8:-1*68=:7*58/8:98:*<.27*7,2*5*?8:-1*68=:7*58/8:98:*<.27*7,2*5*?
'85=6. ;;=. :<2,5.
87#.,8=:;. 88?7"*@6.7<7-%1.8:<0*0..5<-8?7 87#.,8=:;. 88?7"*@6.7<7-%1.8:<0*0..5<-8?7
.;;87;:86&7-.:,*92<*52A*<287.;;87;:86&7-.:,*92<*52A*<287
8>$858687
!-.52*277.;
8558?<12;*7-*--2<287*5?8:4;*<1<<9;2:5*?7.</8:-1*6.-=3,D
"*:<8/<1.*?86687;
#.,866.7-.-2<*<287#.,866.7-.-2<*<287
8>$858687*7-!-.52*277.;
87#.,8=:;. 88?7"*@6.7<7-%1.8:<0*0..5<-8?7
.;;87;:86&7-.:,*92<*52A*<287
8:-1*68:927
>*25*+5.*<1<<9;2:5*?7.</8:-1*6.-=3,D>852;;
%12;:<2,5.2;+:8=01<<8@8=/8:/:..*7-89.7*,,.;;+@$%1.8:-1*6*?:,12>.8/$,185*:;129*7-
2;<8:@<1*;+..7*,,.9<.-/8:27,5=;287278:-1*68=:7*58/8:98:*<.27*7,2*5*?+@*7*=<18:2A.-.-2<8:
8/$%1.8:-1*6*?:,12>.8/$,185*:;129*7-2;<8:@8:68:.27/8:6*<28795.*;.,87<*,<
<6.572,45*?/8:-1*6.-=
87#.,8=:;. 88?7"*@6.7<7-%1.8:<0*0..5<-8?7.;;87;:86 87#.,8=:;. 88?7"*@6.7<7-%1.8:<0*0..5<-8?7.;;87;:86
&7-.:,*92<*52A*<287&7-.:,*92<*52A*<287
8>.:"*0.88<78<.8>.:"*0.88<78<.
∗'2;2<270#.;.*:,1$,185*:&72>.:;2<@8/2,120*7*?$,1885;;2;<*7<":8/.;;8:,*-.62,.7<.:8/
*?=;27.;;#*6*<*7-3=7,<.,<=:.:*:5*7&72>.:;2<@*,=5<@8/*?"1*?
27*7,.*:5*7&72>.:;2<@∗∗'2;2<270$,185*:&72>.:;2<@8/".77;@5>*72**?$,1885
"1,*7-2-*<.*:5*7&72>.:;2<@*,=5<@8/*?(.?8=5-524.<8<1*74-2@*5
#8+.:<*:;4@+:*1*6.552:2*62<<87*>2-*17;;*/*6-*728;1.*:$1.6.;1
'24:*6*-2<@*1*77*$1*586.:7.:#2,1*:-2.+)*2:2;<8427#87*5-*772-.87"*:,1868>;4@.*
"*;.:6*78A./8>:2.#.2,1*>2-$4..5$<./*7%=,4.:*7-<1.9*:<2,29*7<;27<1.:.;.*:,1;.627*:
*<<1.&72>.:;2<@8/2,120*7*?$,1885<1.!;088-B;*55*?$,1885B;77=*5:*-=*<.*?$<=-.7<B;
87/.:.7,.<1.;;8,2*<287/8:*?":89.:<@*7-$8,2.<@$.,87-77=*587/.:.7,.*<.8:0.<8?7
*?.7<.:*7-<1.*?*,=5<@;.627*:*<<1.,*-.62,.7<.:8/*?=;27.;;/8:1.59/=5,866.7<;
*7--2;,=;;287;8>$8586870:*<./=55@*,478?5.-0.;C7*7,2*5;=998:</:86<1.2,120*7:8<2=;
#.;.*:,1.558?;129&72>.:;2<@8/2,120*7*?$,1885<1.$,1=9/8=7-*<287?*:-*7-*:5*7
&72>.:;2<@
%12;*:<2,5.2;*>*25*+5.278:-1*68=:7*58/8:98:*<.27*7,2*5*?1<<9;2:5*?7.</8:-1*6.-=3,D>85
2;;
529
NON-RECOURSE, NO DOWN PAYMENT
AND THE MORTGAGE MELTDOWN:
LESSONS FROM UNDERCAPITALIZATION
Dov Solomon
∗
Odelia Minnes
∗∗
A
BSTRACT
The recent global financial crisis, sparked by developments in the American
mortgage market, provides a timely opportunity for a thorough analysis of
the standard model for financing home purchases. The United States
residential mortgage market has two prominent aspects: first, a significant
part of mortgages are de facto non-recourse loans that allow the borrower to
limit his liability solely to the collateral securing the loan; second,
residential mortgages confer the aforementioned advantage on borrowers
while requiring merely a minimal down payment, or no down payment at
all. This article examines the implications of each of these aspects, as well as
the interplay between them. The findings of this examination lead to the
novel insight that a non-recourse mortgage with no initial down payment
resembles the case of corporate undercapitalization. Utilizing legal analysis
and remedies applied in the case of corporate undercapitalization lends
∗
Visiting Research Scholar, University of Michigan Law School; Assistant Professor,
Academic Center of Law & Business, Ramat Gan; Adjunct Lecturer, Bar-Ilan
University, Faculty of Law; PhD (Law), MBA (Finance), LLB, Bar-Ilan University.
∗∗
Visiting Scholar, University of Pennsylvania Law School (2008-2009); PhD
candidate, LLB, Bar-Ilan University, Faculty of Law. We would like to thank Adi
Ayal, Robert Barsky, Abraham Bell, Miriam Bitton, David Hahn, Assaf Hamdani,
Moshe Har Shemesh, Vikramaditya Khanna, Shalom Lerner, Richard Lieb, Yair
Listokin, Ronald Mann, Gideon Parchomovsky, Lea Paserman-Jozefov, Arie Reich,
David Skeel, Stefan F. Tucker and the participants in the research seminar at the
University of Michigan Law School, the Osgood’s Hall Law School’s Annual Graduate
Law Student’s Conference, the Association for Law, Property, and Society Second
Annual Conference at Georgetown Law Center and the Law Faculty seminar at the
Academic Center of Law & Business for helpful comments and discussions. Dov
Solomon gratefully acknowledges financial support from the Michigan Grotius
Research Fellowship, University of Michigan Law School; the Schupf Foundation
Award; and Bar-Ilan University.
530 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
insight into creating mortgage arrangements that properly balance the
competing interests of the various players in the home ownership credit
market.
TABLE OF CONTENTS
I.
INTRODUCTION
II.
THE AMERICAN HOME MORTGAGE MARKET
A.
NON-RECOURSE MORTGAGES
1. Legislation
2. Theory
B.
NO DOWN PAYMENT REQUIREMENT
III.
THE MORTGAGE MELTDOWN
IV.
UNDERCAPITALIZATION
A.
WHAT IS CORPORATE UNDERCAPITALIZATION?
1. Not Investing or Investing Very Little
2. Investing Money as an Owner’s Loan
B.
THE PROBLEM WITH UNDERCAPITALIZATION
C.
LEGAL REMEDIES IN UNDERCAPITALIZATION
1. Piercing the Corporate Veil
2. Subordination
3. Differences Between Piercing the Corporate Veil and
Subordination
D.
COMPARISONS BETWEEN THE RESIDENTIAL MORTGAGE AND
CORPORATE UNDERCAPITALIZATION
V.
HOME MORTGAGE ARRANGEMENTS: PROPOSED SOLUTIONS
A.
MINIMUM DOWN PAYMENT REQUIREMENT
B.
BORROWER’S LIMITED LIABILITY
C.
RECAP OF PROPOSALS
VI.
CONCLUSION
2011] THE MORTGAGE MELTDOWN: 531
LESSONS FROM UNDERCAPITALIZATION
I.
INTRODUCTION
The recent global financial crisis that emerged from the American
mortgage market meltdown provides a timely opportunity for a thorough
review of home purchase financing. This article investigates the
legislative and practical mortgage arrangements that played a substantial
role in the creation of the housing boom and bust.
The American residential mortgage market has two basic features,
both of which are examined in Part II of this article. First, a large
portion of mortgages, mainly due to states’ foreclosure rules, are de
facto non-recourse loans, meaning they are solely secured by
collateralized assets and impose no personal liability on the borrowers.
1
Non-recourse loans produce a unique risk allocation between the parties.
This is particularly seen when the real estate market falls and,
correspondingly, the value of the collateralized asset drops far below the
outstanding balance on the mortgage.
2
In such a case, the borrower has
a strong incentive to stop paying the loan and “walk away” from his
home even though he may be able to afford his current mortgage
payments.
3
By leaving his house for the lender, the borrower discharges
the loan.
The second basic feature of the residential mortgage market is that
lenders allow borrowers to contribute very minimal down payments on
their mortgage. The relaxation of credit standards is manifested most
1. See The Economic Stimulus and Sustained Economic Growth: Hearing Before
the H. Democratic Steering & Policy Comm. 111th Cong. 3 (2009) (statement of Martin
Feldstein), available at http://www.nber.org/feldstein/EconomicStimulusandEconomic
GrowthStatement.html (“. . . [M]ortgages loans are generally non-recourse loans. . . .
This ‘no recourse’ character of mortgages is unique to the United States.”).
2. The situation in which the home’s current market value drops below the
outstanding balance on the mortgage is referred to as negative equity or “underwater”.
3. Media coverage has shown high concern over the increasing phenomena of
homeowners walking away from their homes. See, e.g., Nicole Gelinas, The Rise of the
Mortgage ‘Walkers’, W
ALL ST. J., Feb. 8, 2008, at A17, available at
http://online.wsj.com/article/SB120243369715152501.html?mod=rss_Today’s_Most_P
opular; Barbara Kiviat, Walking Away From Your Mortgage, T
IME, June 19, 2008,
available at http://www.time.com/time/magazine/article/0,9171,1816472,00.html; Ruth
Simon & James R. Hagerty, One in Four Borrowers Is Underwater, W
ALL ST. J., Nov.
24, 2009, at A1, available at http://online.wsj.com/article_email/SB1259034897
22661849-lMyQjAxMDI5NTI5NDAyMzQ0Wj.html; David Streitfeld, When Debtors
Decide to Default, N.Y.
TIMES, July 25, 2009, at 6, available at http://www.nytimes.
com/2009/07/26/weekinreview/26streitfeld.html.
532 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
dramatically by lenders who allow borrowers to forego down payments
entirely,
4
which is commonly attributed to the prosperity of the
securitization market.
5
Part III of this article examines the implications of both of these
features, as well as the interplay between them. It establishes that the
financing of home purchases through non-recourse mortgages with no
initial down payments directly contributed to the creation of a price
bubble in the real estate market by generating an imbalanced risk
allocation. The availability of relatively riskless and convenient
financing increased demand for housing and created an artificial
appreciation in real estate market prices.
6
This was followed by a steep
decrease in prices catalyzed by homeowners walking away from their
homes. These features played an important role in the events leading to
the continuing meltdown, but have yet to be properly analyzed.
Next, Part IV of this article highlights the parallels between non-
recourse mortgages with no down payments and undercapitalization of a
corporation by its shareholders. This interdisciplinary comparison is
unique and useful, as it may lead to a better understanding of
problematic features. Undercapitalization and non-recourse mortgages,
combined with the lack of down payment requirements, are financing
4. See Joshua Rosner, Housing in the New Millennium: A Home Without Equity is
Just a Rental with Debt 1 (
2001), available at http://ssrn.com/abstract=1162456.
5. See, e.g., Legislative and Regulatory Options for Minimizing and Mitigating
Mortgage Foreclosures: Hearing Before the H. Comm. on Fin. Servs., 110th Cong. 74
(2007) (statement of Ben S. Bernanke, Chairman, Bd. of Governors, Fed. Reserve Sys.)
[hereinafter Mortgage Foreclosure Hearing]; Benjamin J. Keys et al., Did
Securitization Lead to Lax Screening? Evidence from Subprime Loans (EFA 2008
Athens Meetings Paper, 2008), available at http://ssrn.com/abstract=1093137; Luc A.
Laeven et al., Credit Booms and Lending Standards: Evidence from the Subprime
Mortgage Market 1-37 (IMF, Working Paper No. 08/106, 2008), available at
http://ssrn.com/abstract=1153728; Atif R. Mian & Amir Sufi, The Consequences of
Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis (2008),
available at http://ssrn.com/abstract=1072304.
6. See Christopher J. Mayer et al., The Rise in Mortgage Defaults 23 (Fed.
Reserve Bd., Fin. & Econ. Discussion Series, Paper No. 2008-59, 2008), available at
http://www.federalreserve.gov/pubs/FEDS/2008/200859/200859pap.pdf (finding that as
underwriting standards loosened, more new borrowers entered the market, thereby
increasing the demand for housing and, by extension, house prices); Andrey D. Pavlov
& Susan M. Wachter, Underpriced Lending and Real Estate Markets (2006), available
at http://ssrn.com/abstract=980298 (finding that easy access to low-cost financing
stimulates demand and drives up prices above the fundamental values of the underlying
properties).
