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Chapter 13 and the Durbin mortgage modification bill

As I mentioned in an earlier post, a number of bills are floating around Congress that would revise Chapter 13 so as to ease the burden on homeowners. Currently, under Chapter 13, if you own a house with a $250,000 mortgage but only a $200,000 market price, you can't escape the entire mortgage. Either you lose your house or you emerge from Chapter 13 with (roughly) the same $250,000 secured debt. Durbin's bill would allow the bankruptcy judge to strip down the mortgage debt to the value of the house. The debtor would be permitted to keep the house as long he accepts a $200,000 mortgage and has an income adequate to pay it off.

Hard-hearted people like me might be tempted to dismiss this bill as a redistribution of wealth from creditors to debtors, one that will just increase the cost of credit in the future, while rewarding irresponsible people to boot. But that would be a mistake. The Durbin bill, or some variant of it, makes good sense.

To see why, one must bear in mind that these are not normal times, and that there are good reasons for allowing homeowners to escape a portion of their debt. Indeed, in the good olde days, this would hardly raise an eyebrow. Suppose that a person borrows $250,000 from a bank, buys a house worth $300,000, and then temporarily loses his job or even experiences a permanent reduction in income. Meanwhile, the value of the house has plummeted to $150,000. The debtor can't make his mortgage payments, at least for the time being. Should the bank foreclose? No! Foreclosure typically reduces the value of a house by as much as 50 percent, and can reduce the value of neighboring houses as well. If the bank forecloses, it will hold a piece of property worth $75,000, and it is unlikely that it will be able to recover the lost $175,000 from the debtor (impossible in some states). The bank and debtor are better off if they renegotiate the mortgage—say, a new $200,000 mortgage that the debtor can afford on a lower income. Of course, banks had to be careful not to renegotiate too quickly or easily, for then debtors would fake distress in order to obtain better terms. But renegotiation of mortgage loans has always been routine.

Until, that is, the rise of mortgage-backed securities. Now the debtor can only renegotiate with a loan servicer, which passes on the principal and interest payments to thousands of dispersed holders of MBS's. In theory, the loan servicer has the contractual right to renegotiate loans on behalf of the investors, but it is hardly clear that the servicer has proper incentives to do so, and in any event investors have not been cooperative, perhaps because they do not trust servicers to act in their interests.

Durbin's bill gives the debtor the option to enter bankruptcy and, in essence, force the investors to accept a renegotiated loan contract. It appears that the new mortgage would be the market value ($150,000, in my example) rather than the foreclosure value ($75,000). Whatever the case, the gains ought to be significant. A debtor who would walk away from a $250,000 mortgage on a $150,000 house may be willing to accept a $150,000 mortgage on the same house, particularly if (as is likely) he values the house more than the market does. That means fewer houses being foreclosed, and potentially an enormous amount of value being preserved.

The bill is far from perfect, however. For one thing, a revision of the law will have prospective effects, and it might raise the cost of credit (though it might not, if debtors are sufficiently risk averse). In addition, bankruptcy is costly and time-consuming, and there just aren't enough bankruptcy judges for the millions of people who are on the verge of losing their homes. Finally, the forced renegotiation is incredibly crude. Many people will walk away even if allowed to reduce their mortgage to the market value of the house, and others will benefit from the change in the law who don't need it—and this will raise the cost of credit without producing an offsetting benefit. In my next post, I will examine another approach that may reduce some of these costs.

VFBVFB (mail):
Valuing real property is not a precise science. I'd imagine the courts would be swamped with a huge number of proceedings in which the value of property is disputed. The appraisers who earn a living as expert witnesses stand to do well with this proposal.
1.21.2009 9:56pm
Laura S.:
Your analysis neglects an important fact.

