The Contract Clause is, honestly, new to me. But I have two thoughts:

(1) There is also a bankruptcy clause, and it seems to me that it contemplates debts being entirely discharged, not just readjusted. In practical terms, that may mean you give the creditor a choice to voluntarily split the debt into two parts, one of which will be discharged out. Or, if they refuse to split their loan, you just discharge it out.

(2) Does your working model of the Contracts Clause mean that all retroactive changes in bankruptcy laws (such as those crammed down on debtors a few years back) are invalid? If it's true that every contract silently incorporates the then-existing state of bankruptcy law, there will be a ton of debtors saying "This wasn't the law when I took out this credit card! The attempt to apply new bankruptcy law to me is a violation of the Contracts Clause." Surely the Contracts Clause isn't a one-way street; contracts are about things being a two-way street.

If anything, I thought the contracts clause was about contracts out there in the real world, not in bankruptcy court.

shouldn't the person who took the highest amount of donations from FM/FM and received sweetheart loans from Countrywide be prohibited from offering any nuggets of wisdom on the current mess? go ahead and vote-just keep your vast brain power away. far far away.

My fuzzy recollection is that the Contracts Clause does not apply to federal legislation.

As an indication of the low ebb that the Contracts Clause has reached, Deleware passed a law in the 1990s allowing a bank to unilaterally change any term of a revolving credit contract (except increasing the interest rate) without notice (unless required by Federal law), even after closure of the account and regardless of the availability of future credit, and to do this retroactively for agreements reached under prior law. Many other states have copied it.

If such a clause is consistent with the Contracts Clause, then the Contracts Clause's exceptions have so swallowed the rule that there isn't really any substance to the clause left. The provision represents everything the Contracts Clause -- indeed, the 13th Amendment -- was designed to prevent. If this isn't an impairment of contracts for purely private gain in the complete absence of any pretense of a public purpose, it's hard to understand what could be. (It's one thing if the state required or forbid certain provisions for public policy reasons, but a law that calls for unilateral amendment by one party at its sole discretion is something else.)

5 Del Cd. 2224 Amendment of Agreement

(a) Unless the agreement governing a revolving credit plan otherwise provides, a licensee may at any time and from time to time amend such agreement in any respect, whether or not the amendment or the subject of the amendment was originally contemplated or addressed by the parties or is integral to the relationship between the parties. Without limiting the foregoing, such amendment may change terms by the addition of new terms or by the deletion or modification of existing terms, whether relating to plan benefits or features, the rate or rates of periodic interest, the manner of calculating periodic interest or outstanding unpaid indebtedness, variable schedules or formulas, interest charges, fees, collateral requirements, methods for obtaining or repaying extensions of credit, attorney's fees, plan termination, the manner for amending the terms of the agreement, arbitration or other alternative dispute resolution mechanisms, or other matters of any kind whatsoever. Unless the agreement governing a revolving credit plan otherwise expressly provides, any amendment may, on and after the date upon which it becomes effective as to a particular borrower, apply to all then outstanding unpaid indebtedness in the borrower's account under the plan, including any such indebtedness that arose prior to the effective date of the amendment. An agreement governing a revolving credit plan may be amended pursuant to this section regardless of whether the plan is active or inactive or whether additional borrowings are available thereunder. Any amendment that does not increase the rate or rates of periodic interest charged by a licensee to a borrower under § 2216 or § 2217 of this title shall become effective as determined by the licensee, subject to compliance by the licensee with any applicable notice requirements under the Truth in Lending Act (15 U.S.C. §§ 1601 et seq.), and the regulations promulgated thereunder, as in effect from time to time. Any notice of an amendment sent by the licensee may be included in the same envelope with a periodic statement or as part of the periodic statement or in other materials sent to the borrower.

