Contracts in Crisis: Variations in Z and S

[Joanne98]

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.

November 15, 2008 at 11:36 PM
http://www.creditslips.org/creditslips/2008/11/contracts-in-cr.html#more