Did Contract Rigidities And Law Function As 'Social Suicide Pacts' During The Financial Crisis?

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 hyper-rigid: 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.

From a recent article, "Rewriting Frankenstein Contracts: The Workout Prohibition in Residential Mortgage-Backed Securities" by Anna Gelpern, American University Washington College of Law, and Adam J. Levitin, Georgetown University - Law Center. [Free Download].

The paper suggests a few strategies:

These strategies include narrowly tailored legislation that renders the problem terms unenforceable on public policy grounds, administrative restructuring mandates, and special bankruptcy regimes.

(HT: The Conglomerate Blog)