2011] THE MORTGAGE MELTDOWN: 533
LESSONS FROM UNDERCAPITALIZATION
methods that may induce inefficient behavior by creating incentives to
act while limiting the liability for those actions. Both the shareholder
and the borrower in these situations have an opportunity to engage in a
risky behavior while knowing that their actions will primarily, if not
entirely, impact someone else. In effect, this creates an externalities
problem.
Drawing on insights from the case of corporate undercapitalization,
Part V of this article proposes two alternative ways of administering
residential mortgages. While these solutions resemble those already
utilized in the case of corporate undercapitalization, they also
incorporate the unique characteristics of home purchase financing.
Notably, each proposal addresses a different phase in the mortgage
lifecycle. The first proposal tackles the ex ante phase of the mortgage
lifecycle by requiring a minimum down payment from the borrower who
seeks a non-recourse mortgage. The second proposal is an ex post
solution designed to impose limited personal liability on a borrower who
initially put no money down. These proposals aim to create a system
that forces borrowers to internalize the risks associated with their actions
in order to minimize the probability of borrowers taking out loans with
prior knowledge that they may have difficulty repaying them. They also
moderate the borrower’s incentives to walk away from his home if real
estate market prices decline in the future.
II.
THE AMERICAN HOME MORTGAGE MARKET
The United States residential mortgage market is characterized by
two prevalent features. First, a significant part of mortgages are de facto
non-recourse loans that allow the borrower to limit his liability solely to
the collateral securing the loan. Second, residential mortgages confer
the aforementioned advantage on borrowers while requiring merely a
minimal down payment, or no down payment at all. This Part examines
the implications of each of these aspects, as well as the interplay
between them.
A.
NON-RECOURSE MORTGAGES
A non-recourse mortgage is secured by a pledge of collateral, which
is typically the real estate asset purchased with the mortgage. Several
states’ foreclosure laws have anti-deficiency judgment legislation
534 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
forbidding the lender to seek recourse from the borrower. Non-recourse
mortgages are particularly interesting because they produce a unique
risk allocation between the mortgagor and the mortgagee that is deeply
affected by the market value of the collateralized asset.
1. Legislation
The prevalence of the non-recourse feature in the American home
mortgage market is primarily a result of states’ foreclosure rules.
Approximately ten to twenty states, including foreclosure hot spots such
as California and Arizona,
7
have anti-deficiency judgment legislation,
also known as “non-recourse laws.”
8
Non-recourse laws limit a lender’s
remedy to foreclosure and deprive him of the right to sue the borrower
personally for any deficiency arising from the difference between the
foreclosure sale price and the outstanding balance of the mortgage.
9
For the most part, contemporary anti-deficiency laws represent the
7. California and Arizona lead the top ten list for home sales. See Arizona,
California Markets Lead Top Ten List for Home Sales (Oct. 27, 2009),
http://www.upi.com/Business_News/Real-Estate/2009/10/27/Arizona-California-
Markets-Lead-Top-Ten-List-for-Home-Sales/3731256654866/.
8. See Oren Bar-Gill, The Law, Economics and Psychology of Subprime Mortgage
Contracts, 94 C
ORNELL L. REV. 1073, 1113 (2009); CONG. OVERSIGHT PANEL,
OCTOBER OVERSIGHT REPORT: AN ASSESSMENT OF FORECLOSURE MITIGATION EFFORTS
AFTER SIX MONTHS 157-58 (2009), available at http://cop.senate.gov/reports/
library/report-100909-cop.cfm [hereinafter O
CTOBER OVERSIGHT REPORT]. It is quite a
difficult task to estimate exactly how many states have anti-deficiency laws, as
foreclosure rules vary greatly from state to state. Therefore, scholars disagree on the
number and identity of non-recourse states. See Todd J. Zywicki & Joseph D.
Adamson, The Law and Economics of Subprime Lending, 80 U.
COLO. L. REV. 1, 30
n.134 (2009) (estimating that approximately fifteen to twenty states, including many
large states, have anti-deficiency laws); Andra C. Ghent
& Marianna Kudlyak,
Recourse and Residential Mortgage Default: Theory and Evidence from U.S. States
(Fed. Reserve Bank of Richmond, Working Paper No. 09-10, 2009), available at
http://ssrn.com/abstract=1432437 (classifying eleven states as non-recourse states); Ron
Harris, Recourse and Non-Recourse Mortgages: Foreclosure, Bankruptcy, Policy
(2010), available at http://ssrn.com/abstract=1591524 (stating that ten to fifteen states
are considered non-recourse states). A full list of state foreclosure laws in the United
States is available at http://www.foreclosurelaw.org/. Some Canadian provinces, such
as Alberta, have also enacted anti-deficiency judgment laws. See generally Lawrence
D. Jones, Deficiency Judgments and the Exercise of the Default Option in Home
Mortgage Loans, 36 J.
L. & ECON. 115 (1993).
9. Zywicki & Adamson, supra note 8, at 30-31.
2011] THE MORTGAGE MELTDOWN: 535
LESSONS FROM UNDERCAPITALIZATION
vestiges of debt-relief legislation enacted in the 1930s.
10
During the
Great Depression of the 1930s, the real estate market experienced
tremendous declines in value and there were few buyers at any price.
11
Foreclosing mortgagees made nominal bids at their foreclosure sales,
acquired the borrower’s property for far less than the mortgage debt, and
then obtained deficiency judgments for nearly the full amount of the
debt.
12
This led to a general perception that deficiencies based on
“distressed,” rather than “fundamental,” market values were inequitable
and contributed to the severity of the depression.
13
The prevalence of
this view resulted in a proliferation of state anti-deficiency judgment
legislation.
14
Most state anti-deficiency laws fall into one or more of the
following categories: (1) laws that prohibit the recovery of any
deficiency under a loan secured by residential real estate; (2) laws that
prohibit any deficiency when the mortgage or deed of trust is “purchase
money;” (3) laws that prohibit the recovery of any deficiency following
a non-judicial foreclosure by power of sale; and (4) laws that limit the
deficiency to the difference between the loan balance owing and the
greater of the foreclosure sale price or the fair market value of the
property.
15
In Honeyman v. Jacobs
16
and Gelfert v. National City
Bank,
17
the U.S. Supreme Court affirmed states’ authority to intervene in
mortgage contracts through the enactment of such laws. However,
scholars and policymakers have harshly criticized anti-deficiency laws.
18
10. For an economic analysis of debt-relief legislation, see generally Michael H.
Schill, An Economic Analysis of Mortgagor Protection Laws, 77 V
A. L. REV. 489
(1991).
11. 2 MICHAEL T. MADISON ET AL., THE LAW OF REAL ESTATE FINANCING § 12:69
(rev. ed. 2009).
12. Id.
13. Jones, supra note 8, at 115 n.6.
14. See GRANT S. NELSON & DALE A. WHITMAN, REAL ESTATE FINANCE LAW § 8.3
(5th ed. 2007).
15. The last category of anti-deficiency laws does not deprive the lender entirely of
the right of recourse. Reflecting the lack of uniformity in this area, some states employ
more than one of these categories, while some states combine two or more categories in
the same law. See 2 M
ADISON, supra note 11, § 12:69 - § 12:72.
16. 306 U.S. 539, 543 (1939).
17. 313 U.S. 221, 231 (1941).
18. Congressman Jeb Hensarling claimed that “homeowners have become aware of
the economic implications arising from applicable ‘anti-deficiency’ and ‘single-action’
laws and other rules adopted in many states that permit, if not indirectly encourage,
536 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
Most of the critiques of these laws examine them from an ex post
perspective, finding that they create high costs that are passed on to
borrowers without generating any substantial benefits for them.
19
Even in states that lack non-recourse legislation, homeowners do
not always face the risk of a deficiency judgment. Some public
authorities, such as the Federal Housing Administration (“FHA”), have
long-standing policies of substantial forbearance and waiver of
deficiencies.
20
Because it is often costly and time-consuming to pursue a
defaulting borrower, deficiency judgments may be rare in practice, even
in the private sector.
21
This is particularly true in states where lenders
are overwhelmed with foreclosures.
22
Moreover, borrowers may be
judgment-proof because of a general lack of other assets, especially if
the borrower made little or no down payment because of an absence of
homeowners to avoid their contractual mortgage obligations.” See OCTOBER
OVERSIGHT REPORT, supra note 8, at 157.
19. See, e.g., Mark Meador, The Effects of Mortgage Laws on Home Mortgage
Rates, 34 J.
ECON. & BUS. 143, 146 (1982) (finding that the existence of an anti-
deficiency law increases the interest rate charged on loans secured by newly constructed
homes by 13.87 basis points, and for loans secured by existing homes, Meador
estimates that anti-deficiency laws increase the interest rate by 22.65 basis points);
Susan E. Woodward, A Study of Closing Costs for FHA Mortgages, 2008 U.S.
DEP’T OF
HOUS. & URBAN DEV. 50-52, available at http://www.huduser.org/Publications/
pdf/FHA_closing_cost.pdf (finding that the nonrecourse legal regime raises costs to
borrowers by $550 per $100,000 of loan amount); Brent W. Ambrose & Anthony B.
Sanders, Legal Restrictions in Personal Loan Markets, 30 J.
REAL ESTATE FIN. & ECON.
133, 149 (2005) (finding that borrowers in states that prohibit deficiency judgments pay
higher credit costs on high LTV mortgages by about 33 basis points). But see Schill,
supra note 10.
20. See John Mixon, Fannie Mae/Freddie Mac Home Mortgage Documents
Interpreted as Nonrecourse Debt (with Poetic Comments Lifted from Carl Sandburg),
45 C
AL. W. L. REV. 35, 39-40 (2008); Jones, supra note 8, at 118; see also Ghent &
Kudlyak, supra note 8, at 3.
21. Steven Wechsler, Through the Looking Glass: Foreclosure by Sale as De Facto
Strict Foreclosure: An Empirical Study of Mortgage Foreclosure and Subsequent
Resale, 70 C
ORNELL L. REV. 850, 878 (1985) (finding that “of the ninety-four studied
cases in which the foreclosure sale left a deficiency amount, the mortgagee obtained a
deficiency judgment in only one case, and in that case the judgment was not satisfied”);
Vikas Bajaj, Mortgage Holders Find It Hard to Walk Away from Their Homes, N.Y.
TIMES, May 10, 2008, at C1, available at http://www.nytimes.com/2008/05/10/
business/10housing.html?pagewanted=1&_r=1.
22. Brent T. White, Underwater and Not Walking Away: Shame, Fear and the
Social Management of the Housing Crisis, 45 W
AKE FOREST L. REV. 971, 985 (2010).
2011] THE MORTGAGE MELTDOWN: 537
LESSONS FROM UNDERCAPITALIZATION
funds.
23
Therefore, filing an action for deficiency often is not cost
effective for the lender, and mortgages consequently become de facto
non-recourse loans.
24
2. Theory
A non-recourse mortgage is a mortgage secured solely by a pledge
of collateral, which is typically the real estate asset purchased with the
mortgage. This structure allows the borrower to avoid personal liability
on the mortgage. Traditionally, personal liability of the mortgagor was
essential to the classical common law mortgage.
25
However, modern
legal systems acknowledge the possibility of a mortgage without a
mortgagor’s personal liability for the debt.
26
If a borrower defaults, the
lender is limited to repayment only by foreclosure of the mortgage.
Even if the foreclosure sale yields only a fraction of the total outstanding
mortgage, the lender is not able to sue the borrower personally for
repayment from the borrower’s unsecured personal assets and future
income. Moreover, the borrower has no obligation to pay the deficiency
even in circumstances where he has the financial ability to make the
payment.
Non-recourse mortgages produce a unique risk allocation between
the mortgagor and the mortgagee that is deeply affected by the market
value of the collateralized asset.
27
When the price of the real estate asset
rises and its current market value is higher than the outstanding balance
on the mortgage, the borrower has an incentive to continue paying the
lender. However, when the real estate market falls and the value of the
asset drops far below the present value of mortgage payments, i.e. the
23. Zywicki & Adamson, supra note 8, at 30.
24. Bar-Gill, supra note 8, at 1113.
25. GEORGE E. OSBORNE, HANDBOOK ON THE LAW OF MORTGAGES 156-157 (2d ed.
1970).
26. See RESTATEMENT (THIRD) OF PROP.: MORTGAGES § 1.1 (1997) (“A mortgage is
a conveyance or retention of an interest in real property as security for performance of
an obligation. A mortgage is enforceable whether or not any person is personally liable
for that performance.”);
NELSON & WHITMAN, supra note 14, § 2.1.
27. Non-recourse mortgage is a method by which lenders indirectly invest in the
real estate market while trying to predict future fluctuations. This type of loan is offered
by lenders based on estimations regarding the future value of the asset. In situations
where the value of the asset eventually declined, the lender’s estimation was incorrect,
and it was not able to predict what would happen next.
538 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
borrower is “underwater,” the borrower has a strong incentive to stop
paying the loan, leave the asset to the lender
28
and become a renter.
29
By
merely sending the keys of his home to the lender, the borrower
discharges the loan and is no longer liable for the debt. This
phenomenon is known as a “strategic default.”
30
The risk allocation between the parties in a non-recourse mortgage
is markedly different from the risk allocation between the parties in a
mortgage arrangement that provides the lender with a right of recourse
against the borrower.
