Contract Modification as a rebus sic stantibus Solution to the Subprime Crisis

Abstract

Invalidating conjectures of financial engineering by supervening events, the subprime crisis called for critical rationalism. Contract modification based on rebus sic stantibus would be its perfect legal translation. Since the crisis originated in the US, legal origins theory (LOT) should predict an adaptive solution based on judge-made law, but has remained silent so far. As a ruling on frustration of purpose in a previous economic crisis, Alcoa vs. Essex could serve as a precedent in American common law. Instead, the US relied on legislative, regulatory, executive, fiscal and monetary means, which LOT associates with “political channels” prevailing in civil law countries. We argue that judicial relief and legislation can interact functionally. Their slow process in the US and America’s backward real estate recording system has impeded rapid crisis resolution, however. To avoid the risk of a global version of Japan’s “lost decade”, we suggest banks apply rebus sic stantibus notionally. Negotiated contract modification and balance sheet adjustment, linked by a feedback loop, would maintain value in otherwise “toxic” mortgage-backed securities, mitigate losses, reduce new capital needs, avoid the cost of ever more foreclosures and provide a more focused stimulus to the economy than the Federal Reserve’s quantitative easing. It would rapidly restore Hayekian “spontaneous order” in the financial sector’s own best interest.