First you establish a false dichotomy between foreclosure or a haircut. On the contrary, a bankruptcy does not relieve the borrow of the primary mortgage. He is still obliged to service the mortgage debt. Most people in bankruptcy have cash-flow; just inadequate amounts. Normally the court will cut-down the unsecured debt--leaving the borrow with the means to continue paying the mortgage.

Indeed, the only reason the debtor would choose foreclosure is if he was underwater, but if he is underwater he better off defaulting BEFORE bankruptcy.

So what you're proposing is in fact to write-down the value of otherwise sound mortgages. Such an event requires a bank to take a charge against capital. Bank capital is in very short-supply.

Mandatory mortgage modification programs are likely to smash the entire banking system into technical insolvency (unless the government bought-out the portion of the loan being forgiven).
1.21.2009 10:05pm
Dave D. (mail):
..." One must bear in mind that these are not normal times ".
...Sounds an awful lot like " This time is different ", the belief of which helped get us into this mess. Why is the homeowner more important in this equation than the mortgage holder ? Since the mortgage holder didn't factor in the eventuality that the Government would void his contract and nullify at least part of his investment, shouldn't he now plan on this and charge a higher interest rate in the future ? How does he price the risk of confiscation ? Folks who lent the money for mortgages depend on those returns to buy their food and pay their mortgages. Why are they less important than the folks they lent to ?
1.21.2009 11:08pm
Laura S.:
Dave D. focuses on:

..." One must bear in mind that these are not normal times ".

I have to agree with Dave's concern. There is a lot of ink being spilt on the notion that something extraordinary is afoot. The banking system is in bad shape for rather uniquely modern reasons, but the recession is quite normal by historic standards. Unemployment is below 1990-91 levels, mortgage delinquencies and charge-offs are below the 90s level too. Commercial loans by banks are in very good shape. Lending volumes are stable, just not growing (as is more typical). Most of the debt markets are functioning very well--the only major hurt is in bank debt--which is actually the target of the Federal Reserve commercial paper program.
1.21.2009 11:25pm
Laura S.:
Dave D. focuses on:

..." One must bear in mind that these are not normal times ".

I have to agree with Dave's concern. There is a lot of ink being spilt on the notion that something extraordinary is afoot. The banking system is in bad shape for rather uniquely modern reasons, but the recession is quite normal by historic standards. Unemployment is below 1990-91 levels, mortgage delinquencies and charge-offs are below the 90s level too. Commercial loans by banks are in very good shape. Lending volumes are stable, just not growing (as is more typical). Most of the debt markets are functioning very well--the only major hurt is in bank debt--which is actually the target of the Federal Reserve commercial paper program.
1.21.2009 11:25pm
Laura S.:
Dave D. focuses on:

..." One must bear in mind that these are not normal times ".

I have to agree with Dave's concern. There is a lot of ink being spilt on the notion that something extraordinary is afoot. The banking system is in bad shape for rather uniquely modern reasons, but the recession is quite normal by historic standards. Unemployment is below 1990-91 levels, mortgage delinquencies and charge-offs are below the 90s level too. Commercial loans by banks are in very good shape. Lending volumes are stable, just not growing (as is more typical). Most of the debt markets are functioning very well--the only major hurt is in bank debt--which is actually the target of the Federal Reserve commercial paper program.
1.21.2009 11:25pm
John (mail):
If the mortgage is non-recourse, then the bill makes some sense, as the ordinary rule in bankruptcy is that a secured creditor has a secured claim only for the value of the security.

If the mortgage is full recourse, however, the secured creditor might have his interest in the house reduced, but should have an unsecured claim for the balance of the debt; that unsecured debt should then be treated in the fairly harsh manner of all unsecured debts in a Chapter 13.

The real change here is that instead of being paid cash for the value of the secured claim (i.e., the now lesser value of the house), the secured creditor is being given a security interest of the nominally same value, and concomitantly reduced mortgage payments. Not exactly what bankruptcy practitioners are used to, but hardly beyond the pale.

