More on the Mortgage "Cram Down"

Professor of Law Alan Schwartz takes to the pages of the NY Times to criticize expanding the power of judges to "cram down" secured debts in a bankruptcy case to home loans. He has three main points, which we'll break down here:

First, the proposal would swamp bankruptcy courts. There are only about 300 bankruptcy judges, and they are already busy with an increasing number of bankruptcies. Clearing millions of new mortgage cases will take a long time and thus have little immediate effect on the foreclosure crisis. In addition, the flood of new cases would delay the resolution of business bankruptcies, to the detriment of the economy.

This doesn't quite sound right to me. Many people already enter bankruptcy in a last ditch effort to avoid having their homes taken away from them; the automatic stay that follows from filing a bankruptcy petition buys them time to try and get their debts and finances in order so that hopefully they can figure out a way to continue paying for their mortgage while having their payments on other debt reduced. For these people, it simply means that the bankruptcy judge now has to figure out how to deal with the mortgage debt in addition to the rest of the debts that are being restructured in a Chapter 13. Now I'm sure there are many people who might be advised to enter bankruptcy for the primary purpose of saving their home, who wouldn't have already before the cram down provision is enacted, but I'm not sure if that's "millions" of new cases. Maybe.

Second, many debtors will be disappointed. Consider the parties’ incentives. Debtors will argue for low home values while lenders will argue for the opposite, to minimize their losses. Lenders will win many of these valuation contests: they have more expertise than individuals in making their case and greater resources.

This seems like an odd argument. For one, property is always being valued in a bankruptcy case. Judges frequently must oversee the valuation of property to determine how much the secured portion of the debt attached to that property should be. Sure this is more difficult for a home than it is for a car, but that's not much of argument against it by itself, so how is debtor disappointment alone a persuasive argument? Debtors almost always face creditors who know something more about the value of their property than they do. And I don't know how any of this is more disappointing than losing your home.

Finally, the proposal worsens economic uncertainty. A major cause of the financial crisis is that many banks do not know what their assets — and particularly home mortgages — are worth. Valuing homes is simple when prices are stable. An appraiser can look at prices in a neighborhood and plausibly infer that a particular house is worth about as much as similar houses there.

But even experts do not know how to value individual houses when a large number of them are in default, and thus potentially for sale, and cash is tight for prospective buyers. Under the president’s proposal, however, bankruptcy judges who are not experts at valuation would be required to price individual houses. Valuation thus will likely be a shot in the dark, inevitably affected by a judge’s personal sympathies. The arbitrariness of valuing single homes in bankruptcy will further increase the already considerable uncertainty regarding the value of the banks’ “toxic assets.”

This argument is a little more compelling. But I don't see how the end result of a judges' valuation (affixing the mortgage debt at a certain amount) is that much more harmful than the end result of having to foreclose on the home and sell it at a steep loss. If anything, I would think that fixes the value more quickly and with more certainty than waiting for the foreclosure process to produce a buyer who pays far less than the house was worth at the time it was bought. Now of course the buyer of a foreclosed home pays cash right then and there for the home, whereas the debtor in a Chapter 13 has to manage to make it through 3-5 years of scheduled payments to survive bankruptcy (and even then will continue paying on the house for a longer term.) But that's a price I'm willing to have lenders pay to help keep people in their homes.

White House Tackles the Burst Housing Bubble

The burst housing bubble, which kicked off the economic crisis we find ourselves in now, is the problem the Obama administration is not attempting to solve with a proposal to help homeowners who are underwater and/or facing foreclosure:

The plan, which is more ambitious than expected, would spend $75 billion to help keep as many as four million families in their homes, and would help as many as five million more refinance their mortgages to take advantage of lower interest rates.

“The plan not only helps responsible homeowners on the verge of defaulting, but prevents neighborhoods and communities from being pulled over the edge too,” the White House said in a fact sheet.

[...]

The plan would seek to entice lenders into lowering rates, and would offer homeowners a chance to shave thousands of dollars off their mortgages. The government would offer homeowners principal reductions of $1,000 a year for five years if they stayed current on their payments, and would give $500 to loan servicers if they modified loans before borrowers fell behind in their payments.

