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Contracts in Crisis: Variations in Z and S

posted by Anna Gelpern

Luigi Zingales of Chicago GSB put out a mortgage modification proposal about a month ago that got a bit of attention, but deserves more even if it has no political prayer.  It is one of a genre -- advocating across-the-board contract change in response to a macro shock -- that has at least two other prominent exponents, Randall Kroszner and Joseph Stiglitz.  I am noodling this literature for a U. Conn. symposium paper.

Zingales proposes legislation to allow homeowners to reduce the loan principal in line with the drop in home prices in their zip code from the time of purchase (as measured by Case-Shiller).  Creditors would get an equity kicker TBD.

One of the versions of Zingales' paper cites to Kroszner's study of FDR's war on the gold clauses.  These had protected creditors from dollar devaluation by promising to pay the debt value in gold.  In 1933, the Congress declared such clauses unenforceable, which meant about a 40% principal haircut under most long-term debt contracts in the United States.  In 1935, the Supreme Court upheld the move outright for private contracts, and said no harm done for U.S. Government debt. Kroszner reports that both stocks and bonds rallied in response to the deleveraging; hence "it is better to forgive than to receive".

Kroszner's project debuted in 1999, on the heels of the Asian financial crisis; its last version refers to Argentina's 2002 change of all dollar contracts into pesos after the peso dropped from 1:1 to 4:1 to the dollar.  Although many aspects of "pesification" were quite batty, Charles Calomiris credibly credits it with Argentina's quick investment recovery.  (OK, no Z in Calomiris.)

Stiglitz's proposal with Marcus Miller for a "Super Chapter 11" is in many ways the mother of them all.  Miller and Stiglitz argue for "semi-automatic" debt reduction in response to a macro shock, for example, currency devaluation in excess of 40% (cf Zingales' 20% housing price drop trigger).  Indonesia, with its 90% devaluation and two-thirds corporate insolvency rate in 1998, helped inspire Miller-Stiglitz.  Their premise is that no peacetime system can (or should) handle this volume of insolvency, that valuation in such a crisis is meaningless, that the bulk of the firms were not bad or at fault, and that keeping the current owners and managers in place would help economic recovery.

There are lots and lots of objections to wholesale modification, and lots of interesting design concerns.  There is a school of thought that blames the gold clause episode for ending the rule of law in the United States.  With rather more credibility, Argentine scholars argue that rewriting contracts every ten years is different from doing it every hundred.  There is also the moral hazard avalanche gestalt.  My point here is not to argue the wholesale modification brief, but to highlight its breadth and persistence in wildly different economic, cultural, and historical settings.

Moreover, although the academic proposals occasionally sound stark, soft versions are pervasive.  After FDR but before Asia and Argentina, there was the Brady Plan, which effected "quasi-voluntary", substantially standardized debt reduction on the order of 40%.  You can find elements of macro-motivated wholesale contract rewriting in many of the initiatives to deal with the current debacle, including Hope for Homeowners and Sheila Bair's proposals.  Alan White (no Z, no S) is doing some very interesting work on wholesale mortgage modification today -- see here and the follow-on paper coming out in the U.Conn.L.R. symposium.

Aside:  The conference for the symposium issue was exceptionally tight, insightful, informative, and occasionally provocative.  Professor Patricia McCoy at U.Conn. is amazing at pulling together lawyers, economists and policy types who think very differently in a way that brings out the best in all.


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The effectiveness of debt forgiveness depends on the impact on liabilities as well as deposits.

In the case of Argentina, nullification of dollar links in contracts reduced the value of those assets. Importantly, they also reduced the value of bank dollar deposit liabilities. If it hadn't been for this matching impact, the banking system would have gone bankrupt as a result of the loan modifications: a clearly unfavorable outcome.

In the case of U.S. gold clauses, the impact was to reduce the real value of loan assets. However, since bank liabilities did not have these gold clauses, the value of these liabilities would have fallen regardless. So the modification only eliminated a source of profits for the banks, but (all else equal) did not result in an actual loss.

Fast forward to today. Mortgage debt forgiveness reduces the value of bank assets and has no impact on liabilities. The effect is a loss that would wipe out a substantial portion of bank capital. This is a much different outcome from the two cited above.

Finally, the stock market reaction in each case would have to be measured in real terms. That is, the nominal profits of firms may have benefited, in aggregate, form devaluation, whereas the real profits actually fell steeply. In the 1930's case, the amount of immediate inflation did not match the 50% or so devaluation vis a vis gold, so its a question of whether one measures real returns using the dollar price of stocks or the real price using an inflation index as a deflator.

Sorry, I meant "liabilities as well as ASSETS" and not "deposits" in the first line above.

Exactly. Argentina's pesification was asymmetric (assets and liabilities converted at different rates, 40% apart and differently indexed). As a result, the government had to recapitalize the banks with low-coupon domestic bonds all the while it was in default to foreign bondholders. In other cases where banks were the creditors, public or private recapitalization followed or (as in Brady) preceded debt reduction. The big question is the true size of the capital hole, the fiscal capacity to fill it, and the availaibility of alternative sources of capital (sovereign wealth funds no more). Since we are already recapitalizing the banks, defining the size of the hole seems material and time-sensitive.

I heard a housing advocate on Democracy Now! several weeks ago (before the $7 trillion) stating that Paulson had the power right now, written in to the ill-famed MBSs, to rewrite the terms of these mortgages. But this is terms, not principal amounts. Can you comment on this?

David, do you think banks actually have these "assets" now, or is it the case debt forgiveness would "reduce the value" of figmentary assets?

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