31
Notably, in a period of falling real estate market
prices, a borrower with a recourse mortgage is less likely to stop paying
the loan and walk away from his home because after foreclosure he still
will be liable for the difference between the full amount of the debt and
the foreclosure sale proceeds. If those sale proceeds do not satisfy the
mortgage obligation, the lender may obtain a deficiency judgment for
the balance. Therefore, the defaulting borrower faces the risk of losing
personal assets if the lender comes after him with a deficiency
judgment.
32
Thus, it makes more sense for a borrower to try to meet
28. See, e.g., John M. Quigley & Robert Van Order, Explicit Tests of Contingent
Claims Models of Mortgage Default, 11 J.
REAL ESTATE FIN. & ECON. 99, 106 (1995)
(indicating that negative equity is strongly associated with higher default rates); see
also, Adam J. Levitin, Resolving the Foreclosure Crisis: Modification of Mortgages in
Bankruptcy, 2009 W
IS. L. REV. 565, 639-640 (arguing that in the case of non-recourse
mortgage, walking away is an attractive option for a homeowner with negative equity
who can find a better rental deal elsewhere).
29. Theoretically, the borrower may prefer to buy a new house. But walking away
from his current home and declining to repay the mortgage will affect his credit score,
and most, if not all, financial institutions will refuse to grant him a new loan until his
credit score improves. Thus, if the borrower would like to buy a new house, he needs to
get a new mortgage before he would default on his current mortgage and cause damage
to his credit score. Therefore, in most of these situations, the borrower will be inclined
to rent a different house, rather than buying one. See Levitin, supra note 28, at 640 &
655 n.265.
30. See Kenneth R. Harney, Homeowners Who ‘Strategically Default’ on Loans a
Growing Problem, L.A.
TIMES, Sept. 20, 2009, available at http://www.latimes.com/
classified/realestate/news/la-fi-harney20-2009sep20,0,2560658.story (identifying the
characteristics and debt management behavior of strategic defaulters).
31. The customary mortgage arrangement in many jurisdictions throughout the
world includes the lender’s right of recourse to the borrower. See Harris, supra note 8,
at 13 (arguing that in most countries, including Japan, Australia, Canada, Israel and
European Countries, recourse loans are the common practice).
32. The personal assets of the borrower that the lender is able to put his hands on
through a deficiency judgment include the borrower’s future income. See also 11
2011] THE MORTGAGE MELTDOWN: 539
LESSONS FROM UNDERCAPITALIZATION
mortgage payments to prevent foreclosure, as opposed to defaulting,
paying rent for a new house, and still repaying the outstanding debt on
the foreclosed mortgage. Having personal liability for the debt, a
borrower with a recourse mortgage bears much greater risks than a
borrower with a non-recourse mortgage. Empirical studies have
confirmed that the default rate on residential mortgages in states that
allow lenders recourse to the borrowers is much lower than the default
rate in non-recourse states.
33
The lower default rate results from the
deterrent effect of recourse, which stems from the lender’s ability to
pursue a defaulting borrower with a deficiency judgment.
34
The decision of a borrower to default on a non-recourse mortgage is
analogous to an implicit option written by the lender and held by the
borrower.
35
Default may be viewed as a put option that gives the
borrower the right to terminate his mortgage obligation by transferring
the collateral property to the lender.
36
The borrower’s exercise of the
U.S.C. § 1322(a)(1) (2006) (stating that the debtor in a chapter 13 case will file a plan
under which he will provide for the submission of all or a portion of his future earnings
or income).
33. See Jones, supra note 8 (analyzing data from two Canadian provinces: Alberta,
which does not permit deficiency judgments, and British Columbia, which permits
deficiency judgments, and finding that defaults in Alberta are more likely to be due to
deliberate defaults than because of trigger events in the borrower’ lives); Ghent
&
Kudlyak, supra note 8 (comparing defaults in states with and without non-recourse
mortgages, the researchers find that a borrower with negative equity is more likely to
default in a non-recourse state); Zubin Jelveh, When Banks Can’t Go After Defaulters,
N
EW REPUBLIC, July 13, 2009, available at http://www.tnr.com/blog/the-stash/when-
banks-cant-go-after-defaulters (finding that the correlation between price declines and
foreclosures is much stronger in non-recourse states than in recourse ones).
34. Analyzing the deterrent effect of recourse on residential mortgage default
probability, Ghent and Kudlyak find that the magnitude of the deterrent effect of the
lender’s ability to go after a borrower is closely tied to the borrower’s wealth and that
deterrent effect increases with borrowers who have more assets to protect. See Ghent
&
Kudlyak, supra note 8, at 24-25.
35. An option represents a contingent claim that will be exercised under certain
states of the economy but not otherwise. See Yongheng Deng et al., Mortgage
Terminations, Heterogeneity and the Exercise of Mortgage Options, 68 E
CONOMETRICA
275 (2000).
36. A different way of terminating the mortgage early is by prepayment.
Prepayment occurs when the loan is paid in full prior to maturity. It may be viewed as a
call option that allows the borrower to buy back the remaining mortgage payments from
the lender at the prevailing mortgage rate. For a recent review of literature dealing with
mortgage termination risk, see Michael LaCour-Little, Review Articles: Mortgage
540 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
embedded put option in a non-recourse mortgage is a virtual selling of
the collateralized house to the lender at the amount of the outstanding
loan. Option theory, as applied to the behavior of homeowners with
mortgages, predicts that mortgage default will be exercised if the put
option is “in-the-money” by some specific amount, i.e. negative
homeowner equity.
37
Although negative equity is a strong incentive for strategic default,
several economic and non-economic factors may also play a role.
38
As
far as the primary residence is concerned, walking away from the
property involves pecuniary and non-pecuniary relocation costs, such as
difficulty in renting or buying a new home, moving expenses, change of
school for any children in the household, and loss of social relationships
in the community (unless one can relocate around the corner).
39
Additionally, a mortgage default will appear on the borrower’s credit
history and likely will ruin his credit score, thereby negatively impacting
his future ability to borrow and engage in various financial activities.
40
Individuals may have moral considerations that affect their willingness
to default. Some individuals may perceive default as unethical or
irresponsible and thus something to avoid if not at all costs, then at some
Termination Risk: A Review of the Recent Literature, 16 J. REAL ESTATE LITERATURE
297 (2008).
37. See Deng et al., supra note 35, at 284.
38. See Levitin, supra note 28, at 638.
39. To add to these costs, there is some specificity in the housing stock. Most
people remodel their house to fit their needs. After this remodeling they are likely to
pay a premium for their house in respect to a similar house with the same general
characteristics. See Luigi Guiso et al., The Determinants of Attitudes Towards Strategic
Default of Mortgages (NBER, Working Paper No. w15145 and CEPR Discussion,
Paper No. DP7352, 2009), available at http://www.kellogg.northwestern.edu/faculty/
sapienza/htm/Guiso_Sapienza_Zingales_StrategicDefault.pdf.
40. See Bajaj, supra note 21. Foreclosure of a mortgage may cause an immediate
hit to the borrower’s rating score of 140 to 150 points on a Vantage scale, plus a
negative mark on the credit bureau files for up to seven years. See Kenneth R. Harney,
Delinquency and Credit Scores,
WASH. POST, Sept. 12, 2009, available at
http://www.washingtonpost.com/wp-yn/content/article/2009/09/10/
AR2009091004532.html. While the actual financial cost of having a poor credit score
for a few years may be hard to quantify, it is not likely to be significant when compared
to the savings from walking away from a seriously significantly underwater mortgage.
See White, supra note 22, at 983-985. Moreover, in light of the widespread nature of
defaults and foreclosures in the current crisis, future lenders may discount the impact of
this adverse event in comparison to prior eras. See Zywicki & Adamson, supra note 8,
at 32.
2011] THE MORTGAGE MELTDOWN: 541
LESSONS FROM UNDERCAPITALIZATION
significant cost.
41
Finally, even “amoral” people may choose not to
default, even if it is in their narrow economic interest, because of the
social costs associated with this decision. For example, defaulting
strategically on a mortgage may lead to social stigma.
42
Empirical evidence indicates that a strong correlation exists
between the size of a borrower’s negative equity and the propensity of
homeowners to walk away from their homes and mortgages. Given the
aforementioned considerations that make default unappealing, borrowers
are unlikely to default when the portion of negative equity in their home
is small. However, when the portion of negative equity increases, the
borrower’s readiness to default on the mortgage is significantly higher.
43
B.
NO DOWN PAYMENT REQUIREMENT
Traditionally, homebuyers were required to put “down” a
significant amount of money as payment for a home. In order to reduce
the risk of potential default, lenders in the American mortgage market
customarily required borrowers to put down a minimum down payment
of 20% of a home’s total value.
44
Such a requirement created a so-called
“equity cushion,” which was meant to absorb the initial losses resulting
from a decline in home prices. Specifically, this financing arrangement
sought to prevent homeowner equity from becoming negative, so that
default would never be an “in-the-money” option.
45
However, the requirement that homebuyers make significant down
payments was eliminated in the 1990s.
46
At around the same time,
lenders began offering loans with high loan-to-value (“LTV”) ratios,
41. Guiso et al., supra note 39, at 6.
42. Id. at 7.
43. See id. at 9 (finding, when assessing the propensity of American households
who have negative equity in their home to default strategically, that the willingness to
default is clearly increasing over the relative value of the equity shortfall, with only
4.7% of the people willing to default when the shortfall is 10% of the value of the house
and 11.4% when this is between 40% and 50%. Moreover, not only the relative value,
but also the absolute value matters. Per given relative value of a shortfall, roughly 7%
more households are willing to default when the shortfall is $100,000 instead of
$50,000).
44. See Bar-Gill, supra note 8, at 1076.
45. See White, supra note 22, at 1008.
46. See Rosner, supra note 4, at 7-8 (describing the relaxation of credit standards in
the 1990s, including the drastic reduction of minimum down payment levels from 20%
to 0%).
542 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
thus enabling prospective homeowners to borrow up to the full purchase
price of a house.
47
Higher LTV ratios at origination correlate with
higher probabilities of negative equity and default at the termination of
the mortgage.
48
Lenders, however, failed to appreciate the impact of
positive equity on lowering the risk of mortgage default rates.
49
To be sure, no-money-down loans surged in popularity in the
2000s. In many cases, home purchases became highly leveraged
transactions with borrowers taking out a second mortgage without
having to put any money down.
50
The median
51
combined LTV ratio for
subprime purchase loans (including first and second mortgages)
increased from 90 percent in 2003, to 100 percent from 2005 to 2007.
These statistical figures suggest that during the latter stages of the
housing bubble, approximately half of borrowers with subprime
mortgages did not put any money down on their respective home
purchases.
52
The relaxation of credit standards, as evidenced by lenders tacitly
47. The elimination of the down payment requirement has made homeownership
accessible to Americans who previously were forced to rent because of insufficient
funds. According to the Federal Deposit Insurance Corporation, for example, American
homeownership rates stood at 68.9% in 2005 as compared to 63.9% two decades
earlier. See Greg Griffin et al., No money down: A High-Risk Gamble, Denver Post,
Sept. 17, 2006, available at http://www.denverpost.com/ci_4347686; see also U.S.
Census Bureau, Housing Vacancies and Homeownership: Historical Tables, tbl. 14,
http://www.census.gov/hhes/www/housing/hvs/historic/index.html (last visited Oct. 6,
2010) (compiling homeownership rates for the U.S. from 1965 to the present).
48. See, e.g., Deng et al., supra note 35. See also Griffin, et al., supra note 47
(reporting that more than half of all foreclosures on home purchases in August 2006
involved no-down-payment loans).
49. See White, supra note 22, at 1008.
50. Within the home lending industry, second mortgages are commonly referred to
as “piggyback” mortgages. The share of subprime originations with a piggyback rose
from 7% to 28% in the years spanning 2003 through 2006, whereas the share of Alt-A
mortgages with a piggyback rose from 12% to 42% during the same period. See Mayer
et al., supra note 6, at 6.
51. In the field of statistics, the median represents the middle numerical value in a
distribution set.
52. See Mayer et al., supra note 6, at 6; see also Tomoeh Murakami Tse, Down
Payments’ Downward Trend, W
ASH. POST, Jan. 21, 2006, at F1, available at
http://www.washingtonpost.com/wp-dyn/content/article/2006/01/20/
AR2006012000803.html (explaining that from August 2004 through July 2005 more
than four out of every ten first-time homebuyers financed their purchases with no-
down-payment loans).
2011] THE MORTGAGE MELTDOWN: 543
LESSONS FROM UNDERCAPITALIZATION
encouraging borrowers to take out no-money-down loans, can be
attributed to a host of factors.
53
Most markedly, the burgeoning
securitization market permitted lenders to assign to third- and fourth-
parties the default risks associated with mortgages.
54
Under this
complex assignment process, parties could neither foresee nor insulate
themselves from the effects of the ensuing subprime mortgage crisis.
55
Securitization is one of the most important financial tools in a
modern economy.
56
It enables a company, the “originator,” to use its
assets that produce a predictable cash flow to achieve interim financing
for its business activity.
57
The securitization process is based on
separating specific receivables from the originator’s other assets and
selling them to a Special Purpose Vehicle (“SPV”). The SPV finances
the purchase of the receivables by issuing Asset-Backed Securities
(“ABS”) (i.e., securities that are backed by the receivables).
58
The cash
flow produced by the securitized receivables is used as the source of
funds to pay the investors in the ABS.