Or, if a lender lowered interest rates so that buyers were spending 38 percent of their monthly income on mortgage payments, the government would provide matching funds to lower that payment to 31 percent of income. The White House said such a reduction could equal $400 in monthly savings on a $220,000 mortgage.

The plan is necessary because, despite the fact that lenders acknowledge the foreclosure crisis and the importance of preventing further foreclosures, they seem incapable of working with homeowners on the scale necessary to even begin to address the problem.

Democrats in Congress are also working on a modification of bankruptcy law that would permit judges to "cram down" home loans in a Ch. 13 proceeding. In a op-ed I encourage you to read, Tom Evslin points out why this is also an important step in efforts to allow people to hang onto their homes (though there are those who have objections to the idea.)

UPDATE: From McClatchy, an article on the carrot (modification) and stick (cram down) approach of the Obama administration.

Change the Law

At the other end of the global financial crisis are those mortgage backed securities that are tanking, and at the root of that are the homes being foreclosed on. Home equity loans, lax borrowing standards and the bursting of the housing bubble have now left one in six homeowners "under water" on their loans:

The relentless slide in home prices has left nearly one in six U.S. homeowners owing more on a mortgage than the home is worth, raising the possibility of a rise in defaults -- the very misfortune that touched off the credit crisis last year.

The result of homeowners being "under water" is more pressure on an economy that is already in a downturn. No longer having equity in their homes makes people feel less rich and thus less inclined to shop at the mall.

And having more homeowners under water is likely to mean more eventual foreclosures, because it is hard for borrowers in financial trouble to refinance or sell their homes and pay off their mortgage if their debt exceeds the home's value. A foreclosed home, in turn, tends to lower the value of other homes in its neighborhood.

And more foreclosures means more trouble for economy, as faltering banks become the reluctant owners of homes that they can only sell at a loss. Eric Nguyen, a student at Harvard, says in an op-ed in today's NY Times that it's time to reform bankruptcy law to make it easier for homeowners to keep their homes:

While the bankruptcy code Congress amended in 2005 allows a judge to modify mortgage terms for an investment property in order to make the monthly payments affordable, it expressly prohibits modification of terms on a primary residence without the foreclosing bank’s permission. A court can insist that creditors give more time and better terms for people in bankruptcy to pay back loans on cars, boats, rental property and vacation homes — but not on the family home.

For parents with children, of course, there is little relief in keeping the car but losing the home. Data that I have analyzed from Harvard’s 2001 Consumer Bankruptcy Project, a survey of 1,250 people who had recently filed for bankruptcy, indicate that a key reason families with children file is to keep from losing their houses. Having young children nearly doubles the likelihood that the average family in bankruptcy will continue making mortgage payments — to keep the children in the same school and stay in the same neighborhood.

Bankruptcy laws should be flexible enough to allow some parents who will regain their financial footing to continue to make house payments, while denying the same relief to financially irresponsible investors. In addition to helping families, this would help reduce the depressing effect of foreclosures on house prices. And it would cost the taxpayer nothing.

As Nguyen points out, Congress passed on a change in the bailout plan that would permit judges to modify the terms of mortgages that would allow those in bankruptcy to make more modest payments but keep their homes. They may presently feel like they have bigger fish to fry, but no rescue of Wall Street and the global financial system should take place without changes to bankruptcy that benefit the average homeowner as well. Not only is it the right thing to do, it's good for our economy as well.

Anti-Consumer bankruptcy laws exacerbate subprime crisis

According to an article on Business Week Online, because of the revisions to bankruptcy laws that were passed in 2005, more people are fiscally bankrupt (if not legally so) are finding it makes more sense for their own finances to default and simply not repay their debts than to even claim bankruptcy, a move that is adding further damage to the broken housing market. The effect of the law was to force more people to repay their debts.

The new rules could force up anywhere from 4% to 15% of these debtors to repay their creditors under Chapter 13 rules rather than the more lenient Chapter 7 regulations, said Jeffrey Morris, a spokesman for the American Banking Institute.

