There seems to be a lot of momentum toward bankruptcy cram-downs as a way to reduce foreclosures.
Cram-downs are a bit of a policy of last resort but nothing else seems to be working so cram-down policies have risen to the top of the banking crisis discussion lately.
- Cram-downs would reduce foreclosures. (Good)
- Approving cram-downs would cause a bankruptcy stampede. (Bad)
- Cram-downs would force banks to take losses sooner rather than later. (Bad… I think)
- Cram-downs, if permanent, could prevent the non-governmental mortgage lending industry from ever rebounding after home prices bottom out. (Bad)
If you are unfamiliar with the term, here’s how the Journal describes the process:
In a cram-down, a judge modifies a loan, often reducing principal so a borrower can afford it. Lenders hate it because they have to absorb the loss. Bankruptcy judges currently have the ability to modify certain personal loans and even mortgages on vacation homes, but they can not cram-down mortgages on primary residences.
President-elect Obama indicated his inclination to bankruptcy reform to allow cram-downs during his campaign, and two main Congressional players — Barney Frank and Christoper Dodd — have made no secret of their affinity for the program. Given that sort of backing and the Democratic majority, I think you can call it a done deal.
There are only a few problems with the idea.
Think about how the courts are going to handle this. There will be a tidal wave of BKs. No way on earth that they can handle the crunch of say ten or twenty million petitioners. As the cases wind their way through the system, the payments will likely be stayed and a lot of people will live mortgage payment free while the owners of the mortgages, many of whom we have already bailed out, will get hammered.
And here is the downside.
And of course, no investor in his right mind is going to invest in any American mortgage security again without a substantial risk premium. So unless we want to see mortgage rates in the neighborhood of credit card rates, the government is going to have to subsidize the business from here to Kingdom come. Which one of those options do you think is going to come about?
Moral Hazard
Cram-downs could have an “unfairness” effect that could undermine faith in the entire economic system. Your irresponsible, formerly-bankrupt neighbor now pays less for his mortgage every month than you, and later when you both sell your homes, he makes money while you lose money.
In the current “foreclose-not-forgive” system, the irresponsible neighbor is at least shamed by being forced to move out which encourages responsible behavior among the remaining neighbors.
The Best Way to Write-Down a Mortgage?
However, when it comes to lenders forgiving mortgage debt (reducing the mortgage loan balance), there is a “fairness” advantage of doing it within the court bankruptcy process. You know the bankruptcy rules were applied uniformly by the courts in a well established process, and with a bankruptcy, you know the homeowner was wiped out financially.
If a bank forgives debt within a foreclosure process, on the other hand, it opens up a can of worms which is why lenders haven’t done it much.
For example, homeowners who are underwater but who are able to pay the mortgage (and who have plenty of other financial assets) would simply stop paying the mortgage if they thought the bank might forgive a large portion of their mortgage debt. If, however, the homeowner knows the bank will kick them out if they stop making mortgage payments, the homeowner is more likely to make the mortgage payments even if he is underwater.
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Shift 01.01.09 at 8:53 pm
For the most part, I don’t like new laws. There is always unintended consequences.
The thing I think is most messed up about allowing cram-downs is that it changes the playing field mid-game for those who bought the securities at a lower risk premium than would be the case if the cram-down were allowed at the time of purchase.
One of the many reasons we are in this mess is the change in bankruptcy law. I did not like that the law had been changed, but now that we have learned how to live with the new laws, there is talk of changing them. That irritates me.
I would like to have a do nothing congress and a no nothing president. However, I’m probably just being an old grump.
Getting old aint all that much fun.
Get off my lawn!
Brian 01.01.09 at 8:56 pm
John, I don’t like this “cram down” option. Not that anyone is asking my opinion, certainly not Dodd or Frank. As you say, it rewards irresponsibility. There have been better suggestions on this blog, like those that keep people in those homes as virtual “renters” with the option to eventually share the profit with the bank (mortgage holder) on an above water sale down the road.
I just don’t think the seven year credit blackmark is enough of deterrent. Others have pointed out that it is unlikely any of these houses will get back to even in seven years, so a BK is easier than living up to a contract. And you are right, what lender will loan again if all the risk is on the lender and the borrower gets off risk free?
John Wake 01.01.09 at 9:27 pm
Yeah, I was thinking after I wrote the post that the Treasury or Fed should have some influence with the lenders for their $700 billion contribution and that if the politicians really want cram-downs they could make them “voluntary” for those banks who receive the bailout money.
It would prevent some foreclosures. More importantly, it would let the politicians say they were doing something which may prevent them from doing something more stupid.
It would be critical that any cram-down program be temporary.
Shift, State legislation can’t change contracts retroactively (it’s my understanding) but the Feds may be able to. Another reason to make it a “voluntary” program.
Whatever programs the politicians think up, they won’t likely put in place until about the time the market bottoms out in Arizona. In that case, the programs could prolong the misery in Arizona by preventing the non-governmental mortgage sector from bouncing back, or some other unintended consequence.
Any programs that slow or prevent the non-governmental mortgage lenders from bouncing back after prices bottom out will particularly hurt the value of homes that are too expensive to qualify for conforming loans.
Brian 01.01.09 at 10:11 pm
John, you give another good argument for a delayed bottoming and a slower recovery for the upper bracket RE market. I had thought of the facts that the lower end market had the worst kind of financing that caved in first (sub-prime, nodoc, zero down, negative amortizing) and the most action by “flippers” who would walk away at the drop of a pin. So, those home prices have fallen farthest as a percent and fastest. Most of the Federal programs to date have been directed at this low end market (increased GSE conformance limits, pressure on 30 year fixed rate interest rates), so it will be the first to bounce.