59
The practice of securitization emerged from the sale of securities
53. Arguably, one such factor was the intense competition amongst banks. See
generally Jacob A. Bikker et al., Misspecification in the Panzar-Rosse Model:
Assessing Competition in the Banking Industry, (De Nederlandsche Bank, Working
Paper No. 114, 2006), available at http://www.dnb.nl/binaries/Working%
20Paper%20114-2006_tcm46-146771.pdf (exploring competition in the banking
sector).
54. See Mortgage Foreclosure Hearing, supra note 5; Mian & Sufi, supra note 5;
Keys et al., supra note 5; Laeven et al., supra note 5.
55. For a discussion of how the complexity in modern financial markets acts as a
catalyst of market failure, see Steven L. Schwarcz, Regulating Complexity in Financial
Markets, 87 W
ASH. U. L. REV. 211 (2009).
56. Lynn M. LoPucki, The Death of Liability, 106 YALE L.J. 1, 24 (1996); Thomas
E. Plank, Bankruptcy Professionals, Debtor Dominance, and the Future of Bankruptcy:
A Review and a Rhapsody on a Theme, 18 B
ANKR. DEV. J. 337, 362 (2002) (reviewing
D
AVID A. SKEEL, JR., DEBT’S DOMINION: A HISTORY OF BANKRUPTCY IN AMERICA
(2001)); Edward M. Iacobucci & Ralph A. Winter, Asset Securitization and Asymmetric
Information, 34 J.
LEGAL STUD. 161, 162 (2005).
57. Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 STAN. J.L. BUS. &
FIN. 133, 135 (1994); The Comm. on Bankr. & Corp. Reorganization of the Ass’n of
the Bar of the City of N.Y., Structured Financing Techniques, 50 B
US. LAW. 527, 529
(1995); Robert Stark, Viewing the LTV Steel ABS Opinion in its Proper Context, 27 J.
CORP. L. 211, 213 (2002).
58. Iacobucci & Winter, supra note 56, at 164.
59. Joseph C. Shenker & Anthony J. Colletta, Asset Securitization: Evolution,
Current Issues and New Frontiers, 69 T
EX. L. REV. 1369, 1376 (1991).
544 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
backed by residential mortgages.
60
Banks usually sell their mortgages to
SPVs that issue Residential Mortgage-Backed Securities (“RMBS”) to
the public.
61
In fact, nowadays, most subprime mortgages in the United
States are securitized.
62
The mortgage market is often divided into primary and secondary
markets. In the primary market, loan applications are submitted, interest
rates are quoted, applications are underwritten, property is appraised,
and transactions are closed. The securitization process transforms non-
liquidated residential mortgages that originate in the primary market into
RMBS that can be traded in the secondary market and realized at a
specific market value. After selling the mortgages to the SPVs, the
banks that originated the mortgages in the primary market do not
participate in the trade between investors in the secondary market.
Rather, RMBS investors continuously trade amongst themselves. Thus,
the secondary mortgage market makes it possible to bypass the financial
institution’s mediation process.
63
The process of mortgage securitization permits lenders to detach
themselves from the potential default risks attached to the mortgages
they created by assigning these risks to the RMBS investors.
Furthermore, these loans are securitized as part of a pool of assets, such
that the risk associated with each individual loan is not separately and
thoroughly examined.
64
Because lenders are detached from the
outcomes of their lending practices, they are able to position themselves
to offer subprime mortgages
65
with the knowledge that they will not bear
the loss of any default that may occur.
66
This structure shifts default risk
60. For a historical overview of the development of the mortgage-backed securities
market in the United States, see id. at 1383-88
.
61. Jennifer E. Bethel et al., Legal and Economic Issues in Litigation Arising from
the 2007-2008 Credit Crisis, in P
RUDENT LENDING RESTORED: SECURITIZATION AFTER
THE MORTGAGE MELTDOWN 163, 163-235 (Yasuyuki Fuchita, Richard J. Herring &
Robert E. Litan eds., 2009).
62. Kathleen C. Engel & Patricia A. McCoy, Turning a Blind Eye: Wall Street
Finance of Predatory Lending, 75 FORDHAM L. REV. 2039, 2040 (2007).
63. See Andrew R. Berman, “Once a Mortgage, Always a Mortgage” – The Use
(and Misuse of) Mezzanine Loans and Preferred Equity Investments, 11 S
TAN. J.L. BUS.
& FIN. 76, 77-78 (2005).
64. See Schwarcz, supra note 55, at 229 n.98.
65. For empirical study which observes a higher growth of securitization in areas
with higher rate of subprime borrowers, see Mian & Sufi, supra note 5.
66. Even though in the process of providing credit enhancements the lender
(through an affiliate) often buys securities in the subordinated tranches, and, therefore,
2011] THE MORTGAGE MELTDOWN: 545
LESSONS FROM UNDERCAPITALIZATION
to the investors in the capital market and the economy as a whole.
III. T
HE MORTGAGE MELTDOWN
After highlighting two distinctive features of the American
residential mortgage market, non-recourse loans and no-down-payment
requirements, we move on to examine how these features contributed to
the creation of the recent housing boom and bust. Indeed, scholars have
begun to analyze each of these features separately and recognize the
independent role each played in the mortgage meltdown.
67
This article
goes beyond those analyses and focuses on the negative consequences
and legal implications that resulted from the combination of these two
features.
Our claim is that customary mortgage arrangements directly
contributed to the creation of the price bubble in the real estate market
by generating an imbalanced risk allocation. Financing home purchases
through non-recourse mortgages, combined with the practice of not
requiring an initial down payment, insufficiently deterred borrowers
supposedly retains the riskiest securities, outside investors (principally real estate
investment trusts, hedge funds, and overseas investors) buy many of these so-called
“residuals” (some at the time of offering and others through later secondary market
resales). In addition, lenders can resell their subprime residuals to outside investors
through bonds known as “Collateralized Debt Obligations” (CDOs). A central purpose
of residuals is to force lenders to retain the bulk of the credit risk they create. However,
when lenders with subprime residuals shift them off their books through CDOs, they are
able to escape the market discipline that residuals were meant to exert. See Engel &
McCoy, supra note 62, at 2065-68.
67. See Mayer et al., supra note 6, at 16 (“The rise in combined loan-to-value ratios
suggests that lower down payments and an increased use of second liens could have
been important contributors to the mortgage crisis.”); Martin Feldstein, How to Save an
‘Underwater’ Mortgage, W
ALL ST. J., Aug. 7, 2009, available at http://online.wsj.com/
article/SB10001424052970204908604574330883957532854.html (“No-recourse
mortgages increase foreclosures, resulting in more properties being thrown on the
market, and lead to an excess decline in house prices.”); Harris, supra note 8, at 2-3
(“More scholars now realize that this feature plays an important role in the unfolding of
the subprime crisis . . . . It seems that the prevalence of non-recourse mortgages leads to
more foreclosures, a slump in home prices, losses to lenders and holders of mortgage-
backed-securities (MBS), and has spurred the economic crisis.”); Kris Gerardi et al.,
Did Nonrecourse Mortgages Cause the Mortgage Crisis?, F
ED. RESERVE BANK OF
ATLANTA, Feb. 18, 2010, http://realestateresearch.frbatlanta.org/rer/2010/02/did-
nonrecourse-mortgages-cause-the-mortgage-crisis.html.
546 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
from taking loans while being indifferent in regards to their ability to
fulfill their terms. This mortgage practice created a moral hazard on the
part of borrowers and encouraged irresponsible borrowing, the
counterpart to irresponsible lending.
68
The described situation, in which
there is a dual lack of liability both ex ante (no down-payment) as well
as ex-post (non-recourse), produced inefficient results and externalities.
With no personal equity at stake and no exposure to personal liability,
the demand for real estate, along with real estate market prices,
increased.
69
Thus, price appreciation had almost nothing to do with the
assets themselves and was quite artificial.
70
Rather, it was more
attributable to the availability of relatively riskless and overly
convenient funding options.
When borrowers could not pay their debts because the original
loans they received were unaffordable,
71
lenders were forced to take
control of the assets and sell them to recover from the default.
72
The
vast increase in the number of foreclosed homes on the market spawned
a decline in real estate prices.
73
While home prices were dropping, many
68. Ankoor Jain & Cally Jordan, Diversity and Resilience: Lessons from the
Financial Crisis, 32 U.N.S.W.L.J. 416, 440 (2009); Schill, supra note 10, at 534.
69. The New York Federal Reserve has a plan to provide non-recourse loans as an
incentive to the borrowers. See Steve Waldman, Non-Recourse Loans: Positively
Counterproductive, S
EEKING ALPHA (Feb. 22, 2009), http://seekingalpha.com/article/
121916-non-recourse-loans-positively-counterproductive. From this policy, one can
understand that non-recourse loans are perceived as borrower-friendly loans.
70. See Pavlov & Wachter, supra note 6.
71. Some borrowers were unable to cope with the increase in monthly payments
that occurred when the interest rates on their adjustable-rate mortgages automatically
reset. See Feldstein, supra note 67.
72. See James R. Hagerty, Defaults Rise on Home Mortgages Insured by FHA,
W
ALL ST. J., Mar. 31, 2009, at A2, available at http://online.wsj.com/article_email/
SB123840821794969275-lMyQjAxMDI5MzM4MDQzMDA4Wj.html. In the end of
February 2009, the Federal Housing Administration (FHA) reported that 7.5% of the
loans it insured (which are now approximately one third of the loans) were seriously
delinquent. This term refers to loans that are 90 days or more overdue, in the
foreclosure process or in bankruptcy. To note, FHA insured loans are available in loans
with a down payment as small as 3.5% of the home’s value. Id.
73. For a nationwide study that shows the impact of foreclosure sales on home
prices, see Press Release, Lender Processing Services, LPS Releases Study That
Demonstrates Impact of Foreclosure Sales on Home Prices (Sept. 3, 2009), available at
http://www.lpsvcs.com/NewsRoom/Pages/20090903.aspx. See also C
ONG. OVERSIGHT
PANEL, THE FORECLOSURE CRISIS: WORKING TOWARD A SOLUTION 9 (2009), available
at http://cop.senate.gov/reports/library/report-030609-cop.cfm [hereinafter C
ONG.
2011] THE MORTGAGE MELTDOWN: 547
LESSONS FROM UNDERCAPITALIZATION
borrowers who had not been required to make an initial down payment
at origination found themselves with substantial negative equity in their
homes.
74
Ultimately, the borrower’s incentive to care for his property
decreased substantially.
75
Homeowners with substantial negative equity
reasoned that any money they might have invested in their properties,
such as money for basic repairs, did not substantially add to their equity;
rather it was a value that accrued to the lenders in terms of increased
collateral value. Therefore, homeowners were less willing to invest in
maintenance and improvements for their properties, which further
decreased property values in a vicious circle.
76
Moreover, the steep decline in housing prices increased both the
number of homeowners with negative equity and the measure of that
negative equity. Consequently, it was rational for an increased number
of homeowners with substantial negative equity to default on their
OVERSIGHT PANEL REPORT]. A single foreclosure can depress the eighty closest
neighbors’ property values by nearly $5,000. When multiple foreclosures happen on a
block or in a neighborhood, the effect is exponential. Id.
74. For data showing that the proportion of American borrowers who had negative
equity in their homes in the third quarter of 2009 swelled to about 23%, see Press
Release, First American Core Logic, The Negative Equity Report: State-by-State
Estimates for U.S. Single-Family Residential Properties (Nov. 24, 2009), available at
http://www.facorelogic.com/newsroom/marketstudies/negative-equity-report.jsp.
According to this report, nearly 10.7 million residential properties with mortgages were
in negative equity as of September 2009. An additional 2.3 million mortgages were
approaching negative equity, meaning they had less than 5% equity. Together, negative
equity and near negative equity mortgages account for nearly 28% of all residential
properties with a mortgage nationwide. Id. See also G
LOBAL MKTS. RESEARCH,
DROWNING IN DEBT – A LOOK AT “UNDERWATER” HOMEOWNERS 2 (2009), available at
http://www.sacbee.com/static/weblogs/real_estate/Deutsche%20research%20on%20und
erwater%20mortgages%208-5-09.pdf (estimating that 14 million American
homeowners had negative equity as of the end of the first quarter of 2009, and
projecting that 25 million homeowners will have negative equity by the first quarter of
2011).
75. Levitin, supra note 28, at 640. Even when the homeowner’s equity is positive,
his incentives to maintain his house are decreased in a non-recourse state. Because the
lender cannot pursue the borrower’s non-housing wealth, the borrower has less to lose
in the event of a default, so he has diminished incentives to reduce the likelihood that
the market value of the house would fall below the mortgage balance. See John
Harding et al., Deficiency Judgments and Borrower Maintenance: Theory and
Evidence, 9 J.
HOUS. ECON. 267 (2000).
76. OCTOBER OVERSIGHT REPORT, supra note 8, at 11.
548 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
mortgages
77
and walk away from their houses.
78
Borrowers stopped
paying off their loans when their home equity was negative, even if they
did not have cash flow problems.
79
They simply sent their house keys to
the lenders who then had to sell the homes to recover from the defaults.
The increasing supply of homes for sale in a falling market drove down
home prices even further, resulting in the continuous tailspin of
American housing prices since 2006.