It sounds rather counter-intuitive to think that because people must repay their debts, the housing market gets worse, but here's how BW explains it:

The latest lesson for lenders from the housing crisis: Be careful what you wish for. Banks and other financial outfits spent eight years and $40 million lobbying for sweeping new bankruptcy rules that would limit their losses from deadbeat debtors. But it turns out those changes, enacted in 2005, are forcing more troubled borrowers to walk away from their homes—even those who didn't take on risky mortgages in the first place. And that's bad news for lenders, which suffer financially every time they have to take a troubled property on their books.

Before the new rules kicked in, many consumers could find debt relief—and keep their homes—by filing for bankruptcy protection. Now the process is much more onerous and expensive and the benefits more limited, making foreclosure seem appealing by comparison. A July paper by David Bernstein, a researcher at the U.S. Treasury, found that 800,000 fewer homeowners have filed for bankruptcy since the rules kicked in. A quarter of those people, says the report, have likely had to give up their homes as a result—boosting foreclosures nationwide at least 4%. "[The rules] are directly responsible for the rising foreclosure rate," notes another report by investment bank Credit Suisse.

They got what they wanted. Previously, anybody could file for Chapter 7, the quick and cheap proceedings that liquidate financial assets but not the home to cover debts and dismiss unpaid bills. Now only low-income borrowers qualify, and Chapter 7 doesn't stave off foreclosure.

As a result, many struggling borrowers have no other option but Chapter 13, which requires that people follow a court-mandated repayment plan for all their debts, including medical, credit-card, and other bills typically discharged under Chapter 7. Going the Chapter 13 route can halt a foreclosure already in process. But that's often only a temporary salve, since other debts aren't eliminated, and banks can resume foreclosure proceedings as soon as the payments begin to slip anew. Says Chicago bankruptcy lawyer David P. Leibowitz: "In some cases, bankruptcy has become so onerous that it's not worth it to save the house."

Oops. Of course, the blame game can always go back and forth as to who began it all. As far as I'm concerned, there's no credible evidence that shows that any sizable number of people were ever abusing the bankruptcy laws. After all, it ruins your credit. It's not an option you take lightly, even when it was more beneficial. But of course, it's kind of obvious that if corporate lobbyists are spending money trying to get some law passed, it's beneficial to them monetarily and detrimental to the public. And of course it was another piece of partisan hackery passed when Republicans controlled Congress. But even if everything they said was true, the fact that people can't get out of at least some of their debt cleanly makes it much more rational to simply abandon their debts. Unfortunately, this only helps drop the bottom out of the housing market when what we really need is for people to stay in those homes. More important than punishing people for being stupid or punishing lenders for being greedy is the need to stabilize this market.

The bailout of Freddie Mac and Fannie Mae is an effort to keep the economy alive by keeping some liquidity in the market so lender can keep lending. But we also need to keep some liquidity in consumer's pockets, which is why I'm still waiting to hear about a rescue package for struggling homeowners. Well, maybe when we have a Democratic President...

On all things economic

First a couple of links I think you should take a look at. Xanthippas linked to a post about an op-ed. It's very good and worth reading, but that original article has sparked quite a bit of debate. Thus, read it first and be prepared. Second, read the transcript of the Bill Moyers talk with William Greider. It's not directly about the article, but it might as well be. Third, for an excellent illumination of one of the many ways the credit companies manipulate consumers, read this awesome piece on FICO (on Slacktivist), otherwise known as your credit score.

Pop Quiz: Following are two possible explanations for why most Americans are in the dark about the meaning and manipulation of credit scores. Which do you think is more important?

A. We Americans are lazy and ignorant people who can barely manage to feed ourselves unless tut-tutted and prodded by parental figures like Christopher S. Rugaber for our own good.

B. The calculation of credit scores is a protected trade secret, proprietary information closely held by the triumvirate of Transunion, Equifax and Experian, and therefore, legally, by definition, such information is unknown and unknowable by anyone not working for those unelected entities, including you, me and every personal finance reporter in the business including Christopher S. Rugaber.

Again, not directly related to the original NYT article, but it might as well be. And it's just perfect in its refutation of the idea that we're in control of our own monetary destiny. This article shows you that nothing could be further from the truth.

Another piece of evidence that demonstrates our lack of control over our own finances is that we cannot voluntarily increase our incomes, yet quite without our consent or approval, our lives keep getting more expensive. Another NYT article:

Job losses will probably accelerate through this year and into 2009, and the job market will probably stay weak even longer. Home prices will probably keep falling, shrinking household wealth and eroding spending power.

