PROHIBITIONS IN RESIDENTIAL
ADAM J. LEVITIN†
At the heart of the global financial collapse are two kinds of rigid contracts. The first is the residential mortgage contract, which becomes problematic when too many homeowners cannot pay what they owe and yet cannot modify their debts. The second is the pooling and servicing agreement (“PSA&rdquo, which governs the management of securitized mortgage loan pools. PSAs are designed to preclude or severely constrain the modification of both the securitization arrangement and the underlying mortgages. Both mortgage contract and PSA rigidities can fuel foreclosures on a large scale, with spillover effects on communities, financial institutions, financial markets, and the macroeconomy.
Securitization has been described as financial alchemy, a process that can change unremarkable financial assets into valuable ones, like lead into gold.7 Although medieval alchemists contributed much to science and industry, they never made gold and failed to achieve their grandest promise of eternal life. Recent experience in the largest securitization market, residential mortgage-backed securities (“RMBS&rdquo, conjures up less wholesome tales of scientific progress.
“To make bankruptcy remoteness meaningful, the vehicle must be protected from the misfortunes both of the originator who sold the mortgage loans and those of the original debtors. The first of these objectives is achieved with a “true sale”—ensuring that the originator does not retain a residual interest in the mortgage loans, so that such interest does not become an asset of the originator’s bankruptcy estate.”
Institutions have many different and overlapping reasons to securitize. Some are well placed to make (originate) loans but do not want to hold long-term credit risk on their books. By securitizing, they seek to transfer the credit risk to the investors in the securities issued by the SPV. Such institutions make money off up-front fees rather than interest payment streams. Securitization turns delayed payment streams, like periodic loan payments, into up-front cash. Securitization thus increases liquidity, which enables more lending.
Securitization contracts have many attributes designed to make modification costly and difficult. This part explains such attributes, and classifies them into a typology of rigidities: formal, structural, and functional. We consider the barriers to amending contracts governing mortgage pool securitization separately from the barriers to amending the underlying loan contracts. Although mortgage contracts are quite rigid in their own right, we focus on pool-level rigidities and limit the discussion of loan-level rigidities to those arising from securitization arrangements.
Barriers to amendment in securitization contracts generally respond to agency concerns. RMBS have myriads of investors in pools of thousands of mortgage loans. Transaction costs make it impractical for the investors to manage the underlying loan portfolio. Their debtor—the trust that owns the loans—is an inanimate shell that does not make much of a manager. The solution is for the investors to hire an agent, called a servicer, to administer the loan pool: to send out bills, allocate payments, dun delinquent homeowners, and foreclose on homes where the loan is in default. Delegating management to the servicer in turn creates agency risks for investors, including the risk that the servicer will renegotiate the underlying loans, reducing payments to the pool, for example, in exchange for a side payment.
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