Bankruptcy Judges Can Modify Mortgage Loans
You know you’re in a tight spot when Bankruptcy Court begins to look like the least bad solution to a pressing economic problem. But the housing foreclosure situation is pretty ugly, so there we are. Unfortunately, U.S. Bankruptcy Court isn’t allowed to be part of the solution to rising foreclosures, thanks largely to the mortgage banking lobby. Bankruptcy attorneys are just beginning to comprehend that judges can now renegotiate mortgage terms and mandate loan modifications directly with lenders.
Consider the scale of the problem. The number of homes threatened by foreclosure today is estimated as high as 8 million, quadruple the number a year and a half ago. Nearly a quarter-million homes were lost to foreclosure last year in California alone. Experts agree that this is a massive drag on the economy. It undermines communities, drives home prices down, potentially below their fair market value, and creates huge losses for banks and mortgage investors.
Dozens of proposals to stem the foreclosure crisis have been tabled: Force lenders to dicker with every delinquent borrower, pay loan servicers more to avert foreclosures than to allow them, subsidize interest rates or principal values with taxpayer money. The solutions that have been tried, such as voluntary loan modification efforts by banks, all seem to help a tiny fraction of the expected number, in part because it’s hard to distinguish deserving homeowners from those who should never have gotten a mortgage in the first place.
That brings us to bankruptcy. In Chapter 13, which is bankruptcy for working people who have fallen behind in their debts but don’t want to stiff all their creditors, bankruptcy judges can help work out new terms on cars and boats and vacation homes. The process is known by the unlovely legal term “cram-down,” evidently because from the creditor’s standpoint — well, you get the drift.
The only debt a judge is forbidden to cram down is a mortgage on a principal residence. Chapter 13 debtors either have to meet the loan’s original terms, throw themselves on the mercy of their lenders (and we all know how gracious they can be) or give up the house. The absurdity of this rule should be self-evident. Loans on things that are comparatively expendable — your boat, your house in Squaw Valley, your Ford Taurus (or your Lamborghini) — can be modified by a judge to help you hold on to the asset. But your house? Forget it. This makes sense only if you think you may need to keep the car so if you’re thrown out of your house you can move into the back seat.
Still, in an entirely rational world, wouldn’t the rule be exactly the opposite — try to save the house at all costs, and let the repo men fight over the rest? Democrats in Congress, who have been trying to fix this inequity for more than a year, think they’re on the verge of victory. A measure sponsored by Rep. John Conyers Jr. (D-Mich.) sailed through committee this week and is likely to pass the House. But it may not have the requisite 60 votes to pass as a stand-alone bill in the Senate, in part because bankers remain adamantly opposed to mortgage cram-downs in any form. When Citigroup Inc., one of the nation’s biggest home loan lenders, said last month that it would back the change, possibly to boost its odds of getting billions in government handouts, many supporters assumed the rest of the financial industry would fall into line. Instead, the other banks have treated Citi as a renegade, like a Blood going over to the Crips.
The mortgage lobby argues that cram-downs would provoke a headlong rush to Bankruptcy Court. They say mortgage rates for home loans would soar even for worthy homebuyers because lenders would see more risk in the home loan market, as though a market facing 8 million foreclosures doesn’t already fit the textbook definition of “risky.” Economists are sharply divided over the effects of this proposed change in bankruptcy. Michelle J. White of UC San Diego estimated last year that it could save more than 100,000 homes a year, especially in cases in which mortgage lenders were otherwise unwilling to make a deal. But Christopher Mayer, a real estate expert at Columbia Business School, seconds the industry’s assertion that it would drive up rates. “We don’t want to permanently damage the mortgage system,” he says. “It’s been damaged enough.” But it’s worth noting that cram-downs are necessarily limited to mortgages underwater — those with balances exceeding the property’s market value. Such home loans already are highly vulnerable to foreclosure, so the mortgage lenders face huge losses unless someone like a bankruptcy judge can craft a solution.
Under the leading proposal in Congress, a typical plan would work like this for a debtor owing, say, $225,000 on an adjustable-rate mortgage on a home now worth $200,000: The judge reduces the balance to $200,000. The excess $25,000 becomes an unsecured debt to the lender, to be paid off, probably for pennies, at the end of the case. This part of the process is known as a “strip down.” (Who knew bankruptcy lawyers led such colorful lives?)
The judge can request that the lender provide a mortgage modification by converting the adjustable rate to a fixed market rate, adding 1% to 3% as a risk premium. The judge can erase all the fancy gingerbread that makes so many mortgages toxic — periodic rate adjustments, prepayment fees, balloon payments, etc. — and extend it out as long as 40 years. If the judge determines that no combination of these alterations would produce a mortgage the debtor could handle, the house could be foreclosed.
This process addresses one big obstacle to mortgage workouts, the rights of bondholders. The securitization of mortgage loans, which was supposed to be a great innovation in lending, separated the entity servicing the loan — usually a bank that collects payments, chases delinquents and files foreclosures — from the loan’s owners, who are far-flung and faceless investors.
Mortgage service companies worry that if they restructure a home loan to keep payments flowing rather than foreclose, they’ll be sued by bondholders even if the result is arguably better in the long run. But if a judge orders the modification, the servicer gets legal cover.
Nobody thinks that cram-down is perfect, or that it’s the only answer to the housing crisis. But its virtue is that it focuses on the debtors most serious about keeping their homes and least likely to re-default. That’s because sane people don’t subject themselves to Chapter 13 unless they have no alternative. “It’s a fairly draconian process,” J. Rich Leonard told me. He should know: One of the more eloquent proponents of the mortgage cram-down, having briefed Congress on the subject several times, he has been a bankruptcy judge in North Carolina for nearly 17 years.
Michael Hiltzik’s writes a column appears Mondays and Thursdays in the Los Angeles Times. Read the complete bankruptcy article>
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