80
It follows, then, that mortgage lending practices induced negative
results both ex ante and ex post. They induced negative results ex ante
by creating incentives for borrowers to commit to loan agreements that
they might not be able to fulfill. Additionally, they induced negative
results ex post by making the option to walk away from one’s home an
attractive alternative for borrowers with negative equity, even when they
might have been able to afford their current mortgage payments.
Notably, these results are not to be blamed solely on the subprime
borrowers, as the incentives described might very well have influenced
borrowers who would not have otherwise been considered risky.
81
77. See CONG. OVERSIGHT PANEL REPORT, supra note 73, at 23-30 (identifying
negative equity as the single best predictor of mortgage default); Jain & Jordan, supra
note 68 (“In a time of falling house prices and negative equity, it is only logical for
homeowners to walk away from their houses (and their mortgage payments) and send
the keys back to the lender.”).
78. For the high concern over the increasing phenomena of homeowners walking
away from their homes, see supra note 3.
79. Guiso et al., supra note 39 (finding that 26% of the existing defaults are
strategic and asserting that a non-negligible portion of mortgage defaults in the United
States are in fact strategic). Compare Ghent
& Kudlyak, supra note 8 (finding that in
non-recourse states, borrowers default strategically by dumping homes that are worth
far less than what they owe, even if they can afford the mortgage payments due), with
Christopher L. Foote et al., Negative Equity and Foreclosure: Theory and Evidence, 64
J.
URB. ECON. 234 (2008) (concluding, based on their analysis of Massachusetts data,
that negative equity is a necessary but not a sufficient condition for default; however,
Massachusetts is a recourse state and the borrower’s decision to default in recourse
states is substantially less sensitive to negative equity than in non-recourse states).
80. House prices in the United States rose at an average annual rate of 11% from
2000 through 2005, stagnated, and then fell at an average annual rate of 10% from mid-
2006. See Mayer et al., supra note 6, at 21.
81. Stan Liebowitz, New Evidence on the Foreclosure Crisis: Zero Money Down,
Not Subprime Loans, Led to the Mortgage Meltdown, W
ALL ST. J., July 3 2009, at A13,
available at http://online.wsj.com/article/SB124657539489189043.html (“[T]he focus
on subprimes ignores the widely available industry facts (reported by the Mortgage
Bankers Association) that 51% of all foreclosed homes had prime loans, not subprime,
2011] THE MORTGAGE MELTDOWN: 549
LESSONS FROM UNDERCAPITALIZATION
IV. U
NDERCAPITALIZATION
This part shifts our discussion to the issue of corporate
undercapitalization and highlights its parallels with the previously
discussed residential mortgage issues. It examines the case of
undercapitalization and the legal remedies available when such
undercapitalization occurs.
Before delving into undercapitalization, it is important to discuss
the concept of shareholders’ limited liability for corporate debts,
82
one of
corporate law’s fundamental principles.
83
This principle flows from the
legal structure of the corporate entity, which separates the company, the
legal entity, from its shareholders, who act as independent entities. As a
separate entity, the company carries its own obligations and possesses its
own rights. Under the limited liability rule, a shareholder risks only the
value of her investment in the corporation.
84
Thus, in the event that the
company fails, the shareholder has no personal obligation to pay the
corporate debts if the corporation cannot satisfy them.
85
Legal treatises on corporate law identify limited liability as a basic
principle on which the business world is founded.
86
The principle is
justified by the claim that it encourages entrepreneurship and business
activities,
87
which, in turn, increase the total level of societal welfare.
88
and that the foreclosure rate for prime loans grew by 488% compared to a growth rate
of 200% for subprime foreclosures.”).
82. See Merrick Dodd, The Evolution of Limited Liability in American Industry:
Massachusetts, 61 H
ARV. L. REV. 1351 (1948).
83. See, e.g., United Elec., Radio & Mach. Workers v. 163 Pleasant St. Corp., 960
F.2d 1080, 1091
(1st Cir. 1992) (“. . . a pillar of corporate law.”).
84. See Smith Setzer & Sons, Inc. v. S.C. Procurement Review Panel, 20 F.3d
1311, 1317 (4th Cir. 1994) (“[T]he shareholders of a corporation limit their exposure to
direct personal liability to the value of their shares.”).
85. See Henry G. Manne, Our Two Corporation Systems: Law and Economics, 53
V
A. L. REV. 259, 262 (1967); Richard A. Posner, The Rights of Creditors of Affiliated
Corporations, 43 U.
CHI. L. REV. 499, 502 (1976) (explaining the effect of limited
liability as well as disadvantages unlimited liability might create).
86. Easterbrook & Fischel explain that limited liability rule was designed to
contend with the problem of the separation between ownership and control in publicly
held companies. Frank H. Easterbrook & Daniel R. Fischel, Limited Liability and the
Corporation, 52 U.
CHI. L. REV. 89, 93-97 (1985).
87. See Manne, supra note 85 (claiming that without limited liability, publicly held
corporations could not exist).
550 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
This effect results from the expectations for high gain at considerably
low risks.
89
Additionally, limited liability reduces the costs associated
with agency problems that arise from the division between ownership
and control.
90
Nevertheless, it should be noted that limited liability does generate
some negative side-effects that are particularly relevant to corporate
undercapitalization. The most prominent negative effect is that limited
liability enables shareholders to externalize the company’s risk onto
third parties, i.e. the company’s creditors.
91
This ability to externalize
the company’s risk presents problems for those creditors who cannot
protect themselves in advance, which is further explored in our
discussion of corporate undercapitalization.
92
A.
WHAT IS CORPORATE UNDERCAPITALIZATION?
The term “corporate undercapitalization” refers to a situation in
which the company’s equity is not reasonable when compared to the
obligations and risks it undertakes during its corporate activities.
93
From
the shareholder’s perspective, undercapitalization limits her potential
loss and personal exposure in the event of a company’s failure. At the
same time, from the creditor’s perspective, undercapitalization exposes
him to a higher degree of risk.
88. See Robert B. Thompson, Unpacking Limited Liability: Direct and Vicarious
Liability of Corporate Participants for Torts of Enterprise, 47 V
AND. L. REV. 1, 23
(1994).
89. See David W. Leebron, Limited Liability, Tort Victims, and Creditors, 91
C
OLUM. L. REV. 1565, 1570-74 (1991) (demonstrating how the limited liability rule has
a positive effect on the choice to invest in certain projects).
90. See FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC
STRUCTURE OF CORPORATE LAW 41 (1991).
91. See J. William Callison, Rationalizing Limited Liability and Veil Piercing, 58
B
US. LAW. 1063, 1070 (2003).
92. This problem induced the scholar’s proposals not to apply a limited liability
rule on tort creditors. See Henry Hansmann & Reinier H. Kraakman, Toward Unlimited
Shareholder Liability for Corporate Torts, 100 Y
ALE L.J. 1879, 1894-1909 (1991).
93. See Harvey Gelb, Piercing the Corporate Veil – The Undercapitalization
Factor, 59 C
HI.-KENT L. REV. 1, 3 (1982). In some cases, although the obligations of a
company are not so high per se, the risks involved in the business are high such that the
equity invested should also be high. That may be the case with a pharmaceutical
company, gas or oil companies, etc. In these types of companies, the chances of mass
failure due to the activity involved might be higher than in other companies.
2011] THE MORTGAGE MELTDOWN: 551
LESSONS FROM UNDERCAPITALIZATION
A shareholder can undercapitalize a company in one of two ways.
Under the first method, the shareholder chooses to invest very little, or
sometimes nothing at all, in the company. The second method occurs
when the shareholder transfers money to the company in the form of an
owner’s loan.
94
The following sections will explain the effects of these
actions on the company’s creditors and shareholders.
1. Not Investing or Investing Very Little
When a shareholder invests little or nothing in the company, the
impact on the creditors is quite obvious: the less money the company
has, the less there is to pay to creditors in the end. While the
shareholder, as an owner in the company, earns the right to profit from
the company’s activities, very few, if any, of the risks associated with
those activities inure to her detriment. In sum, under this method, the
shareholder will profit if the company succeeds, but will not lose if the
company fails.
2. Investing Money as an Owner’s Loan
In the second method of undercapitalizing, a more complicated
situation is created. In this scenario, the shareholder chooses to risk
something from her own pocket, not by investing equity in the company,
but, rather, by lending money to the company. However, if the
shareholder does risk something, how is such a loan considered an
undercapitalization method? The answer to this question lies in both
bankruptcy and corporate law.
Bankruptcy law deals with circumstances involving insolvency,
which is defined as a situation where there are not enough assets to
cover all obligations.
95
This means that not all legitimate claims will be
paid in-full. To deal with this scenario, bankruptcy law prioritizes
entities that have a right to get paid from an estate. Generally, the law
identifies three main groups of claimants:
96
secured creditors,
97
who are
94. See 18A AM. JUR. 2d Corporations § 636 (2010).
95. See 11 U.S.C. § 101(32) (2006).
96. There are also administrative costs which will be paid separately after the
secured creditors’ claims.
97. Secured creditors are creditors that have a lien or a security right on the
company’s assets.
552 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
supposed to get paid first; general creditors;
98
and, lastly, shareholders.
99
Corporate law states that shareholders have residual claims on the
company’s assets, i.e., they will get paid only after the rest of the claims
against the company have been fulfilled.
100
Since shareholders are
ranked as the lowest group of claimants, they practically never get paid
in bankruptcy.
101
However, when a shareholder transfers money to the company in
the form of a loan, the shareholder is treated as an ordinary creditor, thus
assuming a dual role in the company as both a shareholder and a
creditor. As a shareholder, she holds the right to the company’s gains
shall it succeed. As a creditor, in some cases, she will be ranked among
the general creditors, while in other cases she will be placed in the
secured creditors group. A shareholder may obtain secured status when
the company secures some of its assets on behalf of her against the loan
taken. Either way, the shareholder is ranked higher (in some cases,
much higher) than she would have been if instead she had invested the
money as equity. Though the shareholder is investing money in the
company,
102
she is doing so by issuing credit and, thus, exposes herself
to a much lower risk than what she would have had she invested it as
equity. Thus, the case of secured lending enables the shareholder to
98. General creditors can be contractual creditors, tort creditors, etc.
99. See 11 U.S.C. § 726(a)(6) (“[P]roperty of the estate shall be distributed . . .
sixth, to the debtor.”). According to the Code, the debtor is the last who gets paid from
the debtor’s assets, namely, the residual claimant. In liquidation, since the company
disappears when the procedure is over, the residual claimants are its shareholders.
100. See Frank H. Easterbrook & Daniel R. Fischel, Voting in Corporate Law, 26 J.
L. & ECON. 395, 403-04 (1983).
101. It should be noted, though, that in reorganization cases the shareholders are
usually being paid at least a small amount. That is because of the requirement that each
class of stakeholders approve the reorganization plan, so that the plan will be confirmed
by the court. Since the shareholders are a separate class, it is necessary that they
approve the plan. See 11 U.S.C. § 1122. For that to be accomplished, they should get
something in return. Many commentators have criticized this feature of the law. See,
e.g., Barry E. Adler, Bankruptcy and Risk Allocation, 77 C
ORNELL L. REV. 439, 446-54
(1992). On the other hand, there is the option of a “cramdown”, which means the plan
will be forced upon the non-consenting class by the court in certain circumstances. See
Bankruptcy Code § 1129(b)(1)-(2).
102. This type of undercapitalization is supposedly no different than the other type,
in which the shareholder does not invest anything or invests very little in the
corporation. But the importance of clarifying these two methods derives from the
complexity of this undercapitalization method in which money is in fact being delivered
from the shareholder to the corporation.
2011] THE MORTGAGE MELTDOWN: 553
LESSONS FROM UNDERCAPITALIZATION
transfer money with the lowest risk possible.
In both circumstances of undercapitalization, the shareholder puts
herself in a position in which she still has the possibility of future profits
should the company succeed. The probability of her being financially
penalized if the company does not succeed is much smaller. The
question remains: Does the lower risk represent a problematic situation
that needs to be addressed? This question will be discussed in the next
part.
B.
THE PROBLEM WITH UNDERCAPITALIZATION
As previously discussed, the limited liability rule enables
shareholders to externalize the company’s risk onto third parties. This
negative implication of limited liability is further complicated by the
agency problems that are inseparable from the company’s activities.
Corporations face three types of agency problems: those between
shareholders and management;
103
those between shareholders and
creditors; and those between the shareholders themselves.
104
Our
discussion concerns the second type of agency problem that focuses on
the relation between shareholders and creditors of the company. Since
shareholders have a lot to gain and only a limited probability of loss,
105
they may decide to act for the company in ways that are not
economically efficient,
106
given the outcome in the case of default will
be imposed on the creditors.
107
Thus, the limited liability rule enables
103. See generally Eugene E. Fama, Agency Problems and the Theory of the Firm,
88(2) J.
POL. ECON. 288 (1980).
104. The latter usually refers to problems which arise when there are both
controlling and minority shareholders. This is especially true with a public company
where the public is usually the minority shareholder, since it represents a large and
widely dispersed group of shareholders.
105. This is one of the basic agency problems that arise during the firm’s activity.
See the seminal work in this area: Michael C. Jensen & William H. Meckling, Theory of
the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J.
FIN.
ECON. 305 (1976).
