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Unenforceable Securitization Contracts

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A “portfolio” here is a bundled set of contracts. In this Article, we address a commercially important example, where a local bank finances home purchases. The bank bundles the resultant contracts—the mortgage-backed securities (MBS)—into a portfolio, which it then sells to a firm, denoted an “originator.” The originator buys portfolios from several local banks and sells the portfolios to a large bank, which markets the portfolios to public investment vehicles, such as trusts. “Portfolio contracts” govern each of these sales.

We show that the initial portfolio contract between the local bank and originator is unenforceable for two reasons. First, in contrast to goods sellers, who warrant that the goods perform, the local bank warranted that it created each of the constituent MBS in the portfolio according to good underwriting practice. Hence, while breach is observable to the goods buyer (who can see that the goods did not perform), the portfolio buyer cannot observe breach because efficiently and inefficiently created MBS are facially identical. Thus, an MBS buyer would have had to reconstruct how the local bank created particular loans in order to establish a warranty breach. Second, the goods in a bundle usually are homogenous, so the buyer can prove damages by extrapolating the loss on sampled goods to the whole. In contrast, the MBS in a portfolio usually are heterogeneous: the loans have different face values, and the individual obligors have paid different sums before defaulting. Hence, the originator must prove damages contract by contract. For these reasons, it would have been too costly for an originator to prove breach and damages.

The originator, however, sold the MBS portfolio to the large bank, remaking the unenforceable local-bank warranties that had been made to them. The large bank then remade the warranties to the public-investment vehicles. These vehicles were even less able than the originators to enforce the best practice warranties. Hence, no one could—and no one did—enforce an MBS portfolio contract as it was written.

Anticipating this result, the originating local banks reduced pre-loan screening of potential borrowers. This increased the number of marginal borrowers with two results: (i) many borrowers defaulted because they could not pay, and (ii) some borrowers who could pay defaulted strategically because they believed that the large number of defaulters overwhelmed a portfolio buyer’s capacity to pursue them. Anecdotal data indicate that market agents today continue to sell MBS portfolios under similar unenforceable contracts. A material fall in housing prices thus could yield macroeconomic consequences similar to those experienced in the Great Recession.