Note: The law explicitly adopted the narrowest possible interpretation of the Truth in Lending act, explicitly saying that various interest rate changes would not constitute an increase triggering a notice requirement. For example:

(c) For purposes of this section, the following are examples of amendments that shall not be deemed to increase the rate or rates of periodic interest charged by a licensee to a borrower under § 2216 or § 2217 of this title:

(1) A decrease or increase in the required number or amount of periodic installment payments;
...
(4) A change from a variable rate plan to a fixed rate, or from a fixed rate to a variable rate plan so long as the initial rate that would result from such a change, as determined on the effective date of the change, or if the notice of the change is mailed or delivered to the borrower prior to the effective date, as of any date within 60 days before mailing or delivery of such notice, will not be an increase from the rate in effect on such date under the existing plan;

So for example, a bank that offers monthly payments at 10% with a default rate of 30% can perfectly legally unilaterally decrease the number of payments to 1 and/or move up the due date without telling the customer and impose the 30% default rate when full payment wasn't made on the unknown new date. Similarly, a bank could move from a fixed rate to a variable rate based on index of its own choosing, perhaps one it knows is likely to increase soon or even one designed for such a purpose. (Although the mailing of a notice permits a bank to move up the effective date, no notice is required if the interest rate isn't deemed increase)

And all this in the face of the Contracts Clause.

If the mortgage holders signed on to the deal, that would eliminate any contract clause problem. It shouldn't be that hard to obtain their agreement: the investors benefiting from the bailout could just refuse to use that new cash to buy any new mortgages from lenders who don't sign on. No secondary market means no new mortgages, which severely cuts down on profits. So the creditors will sign on if forced to.

I'm certain your concern can be covered in the details. What is more important here, however, is how they arrange Dodd's cut on each such transaction to be secretly paid to him. And, then, of course, there is Countrywide that has funded Dodd for many years with it's VIP program; they'll need to be taken care of.

Kate, that is precisely the problem that Dodd is attempting to mitigate. The mortgage holder, if he could be properly found/represented, would rationally prefer to negotiate terms than to let it lapse into foreclosure. Since the bundling makes this difficult, the market cannot make the changes that all parties would rationally consent to. Hence, an imperfect intermediary (a bankruptcy judge) ought to step in and correct an obvious market failure.

I would prefer if the holders of MBS's could get together and somehow delegate the relevant authority to make these negotiations officially, but since the market structure makes that impossible, this solution seems good.

I'll try again, this time with the Supreme Court, in case anyone is interested in what it has to say about the (in)applicability of the Contracts Clause to federal legislation, This is from Pension Benefit Guaranty Corp. v. R.A. Gray Co., 467 U.S. 717, 732-33 &n.9 (1984):

"[I]t is suggested that we apply constitutional principles that have been developed under the Contract Clause, Art. I, § 10, cl. 1 (“No State shall ... pass any ... Law impairing the Obligation of Contracts ...”), when reviewing this federal legislation.FN9 See, e.g., Energy Resources Group, Inc. v. Kansas Power &Light Co., 459 U.S. 400, 103 S.Ct. 697, 74 L.Ed.2d 569 (1983); Allied Structural Steel Co. v. Spannaus, 438 U.S. 234, 98 S.Ct. 2716, 57 L.Ed.2d 727 (1978). We have never held, however, that the principles embodied in the Fifth Amendment's Due Process Clause are coextensive with prohibitions existing against state impairments of pre-existing contracts. See, e.g., **2720 Philadelphia, B. &W.R. Co. v. Schubert, 224 U.S. 603, 32 S.Ct. 589, 56 L.Ed. 911 (1912). Indeed, to the extent that recent decisions of the Court have addressed the issue, we have contrasted the limitations imposed on States by the Contract Clause with the less searching standards imposed on economic legislation by the Due Process Clauses. See United States Trust Co. v. New Jersey, 431 U.S. 1, 17, n. 13, 97 S.Ct. 1505, 1515, n. 13, 52 L.Ed.2d 92 (1977). And, although we have noted that retrospective civil legislation may offend due process if it is “particularly ‘harsh and oppressive,’ ” ibid. (quoting Welch v. Henry, 305 U.S. 134, 147, 59 S.Ct. 121, 125, 83 L.Ed. 87 (1938), and citing Turner Elkhorn, 428 U.S., at 14-20, 96 S.Ct., at 2891-2894), that standard does not differ from the prohibition against arbitrary and irrational legislation that we clearly enunciated in Turner Elkhorn.