106. In some cases the shareholders themselves are also the management, and
therefore they hold virtually all decision-making authority. This may occur in a small
and private company such as a family-owned one. It may also occur in a public
corporation with a controlling shareholder who, de facto, decides for the company
through the management. Even in cases where none of these apply, still the
shareholders may play an important role, for the law often grants them decision power.
107. See WILLIAM A. KLEIN & JOHN C. COFFEE, JR., BUSINESS ORGANIZATION AND
FINANCE: LEGAL AND ECONOMIC PRINCIPLES 256-59 (7th ed. 2000); Clifford W. Smith,
554 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
shareholders to externalize the risks associated with the company’s
activities and driven by their own decision-making. From the
shareholder’s point of view, it is beneficial to take these risks even if
they outweigh probable return because she will enjoy all of the gain
while avoiding most of the loss.
Undercapitalization of a company through one of the
aforementioned methods intensifies this risky-venture phenomenon.
More specifically, the shareholder has even less chance of losing money
because she has invested nothing (or almost nothing) in the first place.
This creates distorted incentives because a personal investment might
have encouraged the shareholder to act with some restraint and prevent
her from making irresponsible decisions. Thus, corporate under-
capitalization incentivizes the shareholder to use her position in the
corporation to create an option for future profits at the expense of other
parties involved.
To be sure, the corporate laws of many jurisdictions around the
world do not obligate shareholders to invest in the company when it is
founded.
108
In other words, the corporate laws do not mandate a
minimal equity investment in order for one to become a shareholder.
109
Thus, one could argue that viewing undercapitalization as problematic
does not reconcile with corporate laws permitting the shareholder to
decide whether and in what amount to invest. How can we grant her the
freedom to decide for herself and then penalize her for doing just that?
Though this argument sounds appealing, we contend that it does not
address the issue correctly. We posit that the lack of a minimum
investment requirement means that ex post intervention should be very
limited but does not mean that the shareholder’s conduct is
unreviewable.
Applying a unified standard requiring an equity investment may
result in inefficiency and damage to entrepreneurship. Every company
requires the flexibility to craft a capital structure suited to its unique
Jr. & Jerold B. Warner, On Financial Contracting: An Analysis of Bond Covenants, 7 J.
FIN. ECON. 117, 118-19 (1979); George G. Triantis, Secured Debt Under Conditions of
Imperfect Information, 21 J.
LEGAL STUD. 225, 237-38 (1992).
108. That is, for example, the Israeli Law. See Companies Act, 5759-1999, SH No.
189 § 8, that does not require minimum equity investment as a prerequisite for a
company’s registration.
109. Obviously, after the company has been founded, a person will usually have to
purchase his right to become a shareholder, either from the other shareholders or the
company itself.
2011] THE MORTGAGE MELTDOWN: 555
LESSONS FROM UNDERCAPITALIZATION
business needs. Thus, the lack of a minimum investment requirement
does not mean that money should not be invested, nor does it indicate
that it is always appropriate to not make an initial contribution. Instead,
it creates a flexible regime that accommodates the unique financing
needs of all corporations. For example, requiring a minimum equity
investment in companies with very low risks would create financial
barriers to entry. However, some minimum contribution may be useful
for particularly risky ventures that may cause other parties to suffer
losses.
Moreover, third parties can assess the financial structure of a
company before engaging in a business relationship with it. The
company’s certificate of incorporation and bylaws contain details
regarding its equity capital
110
and are open for review by the public,
including creditors. Therefore, if a creditor decides to lend to a
company that lacks a reasonable balance between its equity and the risks
or obligations it undertakes, one could assume that the creditor willfully
took on the default risk because the potential return justified it. Thus,
one might question why we should view undercapitalization as
problematic ex post, when the creditor made a well-informed decision
before entering into the relationship with the company. Three
explanations to this question exist.
First, not all creditors choose to engage in a relationship with the
company.
111
In some cases, the relationship is not contract-based and so
does not involve free will and consent.
For example, that is the case
when referring to governmental or municipal authorities. These
authorities do not check the details regarding each entity they’re
involved with when it comes to their administrative and legal
responsibilities.
112
Therefore, they cannot be viewed as choosing to
take on the risk entailed in dealing with an undercapitalized company.
In other cases, the creditors may have been forced to enter into the
relationship, such as when creditors have tort claims against the
110. The certificate of incorporation contains these details. See, e.g., DEL. CODE
ANN. tit. 8, § 102(a)(4) (2010).
111. See Lynn M. LoPucki, The Unsecured Creditor’s Bargain, 80 VA. L. REV.
1887, 1897-99 (1994); James H. Scott, Jr., Bankruptcy, Secured Debt, and Optimal
Capital Structure, 32 J.
FIN. 1, 2-3 (1977); Paul M. Shupack, Solving the Puzzle of
Secured Transactions, 41 R
UTGERS L. REV. 1067, 1094-95 (1989).
112. This is unlike their status in situations in which they are contractual parties,
where they should be treated as voluntary creditors like other entities.
556 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
company,
113
or where criminal offenses are involved.
Second, even creditors that have contracts with the company do not
necessarily check whether the company has sufficient equity capital.
These creditors are usually referred to as “non-adjustable” creditors.
114
There are two types of non-adjustable creditors.
115
The first type is the
general creditor who is owed a relatively small amount of money and
therefore chooses not to verify the company’s information before (or
during) the relationship. A general creditor is normally an
unsophisticated one for whom the cost of getting the information is too
high to justify the information’s negligible value.
116
The second type of
creditor is sophisticated but has fixed terms in his contract with the
company, and therefore cannot adjust to new situations.
117
For these
types of creditors, the claim that the creditor anticipated anything in
advance and willfully entered into the relationship with the company
does not seem valid.
Third, this argument is based on the premise that nothing changes
between the time when the creditor and the company formed their
relationship and the time of bankruptcy. Even if we focus on contractual
creditors who are fully aware of the company’s financial background,
there is no guarantee that the company’s financial situation will remain
the same until the creditors complete their business with the company.
Things may change from the point when the contract was sealed until
the point when the undercapitalization factor suddenly assumes great
relevance.
118
113. See Robert E. Dye, Note, Inadequate Capitalization as a Basis for Shareholder
Liability: The California Approach and a Recommendation, 45 S.
CAL. L. REV. 823,
836 (1972) (viewing the impact of undercapitalization as greater when it comes to tort
creditors as compared to contract ones).
114. See Lucian Arye Bebchuk & Jesse M. Fried, The Uneasy Case for the Priority
of Secured Claims in Bankruptcy, 105 Y
ALE L.J. 857, 887 (1996).
115. Id. at 885-91.
116. One may argue that an ex post intervention is not required because these
creditors make an affirmative choice with respect to analyzing risks. But the claim is
that inefficient results might be created due to the non-adjusting creditors’
characteristics (quite similar to non-voluntary creditors). Their inability to precisely
calculate the risks does not necessarily represent an informed decision but, rather, an
inevitable one that may result in a non-optimal outcome.
117. This might be the case when a new shareholder gets in the company, but,
instead of investing in it, he decides to lend to it.
118. The stockholders have the right to change the certificates of incorporation,
including provisions referring to the company’s capital stock, such as their number, per
2011] THE MORTGAGE MELTDOWN: 557
LESSONS FROM UNDERCAPITALIZATION
In sum, corporate undercapitalization raises questions as to the
circumstances under which legal intervention is needed, as well as the
appropriate methods of such intervention.
C.
LEGAL REMEDIES IN UNDERCAPITALIZATION
There are two main remedies that are used in the case of corporate
undercapitalization. The first remedy applies mainly to the situation in
which the shareholder makes no, or almost no, investment in the
company. The second remedy applies in the case where the shareholder
invests in the company through loans rather than capital equity.
1. Piercing the Corporate Veil
The first remedy for corporate undercapitalization, piercing the
corporate veil,
119
removes the legal separation between the corporation
and the shareholder and obligates the shareholder to repay the
corporation’s debts.
120
Piercing the corporate veil is considered one of
the most extreme remedies in corporate law because its application
contravenes the fundamental limited liability rule.
121
Therefore, the
remedy is applied under extremely limited circumstances and certainly
not on a routine basis.
122
One situation in which piercing the corporate veil might be applied
is severe undercapitalization,
123
when the shareholder does not
value, designations etc. See DEL. CODE ANN. tit. 8, § 242(a)(3) (2010).
119. On this remedy see generally: David H. Barber, Piercing the Corporate Veil, 17
W
ILLAMETTE L. REV. 371 (1981).
120. To note, veil piercing may be used against other controlling persons in the
corporation such as directors and officers. See generally, Robert C. Clark, The Duties
of the Corporate Debtor to its Creditors, 90 H
ARV. L. REV. 505 (1977).
121. For a short description of veil piercing and the situation in which it will be
applied according to courts in several U.S. states, see Fredric J. Bendremer, Delaware
LLCs and Veil Piercing: Limited Liability Has Its Limitations, 10 F
ORDHAM J. CORP. &
FIN. L. 385, 389-91 (2005).
122. It is interesting to note that the tendency to pierce the veil is higher when it
comes to a holding company undercapitalizing its subsidiary. See, e.g., Nilsson,
Robbins, Dalgarn, Berliner, Carson & Wrust v. Louisiana Hydrolec, 854 F.2d 1538,
1543-44 (9th Cir. 1988)
.
123. See Robert B. Thompson, Piercing the Corporate Veil: An Empirical Study, 76
C
ORNELL L. REV. 1036 (1991) (presenting through an empirical study that
undercapitalization is present in more than 18% of contract cases involving piercing the
558 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
contribute anything to the corporation in the form of equity,
124
or
contributes an extremely
125
small amount.
126
Courts evaluate whether a
company was undercapitalized by the conditions that existed at the time
it was allegedly undercapitalized. The eventual collapse of the company
is not a relevant factor in determining whether the financing was
sufficient.
127
Instead, some factors considered in the determination
include the company’s specific circumstances, the type of business it
engages in and the type of market in which it operates.
128
However, courts differ in how they consider undercapitalization in
their decision to pierce a corporation’s veil. Some courts consider
undercapitalization as merely one of several important factors to
consider before deciding whether to use the remedy.
129
Other courts
veil and 73% of the cases in which the veil was eventually pierced). On the reason for
using the tool of piercing the veil in these circumstances, see Ian Ayres, Making a
Difference: The Contractual Contributions of Easterbrook and Fischel, 59 U.
CHI. L.
REV. 1391, 1397-98 (1992) (justifying the use of piercing the veil in undercapitalized
companies by viewing it as a penalty that will create an incentive for the firms to
disclose as much information regarding their equity as possible in the preliminary
stages of contracting).
124. Knowingly operating a business while it is undercapitalized will sometimes be
considered as inequitable, since it enables the shareholders to escape personal liability
for the corporation’s debt. See, W
ILLIAM MEADE FLETCHER, FLETCHER CYCLOPEDIA OF
THE LAW OF PRIVATE CORPORATIONS 648 (Callaghan 1931).
125. See, Cascade Energy & Metals Corp. v. Banks, 896 F.2d 1557, 1576 (10
th
Cir.
1990), cert. denied, 483 U.S. 849 (1990)
.
126. See, e.g., Minton v. Cavaney, 364 P.2d 473 (Cal. 1961); William P. Hackney &
Tracey G. Benson, Shareholder Liability for Inadequate Capital, 43 U.
PITT. L. REV.
837, 859 (1982).
127. See Evans v. Multicon Constr. Corp., 574 N.E.2d 395, 398 (Mass. App. Ct.
1991); Birbara v. Locke, 99 F.3d 1233, 1241 (5th Cir.1996)
.
128. The shareholder’s behavior will be measured considering all the factors
relevant to the corporation’s activity. While the shareholder’s investment might have
been made initially, and was reasonable at that time, his behavior in later stages of the
corporation’s life may be taken into consideration as well. If the corporation later
engaged in more risky activity or if his financial condition deteriorated and it needed
extra funds that the shareholder was willing to supply only as a shareholder’s loan, it
might influence his case negatively. The court will examine the situation according to
the shareholder’s position in the company and the role he played. See also, Stephen M.
Bainbridge, Abolishing Veil Piercing, 26 J.
CORP. L. 479, 507 (2001) (“Minority
shareholders who do not actively participate in the corporation’s business or
management are rarely held liable on a veil piercing theory.”).
129. See, e.g., Harris v. Curtis, 87 Cal. Rptr. 614, 617-19 (Cal. Dist. Ct. App. 1970)
(“Evidence of inadequate capitalization is, at best, merely a factor to be considered by
2011] THE MORTGAGE MELTDOWN: 559
LESSONS FROM UNDERCAPITALIZATION
view undercapitalization as a necessary condition before piercing the
corporate veil, but also require the presence of additional conditions.
130
Such courts reason that the desire to avoid personal responsibility is a
legitimate reason to incorporate in the first place, and so will not be
regarded as the sole basis for veil piercing.
131
Additionally, courts
sometimes address piercing the corporate veil as an “alter-ego
doctrine.”
132
This doctrine holds that the veil is pierced when the
identity of the company and its shareholders are the same, such that their
identities cannot be separated due to their unity in interests. The
enforcement of limited liability in these situations inevitably results in
injustice.
133
2. Subordination
The second remedy for corporate undercapitalization, the doctrine
of subordination, is applied in situations where a shareholder invests
money into the company as debt and not as capital equity.