On balance, not a bad bill. Moreover, it should allow banks to begin to revalue assets that now cannot be priced.
1.21.2009 11:44pm
Laura S.:

If the mortgage is non-recourse, then the bill makes some sense, as the ordinary rule in bankruptcy is that a secured creditor has a secured claim only for the value of the security.

Mortgages on primary residences are non-recourse. The only option is to pay the mortgage or default and face foreclosure. Bankruptcy does not alter this. Typically the judge will structure your other debts so as to allow you continue your mortgage payments unadulterated so that you can keep your house if you choose.

Changing the rules at this point will impair the value of existing mortgages which would be a disaster because it would trigger accounting recognition--whereas now those assets are market held for investment and stay on the books at original value unless a default occurs.
1.22.2009 12:24am
John (mail):
Laura S: I thought the whole accounting "problem" with the subprime mortgages was that the accountants required them to be valued at market, i.e. (in the absence of any buyers) zero. To be able to give some value to those mortgages should therefore be a plus.

Or am I misunderstanding the accounting issues?
1.22.2009 12:32am
tjvm:

Mortgages on primary residences are non-recourse.

That's true in some states, but not others; in some states the creditor can get a deficiency judgment against the (former) homeowner if the proceeds of the foreclosure sale are not sufficient to satisfy the debt.
1.22.2009 1:27am
Laura S.:
John asks:

I thought the whole accounting "problem" with the subprime mortgages was that the accountants required them to be valued at market, i.e. (in the absence of any buyers) zero. To be able to give some value to those mortgages should therefore be a plus.

Not exactly. FAS 157 requires "fair-value" accounting. This can include mark-to-model if the model includes risk adjustments. There is no strict requirement to mark-to-market. Market-prices are only preferred if an active market exists (this is a called a level-1 valuation). But no or few buyers => no need to use the market price. If similar instruments exist those prices are preferred (level-2). If good analogs do not have liquid markets either, mark-to-model (level-3) valuation is allowed.

Contrary to original reports, accountants need not take notice of sales that result from distressed activity. Especially following an October advisory note that reiterated that managers may ignore transactions that they do not feel reflect the true underlying value.

FAS 115 allows banks to classify mortgage assets as held-for-maturity which exempts them from the fair-value rules. The exemption does not apply to Mortgage Backed Securities. Thus Bear Sterns at all with substantial MBS exposure suffered. Most banks hold the mortgages directly rather than via MBS. Thus, they have been relatively spared--except certain banks with very high charge-offs (WaMu, Wachovia, IndyMac).

Changes to the legal structure of mortgages must still be recognized under FAS 115 "held-for-maturity" rules. That's why the Durbin bill and similar efforts risk Armageddon.
1.22.2009 1:35am
Bob Montgomery (mail):
You make a decent argument, but I'd like to see some documentation and context for this:
the millions of people who are on the verge of losing their homes
1.22.2009 1:43am
FE:
Of course, it goes without saying that poor slobs who refused to pay $300,000 for houses that were only worth $150,000 will not get the opportunity to buy the house in foreclosure.
1.22.2009 2:22am
Patrick216:
The servicers hired by MBS holders are not good people, for the most part. And I say this as a creditor-friendly guy.

But I don't know that the solution to that problem is to allow cram-downs of mortgages in Chapter 13s. You create a huge windfall to debtors by doing so.

Suppose the debtor buys a house for $400,000, zero down, 7/1 ARM. Two years later, the mortgage balance is $379,000, and now because of the crisis, the home value (based on appraisal) has plummeted to $300,000. Most of what's holding that value down is the foreclosure crisis. Presumably in a few years, the economy will improve, and housing prices will rebound. Will they come back to 2005-06 levels? Probably not. But that house will likely be a lot closer to a value of $400k than $300k in a few years.