“The open question is whether we’re in for a bad couple of years, or a bad decade,” said Kenneth S. Rogoff, a former chief economist at the International Monetary Fund, now a professor at Harvard.

Lastly, it appears some of the major airlines are near collapse:

"We're looking at the very real possibility of one, two, maybe even three major bankruptcies that are not chapter 11, but park the airplanes and liquidate," ABC News aviation consultant John Nance said earlier this week.

Best use those frequent flier miles folks!

Bankruptcies Up

Not a surprise, but the number of new filings is somewhat troubling:

Consumer bankruptcy filings rose 40% in 2007 as housing-market turmoil and increasing consumer debt levels led more people to seek protection from creditors.

The American Bankruptcy Institute, using National Bankruptcy Research Center data, said total consumer filings rose to 801,840 in 2007 from 573,203 in 2006.

ABI Executive Director Samuel J. Gerdano said the situation is likely to worsen in 2008. "The roughly 40% spike in consumer bankruptcies during 2007 presages even higher filings this year, as the heavy consumer debt load is made worse by the home mortgage crisis," Mr. Gerdano said.

Just another sign of a general economic downturn.

Warning: Creditors Will Screw You

In a related pair of articles, we see that creditors are perfectly willing to play it fast and loose with debts that debtors don't actually owe to them. First, this report from Business Week that explains the growing market in discharged debts:

The case of Van Rathavongsa illustrates how canceled debts regain vitality. The Raleigh (N.C.) factory worker pulled himself out from beneath a mountain of bills by means of a bankruptcy proceeding that wrapped up in 2002. One of the debts the judge canceled, or "discharged," was $9,523 Rathavongsa owed to Capital One Financial (COF), the big credit-card company. But Capital One continued to report the factory worker's discharged debt to credit bureaus as a live balance, according to documents filed in U.S. Bankruptcy Court in Raleigh.

This kind of failure by creditors to update credit reports happens with some frequency, consumer lawyers and court-employed bankruptcy trustees say. And it can have consequences: In September, 2003, when Rathavongsa tried to close on a $274,650 mortgage for a new house, his would-be lender, Wachovia (WB), said he would either have to pay Capital One or show proof from the credit-card company that the debt had been discharged. Despite several calls and a letter from his attorney, he says, Capital One never revised the credit report. To obtain the home loan, Rathavongsa eventually did what many consumers in this situation do. He gave in and paid Capital One $9,523 he no longer legally owed.

Rathavoga got his money back, and fines to boot, but only because he was willing to go back to Bankruptcy Court and get a judge to force Capital One to acknowledge that his debt was legally discharged. But unbelievably, financial institutions are now trading in discharged debts:

Because of episodes like this, discharged debts have attracted the attention of little-known firms expert at buying and selling a range of delinquent consumer obligations. Back-due bills with a face value of billions of dollars change hands at a steep discount every year. Five of the companies in this business are publicly traded on Nasdaq. Others have large private-money backers. B-Line, in Seattle, was acquired last year by the Dallas-based hedge fund firm Lone Star Funds. The investment bank Bear Stearns (BSC) owns two bankruptcy-debt buyers: Max Recovery and eCast Settlement.

The very existence of this marketplace confounds even some veterans in the bankruptcy field. During a preliminary hearing in New York in March, U.S. Bankruptcy Judge Robert Drain asked a lawyer for JPMorgan Chase (JPM) how the bank had managed to sell consumer credit-card debts that had been discharged. "I don't know who would buy a discharged account," the perplexed judge said.

"Happens all the time, your honor," the Chase lawyer, Thomas E. Stagg, responded.

Once you complete bankruptcy proceedings and are granted a discharge (whether in Chapter 7, or at the end of a Chapter 13 repayment period) your legal liability for the debt is dissolved. In other words, you are no longer legally required to repay that debt, and creditors are not permitted to contact you in attempts to collect on the debt. So naturally, a bankruptcy court is going to be inclined to think that such a debt is worthless, since the owner of the debt can't legally collect on it and the debtor is no longer responsible for paying it. But of course, the debt gains value when a creditor or collector can actually coerce you into paying it, even if they're doing so illegally.

