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.