I had already considered that the high end market is composed primarily of better heeled homeowners, who can wait longer for the market to turn, with not too many rental property investors and flippers; and the high end receives no help from the Feds with jumbo mortgage rules and rates or programs to work out underwater mortgages. So, it was obvious that the high end would take longer to bottom out and then recover. But you just provided another good reason for the delayed bottoming and price recovery in the high end RE markets around the country and in Phoenix (i.e. N. Scottsdale).
Shift 01.01.09 at 11:49 pm
“State legislation can’t change contracts retroactively ”
Either contracts have nothing to do with cram-down within bankruptcy OR a cram-down will have little short term affect on the market.
If a cram-down were only to affect new mortgages there should be little fear of this kind of legislation as it would accomplish nearly zero.
Tiffany Cloud 01.02.09 at 9:45 am
John,
I agree with your analysis whole-heartily. If these cram-downs are used they should be voluntary (which by the way means this option will not get used). Why would any investor in the world continue to invest in securities or America for that matter if we can just change the terms when it suits us? This is dangerous stuff - we are talking about undermining faith in the American system to stand behind it’s obligations and be honorable. Yes, we are in a full blown recession and Yes, we HAVE NOT hit the bottom of the housing market but we HAVE to ride this out and honor our obligations. There is no such thing as a quick fix here.
AMC 01.02.09 at 10:27 am
There is no “stay” of mortgage payments in Chapter 13.
And why can a vacation home owners modify his mortgage? Or a landlord modify the mortgage on a rental home? Or a commercial property owner modify a mortgage on commercial property? Or a flipper modify a loan on investment property? Why is it the end of the World if the same ability to modify mortgages is extended to a family’s residence?
There was a break of faith by private mortgage lenders during the housing bubble - mortgage companies were engaging in street level fraud in order to provide mortgages to the private issuers (primarily the now defunct investment banks) so they could commit fraud on an even larger scale in pumping out mortgage backed securities, and the various derivatives that were associated with them.
The evidence shows that the programs Congress has created, and the “voluntary” programs by the mortgage industry, have not worked. It is time to treat mortgages - at least those created between 2002 and 2006 - like any other debt in bankruptcy.
Tiffany Cloud 01.02.09 at 10:46 am
“There is WAS a break in the faith by provate mortgage lenders”. That is true, it was allowed by the financial sector AND government because of greed. The banks have suffered severely for it and we have all suffered with them. How in the world can you write down some loans and not the others? If you are going to write down some loans you have to write them all down and when do we just stop handing out money to everyone? Think about this, your neighbor gets to reduce his mortgage by 100K but you don’t because you have the ability to pay it and he doesn’t. Effectively the homeowner who can make his obligations gets punished. Let’s continue with the loan modifications currently in place; reducing interest rates, lengthening the term of the note, interest on only a part of the balance owed or a combination thereof, but DO NOT allow congress or lenders to punish those that have the ability to pay their mortgages as they promised.
Brian 01.02.09 at 12:09 pm
AMC, there are a lot of problems with your arguments:
First, stop blaming the big, bad, banks for all the problems. I am so tired of apologists for the poor innocent home buyers between 2003 and 2007. Face it, most of them risked nothing. They had zero down, No doc (liar) loans, some that were negative amortizing. Why am I supposed to feel sorry for these people. They created the problem, were not victims of some “fraud” as you call it. Yes, the banks were greedy too. And as Tiffany points out, they have paid dearly with their destruction, the losses of their shareholders and bondholders, and now with the punishment on the tax payer who must back the banks in order to have a functioning economy.
Second, there is no comparison between business loans and mortgages where bankruptcy is concerned. The risk profile of ANY business loan is higher than that of mortgages. That is why interest rates on business loans are much higher. There is no such thing as a 5%, 30 year fixed rate business loan, I promise.
If we want to create even more moral hazard, lets loosen up bankruptcy laws further. Then everyone will declare, even people like me who has a perfect credit rating, is never late on a monthly bill, and used to have 50% equity in my home (down to about 25% now, unfortunately).
You can tell: I don’t feel like subsidizing all the reckless, irresponsible people who bet wrong on an overheated RE market. Let ‘em eat cake!!!
Paul 01.08.09 at 3:16 pm
John-
Looks like cramdowns may soon become a reality as the financial sector is apparently starting to support the idea. I just wrote a (rather lenthy) post on my blog about the topic here.
-Paul
http://www.desertlawblog.com
Shift 01.08.09 at 3:44 pm
Citi agrees to cram-down and the national association of home builders dropped opposition: http://www.cnbc.com/id/28562958
John Wake 01.08.09 at 3:48 pm
Paul, Are you studying up on bankruptcy law?
Common Sence 01.11.09 at 7:46 am
I can’t believe it, the more educated people get, the more common sence they lose. If these so called financial czars were so smart, they could have helped the situation right in the beginning. They could have forced the banks to FREEZE the interest rates on all the Adjustable Rate Mortgages at a low interest rate. This would have stopped the foreclosures right in there tracks. Yes the banks would have lost money, but nothing what they had experienced. I also think they should lower the rates on all those who are struggling, no matter what there credit score looks like. At least it will keep them in there homes and give them the time to sell there homes, if they wish to. This would have stabalized the housing market.