FN9. It could not justifiably be claimed that the Contract Clause applies, either by its own terms or by convincing historical evidence, to actions of the National Government. Indeed, records from the debates at the Constitutional Convention leave no doubt that the Framers explicitly refused to subject federal legislation impairing private contracts to the literal requirements of the Contract Clause:“MR. GERRY entered into observations inculcating the importance of public faith, and the propriety of the restraint put on the states from impairing the obligation of contracts; alleging that Congress ought to be laid under the like prohibitions. He made a motion to that effect. He was not seconded.” 5 J. Elliott, Debates on the Federal Constitution 546 (2 ed. 1876). See 2 M. Ferrand, Records of the Federal Convention of 1787, p. 619 (1911).

Larry Rosenthal
Chapman University School of Law

Larry, has the Supreme Court discussed the subject in terms of a taking issue rather than a Contracts Clause issue? As a matter of pure logic, it seems to me that if I have a vested right under some contract to receive $1000, and the federal government nullifies the contract retroactively, they have deprived me of $1000 and ought to compensate me. I can imagine ways to distinguish that argument, but have they ever confronted it?

So Brad, how would you confirm which bankrupt person was snookered by a bank, mortgage agent, etc and which one was a scumbag speculator or someone who lied on their paperwork. Or someone who was told by their mortgage agent to lie on their paperwork?

Steve: Although the Court has never confronted a Takings Claim claim precisely like the one that might be fashioned against the Dodd Amendment (to my knowledge), the case law is pretty clear that Congress has broad power to rebalance liabilities among private parties without running afoul of the Takings Clause. E.g., Connolly v. Pension Benefit Guaranty Corp., 467 U.S. 211 (1986). A takings claim would be additionally complicated by the difficulty in establishing the current market value of the security interest that is "taken" through some sort of write-down as part of the bankruptcy process. My guess is a Court would conclude that given the uncertainty of the value of these mortgages and the complexity of the current situation, Congress could reasonably conclude that bankruptcy workouts would be unlikely to reduce the fair market value of mortgage rights and hence did not constitute a taking.

If they are going to let the bankrupt people force lenders to take a writedown on mortgages, why shouldn't solvent people (who have had their houses depreciate dramatically) be able to obtain the same deal?

That's what happens in bankruptcy. Lenders take losses.

Professor Posner,

I'd like to direct your attention to Lewis v. United States Dep't of Educ. (In re Lewis), 506 F.3d 927 (9th Cir. 2007).

A very similar argument was made, and the court found no conflict with the contract clause. Excerpts:

Appellant James Lewis seeks review of a final judgment issued by the United States District Court for the District of Idaho in favor of appellee United States Department of Education ("Department"). The bankruptcy court held and the district court affirmed that a congressional amendment to the law governing the dischargeability of a student loan obligation in bankruptcy may be retroactively applied to an obligation incurred prior to the date the law was changed. Whether the district court correctly ruled that the retroactive amendments govern appellant's student loans is the single issue of law before this court on appeal. Appellant's central argument is that he had a right to rely on the statute of limitations in effect at the [**2] time he incurred his obligation because (a) the statute of limitations was an implicit term of the contract he signed, (b) his contract created a property right to discharge his student loans after the prescribed statutory period, and (c) any government action to impair his contractual right violates his Fifth Amendment right to due process. 1

Congress has sought progressively to limit the instances in which student loan debts may be discharged in bankruptcy. In 1998, Congress amended 11 U.S.C. § 523(a)(8)(A), which had provided that student loans in repayment for seven years were eligible for discharge. 5 See Higher Education Amendments of 1998, Pub. L. No. 105-244, § 971, 112 Stat. 1581, 1837 (1998). The 1998 Amendments repealed the safe harbor provision "with respect to [student loans in bankruptcy] [**6] cases commenced under Title 11, United States Code, after the date of enactment of this Act." Id. at § 971(b). The only remaining exception to nondischargeability is through a showing of undue hardship, which is not at issue in this case. Lewis filed a petition for voluntary bankruptcy discharge under Title 11, Chapter 7 on November 30, 2003.