Subordination downgrades the collection priority of debt owed to the
shareholder.
134
The court does not allow the shareholder to enjoy
privileges she had previously tried to acquire as a regular (or even a
secured) creditor. Instead, the shareholder receives payment only after
the creditors are paid in full. This doctrine aims to reverse the damage
the trial court in deciding whether or not to pierce the corporate veil.”); Arnold v.
Browne, 103 Cal. Rptr. 775, 783 (Cal. Dist. Ct. App. 1972) (“To be sure, it is an
important factor, but no case has been cited, nor have any been found, where it has been
held that this factor alone requires invoking the equitable doctrine prayed for in the
instant case.”).
130. See Walkousky v. Carlton, 223 N.E.2d 6 (N.Y. 1966).
131. See Brunswick Corp. v. Waxman, 459 F. Supp. 1222 (E.D.N.Y. 1978), aff’d,
599 F.2d 34 (2nd Cir. 1979); Billy v. Consol. Mach. Tool Corp., 412 N.E.2d 934, 941
(N.Y. 1980). These cases dealt with veil piercing between sister-companies.
Nevertheless, since the court is stricter in these sorts of cases, as previously mentioned,
this rule will likely be applied in regular situations as well. But see Rutherford B.
Campbell, Limited Liability for Corporate Shareholders: Myth or Matter-of-Fact, 63
K
Y. L.J. 23, 53 (1975) (holding that in all cases of undercapitalization, the result should
be veil piercing).
132. The Canadian doctrine is similar in this aspect. See Anil Hargovan & Jason
Harris, Piercing the Corporate Veil in Canada: A Comparative Analysis, 28(2) C
OMP.
LAW. 58 (2007).
133. See In re Sheridan, 187 B.R. 611, 614 (N.D. Ill. 1995).
134. 11 U.S.C § 510(c) (2006).
560 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
to the creditors created by the shareholder’s loan, which otherwise
would have forced creditors to share the total recovered proceeds with
an additional claimant.
The court imposes the doctrine either when the shareholder’s action
causes inequitable damages to the general creditors, or when the
shareholder herself obtains an unfair advantage.
135
One of the most
fundamental situations in which this doctrine is applied is in the case of
corporate undercapitalization.
136
Still, some courts have ruled that
undercapitalization alone is not a sufficient basis for subordination.
137
Such rulings most likely relate to the assumption that creditors should be
aware of the company’s financial structure before deciding to do
business with the company.
138
The doctrine of re-characterization provides an alternative approach
through which courts can re-characterize shareholders’ loans as an
equity investment in the company.
139
This doctrine analyzes the loan
features to determine whether the loan was issued in similar terms as in
the credit market or perhaps was an investment
disguised as a loan to
upgrade the shareholder’s collection priority. If a court finds that the
loan was in fact a scheme to disguise the shareholder’s investment, it re-
characterizes the loan as equity capital that the shareholder invested into
the company. While in subordination the shareholder is still regarded as
a creditor when it comes to the specific debt she is owed, and will be
paid before the other shareholders will (yet after the general creditors),
under the doctrine of re-characterization, the shareholder loses her status
as creditor. So the amount the shareholder “lent” the company is paid to
her pro-rata along with the rest of the shareholder’s claims. In contrast
to subordination, re-characterization not only treats the money transfer
135. See Taylor v. Standard Gas & Elec. Co., 306 U.S. 307, 324 (1939); Pepper v.
Litton, 308 U.S. 295, 307-08 (1939).
136. In re Mobile Steel Co., 563 F.2d 692, 702 (5th Cir. 1977). This ruling was the
first to examine thoroughly the subordination doctrine, the guidelines to its application
and when it would be applied. The doctrine was legislated later. See 11 U.S.C. §
510(c).
137. See In re Lifschultz Fast Freight, 132 F.3d 339, 345 (7th Cir. 1997); In re
Herby’s Foods Inc., 2 F.3d 128, 132 (5th Cir. 1993); In re Fabricators, Inc. 926 F.2d
1458, 1469 (5th Cir. 1991).
138. See supra Part IV.C.
139. See, e.g., David A. Skeel, Jr. & Georg Krause-Vilmar, Recharacterization and
the Nonhindrance of Creditors, 7 E
UR. BUS. ORG. L. REV. 259 (2006).
2011] THE MORTGAGE MELTDOWN: 561
LESSONS FROM UNDERCAPITALIZATION
as equity, but further establishes that it was originally intended to be
treated as such.
140
Though the differences between subordination and re-
characterization are notable, they are more rhetorical than practical.
When these dilemmas arise in bankruptcy, the exact positioning of the
shareholder’s priority usually does not matter. As stated, the general
creditors themselves are almost never paid in full.
141
So even if the
shareholder is placed between them and the other shareholders, it does
not help her recover more money because the absolute priority rule
demands that each group be paid in full before the inferior group begins
to receive payment. Since there is usually not enough money to cover
all of the obligations owed to the general creditors, the lower ranked
shareholder gets nothing regardless of her exact priority placement.
3. Differences Between Piercing the Corporate Veil and Subordination
There are two main differences between the doctrines of veil
piercing and subordination. First, piercing the corporate veil is not
limited in sum. Theoretically, the shareholder can be personally
obligated to pay the entire debt of the company that cannot otherwise be
satisfied. On the other hand, subordination, even though it may be
referred to as de facto piercing the corporate veil, is limited to the
amount of money the shareholder transferred to the company. Second,
subordination does not affect the size of the pie, just the way it is
divided between the different parties involved. Contrastingly, when the
corporate veil is pierced, the pie gets bigger as creditors can seek
satisfaction beyond the corporation’s assets and from the corporation’s
shareholders.
140. See generally id. (examining the difference and resemblance between the two
doctrines, and their application).
141. See, e.g., Lynn M. LoPucki, A General Theory of the Dynamics of the State
Remedies/Bankruptcy System, 1982 W
IS. L. REV. 311, 311 (presenting empirical
research stating that in 80% of chapter 7 cases no money was left for the general
creditor’s claims in the end of the procedure; in the remaining 20%, general creditors
were paid in average 4.5% of their claims).
562 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
D.
COMPARISONS BETWEEN THE RESIDENTIAL MORTGAGE MARKET
AND CORPORATE UNDERCAPITALIZATION
As previously explained, the nature of the American residential
mortgage market is predominately shaped by the combination of non-
recourse loans and a very minimal down payment requirement.
Strikingly, the interplay of these features resembles the case of corporate
undercapitalization. Both financing methods result in inefficiency by
encouraging irresponsible conduct. Moreover, both the borrower and
the shareholder in these situations have the incentive to act in a risky
way, knowing that the consequences of their conduct will be borne
mainly, if not entirely, by someone else.
In our opinion, it can even be said that the borrower is in a better
position than the shareholder who issues credit to the company. The
shareholder, though limiting her risk and upgrading her position, is
likely to lose some of her money in the event the company eventually
fails. On the other hand, the borrower, who is not obligated to pay
anything from his pocket, may risk nothing at all. The risk of losing the
purchased asset is indeed a risk, but it is questionable whether a property
that was not paid for initially could be considered a real loss. At a
minimum, something not purchased with the borrower’s own money is
less valuable to him than something for which he paid. Nevertheless, in
both cases, someone has the ability to act in a way that affects others,
with enhanced risk that those actions will be inefficient due to distorted
risk allocation.
Although the impact of corporate undercapitalization on third
parties is relatively apparent, the impact of a mortgage default on third
parties is less obvious. In the case of a defaulted company, several
parties will ultimately compete among themselves to recover from the
corporation’s assets. In a residential mortgage, however the mortgage is
a private arrangement that supposedly involves only two parties: the
lender and the borrower. Supposedly, the lender and the borrower can
decide for themselves which arrangement suits them best in their
contractual relations. Since the potential damage to other parties is
apparently much lower, why should there be any legal or regulatory
intervention?
Even though the direct consequences of residential mortgage
lending on third parties may be less apparent, we argue in this article
that they are still a very real possibility. As the recent global financial
crisis shows, so-called “private” financial practices may have major
2011] THE MORTGAGE MELTDOWN: 563
LESSONS FROM UNDERCAPITALIZATION
negative impacts on third parties that are not direct participants of the
transaction, and may eventually cause economy-wide catastrophe. Even
though it seems that the risks lie solely on the contractual parties, they
actually may roll over to other parties as a result of sophisticated
financial techniques such as securitization.
142
The complex structures of
such financial instruments make it prohibitively difficult to predict and
evaluate these risks.
143
Moreover, they inhibit our ability to identify the
parties that need protection. Thus, in the end, it appears that not only
does the behavior of the direct parties influence others, but the
complicated situation also does not give the third parties the opportunity
to protect themselves.
144
A notable distinction between residential mortgage practices and
corporate undercapitalization is the ease with which one can identify a
sinister motive behind the actor’s behavior. When a shareholder
undercapitalizes a company, the problematic nature of her behavior is
relatively easy to pinpoint. Her agenda is obvious – she wants to
participate in a game without jeopardizing anything of her own. Even
when the court looks for other factors before granting a remedy,
undercapitalization itself is interpreted as a negative behavior because it
allows the shareholder to place all the risks associated with the company
on the creditor’s shoulders. Contrastingly, the agenda of a mortgage
borrower is not as straightforward. While it is admittedly a negative
action for the borrower to commit “strategic default” ex post,
145
the
142. See supra Part II.B.
143. AMERICAN SECURITIZATION FORUM, RESTORING CONFIDENCE IN THE
SECURITIZATION MARKETS 5 (2008), http://www.sifma.org. (“The level of complexity
of products developed during the height of the market boom . . . exceeded the
analytical and risk management capabilities of even some of the most sophisticated
market participants.”).
144. See Lois R. Lupica, Asset Securitization: The Unsecured Creditor’s
Perspective, 76 T
EX. L. REV. 595, 632-33 (1998) (discussing the difficulty for third
parties to defend themselves from the effects of using complicated financing techniques
like securitization).
145. See, e.g., Secretary of the Treasury Henry Paulson who declared in a televised
speech: “let me emphasize, any homeowner who can afford his mortgage payment but
chooses to walk away from an underwater property is simply a speculator – and one
who is not honoring his obligations.” Secretary Henry M. Paulson, Jr., U.S. Housing
and Mortgage Market Update before the National Association of Business Economists
(Mar. 3, 2008) available at http://www.ustreas.gov/press/releases/hp856.htm. See also
Fox Business: Some Homeowners Who Can’t Pay Choosing to Just Walk Away (Fox
Business television broadcast Feb. 19, 2009), available at http://www.foxbusiness.com/
564 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
borrower is not to blame for the ex ante situation of being able to take a
non-recourse mortgage without putting money down. Accordingly, our
article focuses on the borrower’s actions in the early phase of the
mortgage lifecycle, when he takes the mortgage offered to him. With
regard to the ex ante phase, it seems that the borrower, even one who
strategically defaults, is not specifically responsible for the inefficiency
that may be eventually produced. As previously explained, the overall
mortgage lending practice itself encourages this very behavior that in
turn has the potential of causing market failure. Thus, a borrower’s fault
in the process is much vaguer than that of a shareholder who
undercapitalizes a company.
Though this may be true, we believe that it is not relevant whether
the borrower is to blame. The only thing that matters is whether the
current state of mortgage lending practices enhances the chance of a
future failure. Thus, our aim in this article is to explore the incentives
produced by current mortgage lending practices. If the incentives are
distorted, then they must be modified to minimize the risks of failure.
To that end, we next propose potential modifications that resemble
the remedies used in corporate undercapitalization. Corporate
undercapitalization remedies have valid application in the mortgage
video/index.html?playerId=videolandingpage&streamingFormat=FLASH&referralObje
ct=3644995&referralPlaylistId=1292d14d0e3afdcf0b31500afefb92724c08f046 (“Seems
obscene. Everyone else in the country is trying to pay their mortgages and trying to get
things done. They realize in many cases they are underwater that their mortgage is
worth more than their home. If you have obnoxious kids, walk away from your kids.
Seems weird. Doesn’t it? … I know you are not looking at the ethics of this; you are a
good and savvy businessman. Do you find it even a tinge offensive that we are moving
away from personal responsibility? If we can’t hack it we bail out of it… And you
know when you enter into an agreement and everyone just throws up the keys and says
you know it’s really tough this month, it’s gonna be tough next month, declining real
estate values, we are just going to quit. Can you imagine if we all did that going into
World War II? The Japanese just kicked our butts at Pearl Harbor, the odds are
overwhelming, the Germans have just taken over Europe, and we just quit. What would
happen if we all quit? Let’s just cease and desist.”). But see White, supra note 22.
White claims that even when a borrower strategically walks away from his home, he
should not be considered as acting in a negative way because he is simply complying
with the terms of the mortgage agreement, including the contractual right to default and
transfer ownership of the home to the lender. Id. Indeed, the shareholder complies with
the law (or the judicial agreement applied by it) as well when she undercapitalizes a
company. Still, the courts view it almost as abusing her right to choose how much to
invest in the company.
2011] THE MORTGAGE MELTDOWN: 565
LESSONS FROM UNDERCAPITALIZATION
context because both corporate law’s basic principle of limited liability
for shareholders and the American real estate market’s current financing
practices seek to encourage business and entrepreneurship. This is
accomplished by decreasing the entrepreneur’s risks, whether he is a
shareholder or a real estate purchaser.
