PROPOSED CHANGE TO BANKRUPTCY LAW WOULD AID MORTGAGE HOLDERS

An article at CNN.Money entitled “Bankruptcy 'tweak' could save 600,000 homes” discusses a proposal to change Chapter 13 Bankruptcy law to allow more debtors to keep their homes and avoid foreclosure.

There are two main types of bankruptcies. There is Chapter 7, in which a debtor surrenders her assets and her debts are generally erased. So if a debtor is behind on boat, car, or business debts, she can usually file Chapter 7 and erase those debts. A Chapter 7 debtor that owes a mortgage can either surrender the house, or “reaffirm” the debt by signing an agreement to keep the house and pay the mortgage.

The other type of bankruptcy is “reorganization”. Businesses can reorganize under Chapter 11, while individuals and families can reorganize under Chapter 13. Reorganizations allow debtors to retain assets (collateral) that secure a loan, such as property, vehicles, or machines and equipment.

But under reorganizations, the debtor does not have to pay the full value of the loan. Reorganization allows debtors to “cram down” the debt to the value of the collateral. The reasoning is that if the creditor repossesses the collateral, the creditor will only recoup the value for which it could sell the asset.

Here is an example. Farmer Whiskey borrows $60,000 from Farmers and Seamen State Bank to buy a tractor. The farmer falls behind on tractor payments and upon most other dates. If the bank were to repossess the tractor, it could sell the tractor and recoup some money. But if the value of the tractor has fallen to $40,000, that is all the bank could get by repossession.

And under bankruptcy reorganization, that is all the debtor will have to pay the bank for the tractor loan. The amount of the loan is “crammed down” to the value of the tractor. (It’s a lot more complex in some situations, but this is the general rule.)

CHAPTER 13 IS THE MORTGAGE DEBTOR’S UNLUCKY NUMBER

The same “cram down” rules do not generally apply to a home mortgage for a Chapter 13 debtor. So even if a house has declined in value from the mortgage loan amount, or the costs and delay of foreclosure will net a lender less than the market value of the house, a Chapter 13 debtor will still be required to pay the full loan amount.

The new law would allow a mortgage “cram down”.

Under the House bill, the bankruptcy judge would have the option of reducing what the homeowner owes the lender. Say a homeowner's property is worth less than what he owes. The judge could reduce the principal to match the home's current market value as well as reduce the loan's interest rate.

The rest of the original principal would then be treated as unsecured. That means it becomes a lower priority for repayment than the borrower's secured debt, such as the newly reduced principal on his home. Unsecured debts may be discharged.

MORTGAGE LENDERS OBJECT, CLAIMS LAW CHANGE WILL RAISE THE COST OF ALL CREDIT (Hint to lenders. Just raise the fees, charges and interest rate on credit card debt. No one ever seems to notice.)

If investors in mortgage debt knew that mortgages could be adjusted by the courts without the consent of the lender, that could increase their perceived risk and change their valuation. (AUTHOR’S NOTE: Most lenders used to reduce risk by investigating the assets and creditworthiness of borrowers. It might be time to start doing that again.)

Steve Bartlett, president and CEO of the Financial Services Roundtable, contends the ultimate price would be paid by consumers. "If enacted, [the House bill] could have a de-stabilizing effect on the mortgage markets, which are now begging to stabilize," Bartlett told a House Judiciary subcommittee.


MUCH OF THE LOAF MAY BE BETTER THAN A LITTLE

The reality is that whether the loan gets “crammed down” in bankruptcy or gets FUBARed in foreclosure, the mortgage lender loses. But at least in Chapter 13, a debtor avoids foreclosure, remains in the home and still makes a payment.

Mortgages that go into foreclosure hurt the value of mortgage securities and the pricing of mortgages, too. And since investors and homeowners lose either way, said Henry Hildebrand III, a Chapter 13 bankruptcy trustee in Tennessee, at least being allowed to modify primary residence loans under Chapter 13 means everyone takes a lesser hit than they would in foreclosure.

NO ONE WOULD EVEN CONSIDER BEING “CRAMMED DOWN” IN THE DESERT OF THE REAL!