Appellant argues that the Fifth Amendment due process clause imposes essentially the same restraint on the impairment of contracts as does the Contract Clause 8 (citing Northwestern Nat. Life Ins. Co. v. Tahoe Regional Planning Agency, 632 F.2d 104, 106 (9th Cir. 1980)). The district court held that while that may be true in some instances, the enacting legislation under the Bankruptcy Clause, Art. 1, § 8, cl. 4 of the U.S. Constitution controls in this instance. Relying on Wright v. Union Central Life Ins. Co., 304 U.S. 502, 516, 58 S. Ct. 1025, 82 L. Ed. 1490 (1938), [**11] the district court reasoned that Lewis' student loan contract "was made subject to constitutional power in the Congress to legislate on the subject of bankruptcies impliedly written into the contract between Lewis and the original lender." Dist. Ct. Op. at 3.

This court, reviewing the district court's decision de novo, applies the presumption of constitutionality accompanying congressional acts to the 1998 Amendments. 9 To overcome the presumption, appellant debtor must show a violation of a constitutionally protected right or privilege. In re Simon, 311 B.R. 641, 645 (citing In re Golden, 16 B.R. 585, 587 (Bankr. S.D. Fla., 1981)). In this case, appellant alleges a violation of his Fifth Amendment right to due process. The questions we must answer are whether Congress has the power to impair appellant's contractual obligation through its power to legislate on bankruptcies and whether appellant has a superseding right to discharge in bankruptcy.


As noted by the district court, pursuant to authority under [**13] the Bankruptcy Clause, Congress may pass laws that impair contractual obligations. The court noted that in fact, discharge in bankruptcy necessarily impairs or modifies the rights of the creditor by eliminating the personal liability of a debtor to a creditor. While appellant argues that contemporaneous laws are read into contracts as if they were expressly referred to or incorporated in its terms, he fails to take into account that HN8"essential attributes of sovereign power [are] also read into contracts as a postulate of the legal order." Wright, 304 U.S. at 516 (quoting Home Bldg. &Loan Ass'n v. Blaisdell, 290 U.S. 398, 435, 54 S. Ct. 231, 78 L. Ed. 413 (1934)). Appellant signed his promissory note subject to this congressional authority to impair his contractual obligation.

The district court further found that Congress may impair appellant's contract retroactively. As the district court noted we have previously rejected arguments against retroactivity similar to those made by appellant. In Matter of Reynolds, 726 F.2d 1420 (9th Cir. 1984), this court retroactively made nondischargeable certain support obligations. As the district court also noted, HN9the Supreme Court recently upheld retroactive application of [**14] a change in the law permitting the Department to administratively offset delinquent student loans against Social Security benefits for loans incurred prior to the time the government could do so. Lockhart v. U.S., 546 U.S. 142, 126 S. Ct. 699, 163 L. Ed. 2d 557 (2005). Although not addressing precisely the same issue, Lockhart is "nonetheless a powerful indication that the Supreme Court would not adopt the position advanced by Lewis. . . ." Lockhart applied law as it existed at the time of the decision rather than laws at the time the student loans were made. Applying laws existing at the time of this decision, we hold that Congress has the authority to impair appellant's contractual obligation, and did so appropriately through the 1998 Amendments.

Larry, thanks for the great post.

Actually...

I keep hearing that the securitization of the mortgages makes re-negotiation difficult, that the mortgages are bundled and sold off to firms who then sell various layers of bonds backed by those mortgages.

But wait... all those CDOs are bond sales, not equity sales, right? Buying a bond doesn't transfer ownership rights of the assets of the issuing corporation, it's just a form of loan. The managing companies who own the mortgage bundles, er, they still own the mortgage bundles; they're the assets to balance the liabilities of the issued bonds.

So what's the problem? I don't see where, at any point, a fraction of -an actual mortgage- is sold to any party. The bond-holders don't get any say in how the managing company deals with an individual mortgage (other than the effect on the market price... but it's not like anyone's buying those bonds NOW, right?)

There's also the practical issue - the bond-issuing company's just a paper shell and doesn't actually have people to negotiate WITH, though certainly they could hire some people to do the negotiating. I mean, if the opposing party can't be arsed to retain representation or show up, they have to accept whatever the judge gives them, right?

The mortgage holder, if he could be properly found/represented, would rationally prefer to negotiate terms than to let it lapse into foreclosure. Since the bundling makes this difficult, the market cannot make the changes that all parties would rationally consent to. Hence, an imperfect intermediary (a bankruptcy judge) ought to step in and correct an obvious market failure.