146
However, with benefits of
entrepreneurship also come potential negative externalities. As we saw
earlier, corporate law has developed the doctrines of piercing the
corporate veil and subordination to deal with the external harms
undercapitalization causes. The solutions we present next do the same
for residential mortgages while balancing the need to protect the market
and the desire to avoid too much intervention.
V.
HOME MORTGAGE ARRANGEMENTS: PROPOSED SOLUTIONS
As previously emphasized, current residential mortgage practices
allow contracting parties to externalize default risks onto third parties.
147
Among the parties affected are investors in mortgage-backed
securities,
148
the lender’s creditors, and, ultimately, the economy as a
whole, as the foreclosure epidemic drives down real estate prices.
149
The
discussion about undercapitalization and its comparison to mortgage
lending practice assists us in finding useful solutions to minimize
negative externalization.
We do not support the “piercing the veil” method in the case of
home purchase financing. As shown, the remedy of piercing the
corporate veil is considered extreme and applied in a rather limited way.
Moreover, applying the doctrine in the mortgage context would render
146. Home ownership has been long encouraged by the United States government.
Buying a home is viewed as key to achieving the “American Dream”. See A. Mechele
Dickerson, The Myth of Home Ownership and Why Home Ownership Is Not Always a
Good Thing, 84 I
ND. L.J. 189, 189 (2009).
147. See John Harding, Thomas J. Micelli & C.F. Sirmans, Do Owners Take Better
Care of Their Housing Than Renters?, 28 R
EAL ESTATE ECON. 663 (2000) (pointing to
the externalities which are created in non-recourse mortgages).
148. Investors in mortgage-backed securities have seen their investment’s market
value decline both because of direct losses from default on mortgages collateralizing
their investment and because of the general decline in housing values.
149. The costs of foreclosure spill over from the parties to the transaction to the
neighborhood, larger community, and even the economy as a whole. See C
ONG.
OVERSIGHT PANEL REPORT, supra note 73, at 9-11.
566 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
the borrower fully liable for the mortgage payments in the case of
default, thus jeopardizing the borrower’s entire personal assets.
Although this type of remedy may be appropriate in some
undercapitalization cases, it is not appropriate in a home mortgage case.
It is not a good solution from an ex ante perspective because it will
practically dissolve the entire non-recourse loans practice, even in cases
where such an arrangement makes good economic sense. Additionally,
it can be problematic ex post because it interferes with the private
arrangement between the parties. Furthermore, the borrower’s role in
producing the negative results is more limited than that of a shareholder,
as previously discussed. Obliging the borrower to pay in full for results
that were not entirely his fault creates a different distorted risk
allocation.
Rather, we can attain desirable reform without any radical steps that
may deprive the parties of the basic freedom of contract. We propose
two alternative mortgage arrangements, one that applies ex ante and one
that applies ex post. The first requires a minimum down payment from
the borrower in a non-recourse mortgage. The second imposes limited
personal liability on the borrower when he initially did not put money
down. Like the remedies applied in the case of corporate
undercapitalization, both of these proposals aim to make the borrower
internalize some of the risks created by his actions.
A.
MINIMUM DOWN PAYMENT REQUIREMENT
Our first proposal requires a small, but meaningful, down payment
from the borrower when borrowing money through a non-recourse
mortgage. Modern American credit practices do not obligate the
borrower to pay a meaningful amount of the purchase price from his
own pocket. This prevents the borrower from internalizing his action
and causes most of the risks associated with a potential default to be
borne by someone besides the borrower.
Our proposed down payment requirement will be calculated as a
certain percentage of the purchase price of the property.
150
Requiring
150. In practice, some lenders begin to require substantial down payments as a
lesson from the mortgage meltdown. See Amy Hoak, 100% More Difficult: First-Time
Home Buyers Struggle to Find Down-Payment Money, M
ARKETWATCH (Mar. 9, 2008),
http://www.marketwatch.com/news/story/first-time-home-buyers-struggle-find/story.
aspx?guid=%7B4BF19BC0-C4EE-4107-ACFC-F6524E878D5A%7D.
2011] THE MORTGAGE MELTDOWN: 567
LESSONS FROM UNDERCAPITALIZATION
the borrower to contribute a meaningful portion of the purchase price to
receive a non-recourse loan will lead to more reasonable risk allocation
between the parties. This requirement will positively influence the
borrower's actions when deciding whether to purchase real estate. We
previously explained that the absence of a down payment requirement in
current financing practices directly contributed to the price bubble in the
real estate market. The availability of relatively riskless and convenient
funding options increased the demand for housing and created an
artificial appreciation in real estate market prices. When the borrower
does not need to pay anything from his pocket, he is more likely to
purchase the asset even though its price is higher than its real value.
However, when the borrower pays a meaningful part of the purchase
price from his own pocket, he will be much more reluctant to pay more
than the real value of the property. Therefore, requiring borrowers to
put down a substantial amount of money when purchasing homes
minimizes their incentive to purchase homes at prices higher than their
real value.
151
Furthermore, requiring the borrower to put a meaningful sum of
money down to get a non-recourse mortgage will diminish the
probability of later being “underwater”. It also seems that the option to
leave the real estate asset to the lender will become much less appealing
to the borrower since his initial investment will be lost along with the
asset.
152
B.
BORROWER’S LIMITED LIABILITY
Our second proposal deals with the “non-recourse” aspect of
current mortgage financing practices. This proposal continues to permit
parties the option of a non-recourse mortgage while now requiring that
the borrower with a non-recourse mortgage be held personally
responsible for at least some of the debt in the case of default.
153
151. Liebowitz, supra note 81 (“If substantial down payments had been required, the
housing price bubble would certainly have been smaller, if it occurred at all . . . “).
152. Lenders’ mortgage default risk models have shown a strong relationship
between initial loan-to-value (LTV) and default rates. Herzog and Earley’s study was
among the first to validate the important role of the initial LTV ratio in influencing
default. See J
OHN P. HERZOG & JAMES S. EARLEY, HOME MORTGAGE DELINQUENCY
AND FORECLOSURE (1970). For newer studies, see Quigley & Van Order, supra note
28, and Deng et al., supra note 35.
153. The money the borrower had already managed to pay off from the loan through
568 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
It is important to note that the borrower would not be able to escape
his personal liability by discharging the remaining unsecured balance of
the mortgage loan in bankruptcy. To the extent the borrower has
substantial non-exempt assets, filing for bankruptcy appears to be a less
attractive strategy because Chapter 7 of the Bankruptcy Code requires
the borrower to give up all of his non-exempt assets.
154
Furthermore,
since the 2005 Bankruptcy Reform, the borrower can file under Chapter
7 only if his current monthly income is below the state median or if he
otherwise meets the means test.
155
If he makes more than the state
median and does not meet the means test, then he is forced to file under
Chapter 13 of the Bankruptcy Code. Under Chapter 13, the borrower is
required to propose a repayment plan and repay part of his unsecured
debts over a period of three to five years through his future income.
156
Given that the borrower cannot escape personal liability, our
proposal has two advantages. First, it enables the borrower to purchase a
real estate asset without paying a significant amount of money up front.
This advantage is particularly important when the borrower either has no
savings and therefore does not have the ability to put money down but
has a stable source of income,
157
or when the borrower prefers to buy
his monthly payments will be subtracted from his limited liability obligation. For
example, if the borrower’s limited liability is up to 40% of the loan taken, and the
borrower had already paid off 30% of the loan, he will be liable only to the remaining
10%. See generally R
ESTATEMENT (THIRD) OF PROP.: MORTGAGES, supra note 26, §
1.1.
154. Exempt assets are defined by federal and state law. On exemptions and the
conditions to exempt certain assets, see 11 U.S.C. § 522 (2006).
155. See id. § 707(b)(6)-(7). These changes were enacted through the Bankruptcy
Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). BAPCPA was
meant to deal with the problem of debtors using bankruptcy procedures as a way to
avoid paying debts, while they actually have the ability to repay them. But see, Jean
Braucher, A Fresh Start for Personal Bankruptcy Reform: The Need for Simplification
and a Single Portal, 55 A
M. UNIV. L. REV. 1295, 1305-1315 (2006) (describing the
problems with the legislation); Elijah M. Alper, Opportunistic Informal Bankruptcy:
How BAPCPA May Fail to Make Wealthy Debtors Pay Up, 107 C
OLUM. L. REV. 1908,
1910-1911 (2007).
156. See 11 U.S.C. § 1321 (2006) (“The debtor shall file a plan.”); 11 U.S.C. §
1322(d) (2006) (explaining the repayment period may vary according to the debtor’s
income).
157. Even if the borrower does not have savings and sources of income now, but has
the potential to earn high salary later, the lender may rely on that and offer him this type
of mortgage arrangement. This may happen when the borrower is, for example, a
medical school student. When he finishes his degree, he will probably have a stable
2011] THE MORTGAGE MELTDOWN: 569
LESSONS FROM UNDERCAPITALIZATION
without down payment because his money may yield a higher return
when invested elsewhere. In these situations the borrower may have
good economic reasons for choosing to purchase a property without
contributing a down payment.
Second, this proposal generates a more reasonable risk allocation,
while not depriving the parties of their right to choose their own
agreement. Here, the mortgage agreement basically has two parts: one
part contains a recourse loan while the other part contains a non-
recourse loan.
158
This discourages borrowers from taking loans while
knowing that they may not be able to pay them off. Additionally,
exposing borrowers to some personal liability upon default encourages
them to avoid default. Therefore, exposing the borrower to the risk of
paying the debt from his personal assets positively impacts his actions.
Although our proposed mortgage contract is admittedly more complex,
it minimizes the problems created by the current mortgage
arrangements.
C.
RECAP OF PROPOSALS
In this part we presented two proposals that seek to make the
borrower internalize some of the costs associated with a residential
mortgage default. The proposals focus on the improper risk allocation
generated by current mortgage financing practices
159
and take into
account the many other parties, beyond the lender and the borrower, that
may be impacted by the so-called bilateral agreement. Additionally,
placing some of the risks on the borrower does not necessarily eliminate
the lender’s risks. Rather, it forces the borrower and the lender to act
source of high income, so he might be a good investment for the lender.
158. See Reg’l Fed. Sav. Bank v. Margolis, 835 F. Supp. 356, 357 (E.D. Mich.
1993) (explaining that mortgagors are liable for 30% of debt); Birkenfeld v. Cocalis, 29
A.2d 902, 902 (N.J. Ct. Err. & App. 1943); Wells v. Flynn, 184 N.W. 389, 390 (Iowa
1921). A mortgage may be recourse as to some obligations and non-recourse as to
others, depending on its terms. See Fed. Home Loan Mortg. Corp. v. Inland Indus, Inc.,
869 F. Supp. 99, 101 (D. Mass. 1994) (holding that the mortgagor was liable for
amounts unrelated to principal and interest).
159. In light of the recent home ownership crisis, some scholars criticize the United
States policy that idealizes the importance of home buying. They question whether the
“American Dream” of home ownership remains a goal worth pursuing. See Dickerson,
supra note 146, at 1. This criticism may support our proposals to impose somewhat
greater burdens on home buyers
.
570 FORDHAM JOURNAL [Vol. XVI
OF CORPORATE & FINANCIAL LAW
collaboratively in a way that generates a more efficient economic
outcome. Thus, the proposed mortgage arrangements would create a
system that better balances the competing interests of the different
parties involved.
Additionally, having the option to choose between two alternative
arrangements creates a mortgage lending system that is able to
efficiently handle different types of borrowers. When individuals are
able to pay some of the money upfront, they may prefer the first
mortgage arrangement that does not expose them to personal liability. If
they cannot put money down or for some reason prefer not to do so, they
may choose the second mortgage arrangement that introduces some
limited personal liability.
VI. C
ONCLUSION
In this article, we investigated the practical and legal perspectives
of the American mortgage market, which played a substantial role in the
recent housing boom and bust. As described, the residential mortgage
market has two prominent features that led to this result. First, state
foreclosure rules led to the predominance of de facto non-recourse loans.
Second, borrowers were not obliged to contribute a substantial down
payment or were not required to contribute a down payment at all. This
article examined the implications of these practices and argued that they
directly contributed to the creation of the price bubble in the real estate
market by generating an imbalanced risk allocation.
Moreover, we found that the combination of these financing
features closely resembled the case of corporate undercapitalization.
Shareholders, like non-recourse mortgages borrowers, enjoy limited
liability and, thus, risk only the equity capital they invested in the
corporation. When almost no equity is invested, the shareholder hardly
risks anything of her own, very much like a non-recourse mortgage
borrower with one hundred percent financing.
Drawing on lessons from corporate law’s remedies for
undercapitalization, while incorporating the special characteristics of
home purchase financing, we proposed two alternative solutions to
create a more balanced risk allocation between the parties in a mortgage
agreement. Each of these solutions addresses a different aspect of
current residential mortgage practices. The first proposal requires a
substantial down payment by the borrower for receiving a non-recourse
2011] THE MORTGAGE MELTDOWN: 571
LESSONS FROM UNDERCAPITALIZATION
mortgage. In the second proposal, when the borrower initially did not
put money down, he is held personally liable to pay some portion of the
debt to the lender in the case of default. These proposals aptly modify
the incentive structure of the lender-borrower relationship in the
residential mortgage market.
