Should bankruptcy judges be allowed to modify mortgages on primary residences?
Yes.
The power of a bankruptcy judge to do so is called a cramdown. To understand the pros and cons of allowing cramdowns on personal residences (and personal automobiles), you need to understand a little bankruptcy law and a little economics.
You also need to understand why your house and your car are like a cat, and why this similarity is important to banks. Because, it is this similarity that makes a ban on cramdowns of your personal residence and your car so valueable to them.
Once the motives of the parties, and the winners and losers in the deal are understood, it is clear that cramdowns of home mortgages should be allowed, at least in some circumstances.
What Is A Cramdown?
There are three things that can happen to collateral, like a mortgaged home, a car that backs a car loan, or business assets pledged for business debts, in a bankruptcy.
- The collateral can be sold (with the creditor allowed to offer up the mortgage or car loan or business loan with the collateral, in whole or in part, as that creditor's bid). After the sale, the proceeds are applied first to the creditor whose loan is backed by the collateral. If the debt to the creditor with the collateral isn't paid in full, the creditor gets a claim not backed by collateral for th balance. If the debt to the creditor with collateral is paid in full, the borrower's equity is shared by other creditors.
- The debtor can retain the collateral and reaffirm the debt to the creditor whose loan is backed by the collateral, so that the reaffirmed loan is exempt from the bankruptcy process.
- A judge can break the claim of the creditor with collateral into two parts, one equal to the value of the collateral, and other other not backed by collateral. The debtor keeps the collateral on revised loan terms that reflect the current value of the collateral, and pennies on the dollar (if anything) are paid on the rest of the claim. (The creditor with collateral could also be required to substitute other collateral of equivalent value.)
Option three is called a cramdown. Cramdowns are allowed in Chapter 11, 12 and 13 reorganizations, in all cases, except where the collateral is a personal residence or newly entered into car loan. Banks and other lenders have worked hard to eliminate the cramdown option in personal bankrupcies for recent car loans and for mortgages on a personal residence.
Why Do Lenders Single Out Cramdowns For Personal Loans?
If property had an equal value to everyone, and people had no personal attachments to property, eliminating the cramdown option wouldn't matter. Borrowers would always surrender possession of collateral when the debt was worth more than the property; borrowers would either reaffirm the loan, or sell the collateral at a profit, in cases where the collateral was worth more than the loan.
One of the reasons banks and other lenders don't like cramdowns is that a judge can undervalue the collateral, depriving them of the full benefit of their bargain. Creditors are concerned about this because they think that bankruptcy judges are biased in favor of borrowers. Lenders and borrowers may also make mistakes about the value of the collateral, but are less likely to do so because they are self-interested, the lenders argue.
But, this official distrust of judicial valuations doesn't explain why cramdowns are O.K. with business assets, but are not O.K. in the far more typical consumer bankruptcy where a home or a car is at stake.
A key reason lenders are more vehement about not allowing cramdowns for homes and car loans is that a home or car is often worth more to the current owner, for emotional reasons (and due to the transaction costs and disruption associated with finding a replacement), than its fair market value in a bankruptcy auction. This personal value is destroyed if the creditor repossesses the collateral, or the collateral is sold at auction.
If the only way that a borrower can keep a home or a car is to reaffirm a loan worth more than the collateral, often a borrower will do so to preserve that emotional value. This allows lenders to get a post-bankruptcy loan worth more than their collateral, when other creditors without full collateral for their loans are wiped out in bankruptcy.
About the Cat
Physicists have Schrödinger cat in a box, as their thought experiment.
Bankruptcy lawyers engaged in thought experiments mortgage the cat.
Why does any reasonable creditor extend credit with a cat as collateral? After all, cats are often so worthless in terms of fair market value, that you have to pay people to take them (no kidding, I write wills in my work that routinely provide to pay someone to care for an older cat.)
The reason is not that the cat has a high fair market value, but that the cat is worth a lot to its owner who has a personal attachment to the cat. While the cat is worth nothing to the creditor, the creditor's ability to take the cat away from the owner encourages the owner to pay his debts.
In short, a lender seeks the cat as collateral to blackmail the borrower into paying.
Why Are Mortgaged Cats, Reaffirmed Home Loans and Reaffirmed Car Loans Bad?
When the only way that a borrower can preserve the personal value he has in a cat, or home or car, is to pay a creditor more than the fair market value of the cat, or the home, or the car, the creditor has gotten more than the benefit of the bargain. All of the creditor's loan will be paid, even though the part of the loan that exceeds the auction value of the collateral would be paid only pennies on the dollar, if the loan was not reaffirmed.
Other creditors don't complain because a reaffirmation expands the size of the pie. Borrowers pay off the reaffirmed debt out of post-bankruptcy income.
But, the borrowers loses, by being forced to pay more than fair market value to keep their existing home or car, if they want to preserve the personal value and emotional value that asset has to them, which they often do.
Destroying borrower value without providing financial benefit to lenders is a lose, lose proposition. It is the economic equivalent for foreclosing on the cat.
In contrast, lenders don't worry so much about cramdowns in business cases, because business owners rarely reaffirm loans with collateral worth less than the loan amount, because they have little personal attachment to their business assets. So, lenders rarely have an opportunity to secure a windfall by preventing a cramdown of business assets. Also, business owners who know that they might someday go bankrupt, have more clout politically than economically marginal consumers.
Few provisions of the bankruptcy code so squarely pit vulnerable consumers against lenders in a way calculated to give lenders a windfall, as the ban on cramdowns for personal residences and in newer car loans.
Why Is Now The Time To Allow Residence Cramdowns?
The Democratic proposal to allow cramdowns on residences in bankruptcy, as part of the bankruptcy bill is a proposal whose time is ripe.
Historically, in periods of sterner loan underwriting and steadily appreciating real estate, mortgages for more than a house was worth were rare enough to make judicial undervaluation a greater concern. But now, with zero or low downpayments and a collapsing housing price bubble, everyone acknowledges that many homeowners are legitimately upside down with their mortgage lenders, often as a result of the bad business practices of the lender.
Also, the value of keeping people in their home, if they can afford it at its current fair market value, even if they can't at the original purchase price, protects more than a bankrupt person's emotional value in the property. It also protects community property values and stability, and family stability, by forcing people out of homes only to make them rent similar ones.
And, finally, cramdowns address a key market failure of the moment. It is now often impossible for a person with bad credit to refinance an existing loan in the financial markets, even if the refinance provides a fair return to the original lender, compared to foreclosing on the property. The demise of the subprime and Alt-A markets, make bankruptcy courts the only institutions in our society currently equipped to do what makes rational sense in the cases of many distressed homeowners.
How Should We Compromise If We Must?
If Democratic members of Congress must compromise, they should do so not by surrending the option of a mortgage cramdown, but by limiting the option to borrowers in states where average or median housing prices have fallen by more than the original down payment percentage since the borrower took out the original loan.
This compromise would prevent abuse in good economic times, when judicial undervaluation was an important concern, and in cases where underwriting has been basically sound, while allowing cramdowns to be used as a tool in bad economic times and in the case of loans likely to go bad, to address legitimate concerns of distressed homeowners.