The solution would seem to be: Create a new GSE (like Freddy or Fannie), force the holders of mortgage backed securites to sell them to the GSE in return for stock in the GSE.

The GSE can then sort things out, and if necessary re-negotiate mortgages.

Create a new GSE (like Freddy or Fannie), force the holders of mortgage backed securites to sell them to the GSE in return for stock in the GSE.

Force them to sell? You're going to nationalize the entirety of the MBS market of the United States? Do we get to take over the steel factories next? Power to the proletariat!

The GSE can then sort things out

Because our previous experience with GSEs shows how good they are at that sort of thing?

The answer is to reset the whole financial system, and start another pyramid scheme.

A process server who covers a large part of mid Florida and says they always have a stack of foreclosures to serve that is 5 feet high says that 60% of the people in foreclosures they serve are investors.

I wonder what percentage nationwide are actually losing their home.

Da, tovarisch, we must not let a little thing like an individual's property rights in the assets he has purchased be allowed to interfere with the grand plans of the enlightened economic leadership.

All you're forcing someone to do is exchange a nearly worthless scrap of paper for another scrap of paper which at least has the potential of being worth something someday.

Far better than the alternative, which involves the IRS forcing uninvolved people to give up their money for nothing in return.

Are those really the only two alternatives? How about we don't force anybody to do anything except take the losses they've voluntarily exposed themselved to?

Are those really the only two alternatives? How about we don't force anybody to do anything except take the losses they've voluntarily exposed themselved to?

What about the innocent bystanders who get caught up in the credit crunch? My employer pays me every two weeks, but gets paid by clients at much longer intervals. If the credit markets go tits up I don't get paid, regardless of the fact that my employer has nothing to do with dodgy mortgages.

If I buy into a bundle of mortgages with no way to identify, contact, or negotiate with the people who's debt I'm investing in, that's not a "market failure", that's a personal failure of my intelligence and due diligence.

When two parties would voluntarily agree to a transaction but cannot effectuate it for whatever reason that is the definition of a market failure, even if that failure is directly attributable to one or both of them setting up their finances in an ass-backwards way.

They created the market failure, sure enough, but we are all going to suffer if the credit markets freeze (just think of every business that has a revolving line of credit, paid on time but will be ****ed).

Xrlq, you make your point quite well. Read up for Larry's post (including Supreme Court precedent!) on that point.

Just a dumb question ... won't adding the possibility of a cramdown make resale of existing MBS's even more difficult? With the cramdown possibility, even after the dust has partially settled and foreclosing on a nonperforming mortgage becomes reasonable again, the debtor gets a get-out-of-jail-free card at the expense of the creditor.

-dk

My recollection is that the Constitutional Convention put the bankruptcy power in the Constitution because Govenour Morris was insolvent and needed relief. He got it, so what is the contract clause problem. Even an originalist should understand that, unless, of course, Scalia, as someone you know has said, wants to do more historical reseaarch of the kind done in law offices.

And while we're at it, how about a claw back statute for the new bailout. The bankruptcy power has always included the power to set aside preferences. A preference is a payment which benefits one creditor more than another. Emplayees and officers were creditors.

Putting a claw back into the bankruptcy act would be a problem, because the whole idea is for these firms to dump their bad paper and avoid bankruptcy...that is what restarts liquidity. But you don't have to put a claw back in the bankruptcy act; the bankruptcy power does not have to be exercised soley in statutes titled "Bankruptch Act."

So how about a "financial joy and elixir act", which acts as a sort of virtual bankruptch act? It could say that if an entity avails itself of the new Resolution Trust entity and dumps paper, any employee of officer who was paid or got option worth more than $1 million in the prior five years is deemed, if the entity was more probably than not, going to have assets less than liabliliies within the next year, to have received a preference and has to pay helf of it back.

To increase the likelihood of the entity dumping its bad paper despite the personal risk to its officers, one could add a provision that any entity that did not dump its paper and became insolvent in the next three years could sue its officers, former officers and employees, etc, for the entire emount they had received as salary or options in the preceeding eight years, on a showing of lack of prudence.

As Miss Mentschikoff used to say, there is nothing wrong with using both a carrot and a stick, and what is the power to make rules of decisions for federal cases all about, anyway.