Congress, in drafting the bankrtupcy code, quite reasonably presumed that once they said a debt was worthless, it would actually remain worthless. For the longest time this has mostly been true, as sanctions for creditors that attempt to collect on discharged debts can be quite severe. Of course, if you acquire enough of these debts, and can con enough debtors into paying you even though they don't owe you the money, well then all of the sudden you have an instrument with value that is quite tradeable on the open market. Despite the fact that, of course, the value is premised on illegal behavior.

The only possible remedy is to punish transgressors even more severely for their bad behavior. And by severely, I mean as if God's wrath were coming down on their head. A corporate creditor will tolerate fines and sanctions and lectures from judges here and there on a few debts, if it can collect enough on the other debts it holds to make the whole adventure profitable. And it should be flat-out illegal to trade in discharged debts.

And in even more questionable behavior, mortage lenders are apparently tacking on fees and practicing poor book-keeping to get debtors whose homes are being foreclosed on to fork over even more money as they lose their family home:

Bankruptcy specialists say lenders and loan servicers often do not comply with even the most basic legal requirements, like correctly computing the amount a borrower owes on a foreclosed loan or providing proof of holding the mortgage note in question.

“Regulators need to look beyond their current, myopic focus on loan origination and consider how servicers’ calculation and collection practices leave families vulnerable to foreclosure,” said Katherine M. Porter, associate professor of law at the University of Iowa.

In an analysis of foreclosures in Chapter 13 bankruptcy, the program intended to help troubled borrowers save their homes, Ms. Porter found that questionable fees had been added to almost half of the loans she examined, and many of the charges were identified only vaguely. Most of the fees were less than $200 each, but collectively they could raise millions of dollars for loan servicers at a time when the other side of the business, mortgage origination, has faltered.

On Oct. 9, the Chapter 13 trustee in Pittsburgh asked the court to sanction Countrywide, the nation’s largest loan servicer, saying that the company had lost or destroyed more than $500,000 in checks paid by homeowners in foreclosure from December 2005 to April 2007.

The trustee, Ronda J. Winnecour, said in court filings that she was concerned that even as Countrywide misplaced or destroyed the checks, it levied charges on the borrowers, including late fees and legal costs.

“The integrity of the bankruptcy process is threatened when a single creditor dishonors its obligation to provide a truthful and accurate account of the funds it has received,” Ms. Winnecour said in requesting sanctions.

As you may recall, Countrywide got in a little bit of trouble for inducing some of those homeowners into bad mortgages in the first place. Apparently that's not enough for them, as they now seem to think they're entitled to skim a little bit off the top even as the debtor descends into bankruptcy:

“We’re talking about millions and millions of dollars that mortgage servicers are extracting from debtors that I think are totally unlawful and illegal,” said O. Max Gardner III, a lawyer in Shelby, N.C., specializing in consumer bankruptcies. “Somebody files a Chapter 13 bankruptcy, they make all their payments, get their discharge and then three months later, they get a statement from their servicer for $7,000 in fees and charges incurred in bankruptcy but that were never applied for in court and never approved.”

In bankruptcy proceedings, fees like this MUST be approved by the bankrtupcy court. Debts like this are as uncollectable as discharged debts. But the debtor who doesn't understand the process or doesn't want to have to fork over hundreds or thousands more to a lawyer to contest the debt, are more likely to simply pay up when they get a bill, even after they've been granted a discharge (which incidentally in a Chapter 13, can come as long as five years after filing.) Or, they can simply try to over-bill the debtor, hoping the court won't scrutinize the fees closely and will include them in the Chapter 13 repayment schedule. This won't work in a Chapter 7 where debtors get a discharge and pay little or nothing on most of their debts (unless of course they just send you a bill later, like the credit card lenders in the above article.) But lenders have every incentive to try and game the system, as they often fail to recoup the full value of their loan when they foreclose on a home.

Again, the only recourse for bad behavior like this is to punish lenders severely. Hefty fines, and subordination or avoidance of debt in the bankruptcy proceedings, will help corporate lenders understand that there is a price for illegality. It's absurd that there can be anything but a junk market for suckers in debts that can't be collected. Stories like these are simply unacceptable.