So here's the message you're sending to debtors: if you don't like your mortgage payment, stop paying your mortgage, run up credit card debt, then file a 13. Your friendly local bankruptcy judge will then give you your own personal bailout by cramming down a "renegotiated mortgage" and by wiping out most of that credit card debt, too. How nice for them!
1.22.2009 6:59am
Happyshooter:
This goes a long way to equalizing the bankruptcy and creditor systems in this country.

A major issue I have seen over the years is the way different states treat a home. Go buy a house in Cali and get in trouble, you can way away withonly the hit to your credit rating. Try the same thing in Michigan and the company will either haunt you for the rest of your working life or will stick you with a huge federal tax bill for spite.

Go upside down in a northern state due to huge medical costs your employer's group plan stopped covering the month before, and you lose your home because your 13 plan won't swing both. The same thing happens in Florida, and it is fat city.
1.22.2009 7:39am
Ben P:

So here's the message you're sending to debtors: if you don't like your mortgage payment, stop paying your mortgage, run up credit card debt, then file a 13. Your friendly local bankruptcy judge will then give you your own personal bailout by cramming down a "renegotiated mortgage" and by wiping out most of that credit card debt, too. How nice for them!


That's more or less always been the case except they can or could (depending on their income and expenses) file Chapter 7 and simply walk away from the house and leave the mortgage company sputtering and wondering what to do with $379,000 written off debt an a $300,000 house.
1.22.2009 8:06am
Connecticut Lawyer (mail):
I am an agnostic on the merits of this proposed bill. But two things do need to be pointed out.

First, there is no doubt this will raise the cost of credit. Lending institutions will have to factor in the greater losses they will incur on loans where the borrower goes bankrupt. This may be a good thing: I think we can safely say at this point that too many people have purchased homes who should not have, and discouraging home ownership by forcing up mortgage rates may help to prevent similar problems in the future. But the proponents of the bill should acknowledge that this will be one of the effects.

Second, you should note that home mortgages are not the only area where financiers are advantaged in bankruptcy. Financiers of aircraft and railcars are similiarly protected: in the case of a ch. 11 filing by an airline or rail carrier, the debtor has 60 days (which cannot be extended by the bankruptcy court) either to (1) cure all defaults on the aircraft or railcare leases or secured loans and promise to continue making payments or (2) return the equipment to the financier. Even if the debtor chooses option (1), it can still return the equipment (and reject the lease) at any time before the end of the case. Still, this provision gives a lot of leverage to the financing parties and has resulted (as it was intended to do) in lower financing costs for aircraft and rail cars.
1.22.2009 9:09am
davod (mail):
Doesn't anyone have a problem with such a severe confiscation of private property. Didn't the Founders write specifically about confiscation.

Yes, I know the SCOTUS has broadened the government's rights in this regard, but it is still fraught with danger.

I cannot think of a quicker way to dry up part of the finance market than having a judge be able to rewrite the value of a mortgage to reflect the market value of a property.
1.22.2009 10:22am
davod (mail):
I should also say that the credit institutions will still be forced by the government to hand out loans to those who should not be given a loan, then they get screwed by a bankruptcy judge when the bad credit risk declares bankruptcy.
1.22.2009 10:28am
Jeff S. (mail):
"Should the bank foreclose? No! Foreclosure typically reduces the value of a house by as much as 50 percent..."

I keep hearing this, or some variation of it (30 percent, 40 percent), but have yet to see it. Two identical houses, side by side, one for sale by the homeowner and the other by a lender who foreclosed, sell for almost the same price. There's nothing like a 50 percent difference. Foreclosure has its costs, but it doesn't reduce the value of the home. If that were true, speculators would be snapping up foreclosures and reselling them. In my area, where the housing market has been hammered, this has occurred very rarely.
1.22.2009 11:17am
Dan Weber (www):
I think this will drive up the cost of credit, but mostly on loans where the borrower cannot make a good down payment.

