that could overcome objections to cramdowns while at the same time allowing borrowers to remain in their homes to weather the current economic storm, decreasing the supply of houses on the market and curtailing lenders’ losses to some extent.