Which strikes me as a Good Thing. People borrowing 100% (or more!) LTV drove the bubble. If everyone had been required to put 20% down, I think there's a good chance the bubble would not have happened, or at least been significantly less severe.
1.22.2009 11:43am
Dan Weber (www):
Doesn't anyone have a problem with such a severe confiscation of private property.

It's bankruptcy. You could easily get nothing.

(Although I tend to think that the mortgage holder should get a percentage of some future appreciation on the house for some number of years as compensation.)
1.22.2009 11:49am
Bruce Hayden (mail) (www):
It's bankruptcy. You could easily get nothing
Well, probably not. We are talking debt secured with real property here.

And that is part of the problem. Lenders lend huge amounts of money based on the security of real property, and the expectation that if the borrower fails to make the payments, the lenders can get the properties. As a result, you have people borrowing hundreds of thousands of dollars at 7% or so secured by their houses, and thousands at 21% or higher unsecured. Part of the difference there is the expectation that in bankruptcy, the secured lender will get the property, and the unsecured lender might get nothing. So, seriously threatening lenders this way is almost assured to raise the cost of borrowing for a house.

Maybe the lender will get more this way, and maybe he will get less - a lot less. The housing market is likely to rebound, and there is no rational reason I see to give defaulting borrowers the benefit of the appreciation that their houses will see then, when they are not having to pay the consequences. I see this as a great way to get a crammed down loan on your house, and then get the amount of the cram down later as a bonus when the housing prices rebound.
1.22.2009 12:08pm
Guest12345:
I cannot think of a quicker way to dry up part of the finance market than having a judge be able to rewrite the value of a mortgage to reflect the market value of a property.


But on the other side, the banks should be able to file "houseruptcy" on any house that has gone up in value and get the mortgage principal increased to include the gain in value....

yarghh har har.
1.22.2009 12:19pm
Dan Weber (www):
Well, probably not. We are talking debt secured with real property here.
True dat. If they are the only one with a claim on the real property, they can get its full value. But a $200,000 debt secured against a $100,000 house isn't secured to $200,000, only to the value of the house.
So, seriously threatening lenders this way is almost assured to raise the cost of borrowing for a house.
On mortgages without a significant down payment, yes, the costs will probably go up. That sounds good to me.
there is no rational reason I see to give defaulting borrowers the benefit of the appreciation that their houses will see then, when they are not having to pay the consequences
Yes, which is why I think the lender who gets crammed down should get a portion of the future upside. Attach a lien against the house that gives that lender, say, 50% of the value of the property over the amount crammed down, for N years. We can haggle over the specific details.
1.22.2009 1:00pm
Jagermeister:
I agree with what Dave D., dovod, Bruce, and others have said. There seems to me a vast difference between incentive to renegotiate (foreclosing and taking a loss versus writing down the principle) and straight confiscation. It's that "force" part in "force the investors to accept a renegotiated loan contract" that bothers me so much. Why stop with market value. Think of the stimulatory effect on the economy of a write down <i>below</i> market value?

As others have said: (a) The MBS holders are people as well, with retirement accounts, college funds, and what not depending on the interest income and principle of their investments. (b) This places the entire burden on the lender, who seems to have no choice in the matter. (c) After-the-fact contract modifications are the stuff of banana dictatorships, where no investment is safe from the grasp of government (d) This scheme is sure to drive any remaining private money out of the mortgage market, and leave the entire business in hands of the government, which would then surely base lending decisions and mortgage rates on political patronage, etc.

If the problem is with enabling the service companies to more freely represent the interests of the MBS holders, and engage in negotiations, then deal with that issue. I hardly see that the remedy is to remove all control over negotiations from the private parties, and give it to a judge. It is asking for trouble.
1.22.2009 8:28pm
Curious (mail):
If the loan principal is reduced, would this amount become taxable income to the 'distressed' borrower?
1.23.2009 11:14am
David Drake:
Curious--

Without some Congressional relief and outside bankruptcy, yes.
1.23.2009 3:43pm
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