Mortgages And Bankruptcy

by hilzoy

A bankruptcy judge in the Washington Post:

"Homeowners are the only ones who cannot modify the terms of their secured debts in bankruptcy. Corporate America flocks to bankruptcy courts to do precisely this -- to restructure and reamortize loans whose conditions they find onerous or can no longer meet. Airlines are still flying and auto parts makers still operating because they have used this powerful tool of the bankruptcy process. Lehman Brothers will surely invoke it. But when the bankruptcy code was adopted in 1979, the mortgage industry persuaded Congress that its market was so tightly regulated and conservatively run that it should be exempted from the general bankruptcy rules permitting modification.

How far we have come. (...)

Allowing modifications is a solid solution, as evidenced by my example. This homeowner could have restructured her loan to terms resembling those of a conventional mortgage. If the court found that the market value of her home had fallen below what she owed, the secured portion that must be repaid in full would be reduced to the house's actual value; otherwise, the amount to be repaid would stay the same. The interest rate would be adjusted to reflect the prevailing market. However, because this homeowner is a riskier borrower than most, I would have raised her rate to account for that increased risk, as Supreme Court precedent requires. Instead of 14 percent, the rate would probably have been in the high single digits. This homeowner -- with her steady income -- could have made the reduced payments.

Such a solution would have been better for everyone. Obviously, it would have been good for the homeowner and the community in which she lives. Instead of another abandoned house tied up in foreclosure, her residence would be owned by a taxpaying citizen. More important, it would have been good for the lender. Whatever unknown mortgage syndicates hold pieces of this loan, they are never going to get their 14 percent return. Instead, the total recovery will be limited to the proceeds from a foreclosure sale in a depressed market. Any deficiency owed by the homeowner will be discharged as part of her bankruptcy. No one has been able to explain to me why it is not better for mortgage holders to get a fair return of principal back, albeit at a lower interest rate, than to take a lump sum through foreclosure that is probably much less than the value of the note."

Perhaps it once made sense to think that mortgages should not be restructured in bankruptcy. I don't think it makes sense now. It would be great if a repeal of this provision of the bankruptcy laws were one of the bills that will be waiting for President Obama to sign when he takes office.

Comments

[OCSteve]

If the court found that the market value of her home had fallen below what she owed…

Setting that value is tricky though as it’s typically done based on “comps” – sales of comparable property in the same neighborhood. What I’ve been seeing is that sellers are trying to hold out for 2006 prices. So nothing is selling at reduced prices. Thus the comps remain high – the last few comparable properties sold back when the market was still high. So the value based on comps may still be high, but no one in reality would pay that much for it now. That situation doesn’t change until someone in the neighborhood blinks – accepts a more realistic price for their property…

Also I have to say that the banks are acting a little flaky right now. They seem to be holding out for something. Bailout maybe? I offered 80 cents on the dollar (for what the bank was owed on the property) for a foreclosed property and the bank turned their nose up - didn’t even want to negotiate. I thought that recouping 80 cents on the dollar was a pretty good deal. Instead the property sits empty and the bank is paying the utilities month after month and the taxes etc.

In fact, I have had 3 offers turned down because I expect valuations to return to 2004 levels so that is what I’m offering. No one is biting. If it’s a buyers market you couldn’t prove it by me…

[Rune]

As the judge points out, Chapter 13 bankruptcies can provide relief from certain debts, but not mortgages. The revised Chapter 13 process he recommends would allow the debtor to retain possession of the asset (a home) while paying a certain amount per dollar on the debt (a lower interest rate). The court fixes the terms and period for repayment. That reform was long overdue even before the current crisis. Corporate debtors essentially get a free ride under the present system.

Empty homes that have been foreclosed contribute exactly nothing to anyone: no mortgage payments, no property tax payments, and no roof over the heads of families.

[RepubAnon]

This should be #1 on the list of reforms - it works on many levels, not least of which is the double-benefit of both helping homeowners while discouraging irresponsible lending practices.

[Bernard Yomtov]

Also I have to say that the banks are acting a little flaky right now.

Banks often act flaky. I wish I knew why. Is it just bureaucratic silliness, or are there deep bankers' reasons for flakiness?

As you say, it's expensive to hold empty houses. Lots of costs, no return, probably. Mysterious.

[Model 62]

Bankers may be flaky, but they aren't irrational -- my guess is that those homes they are holding show up in their accounting as assets valued at the last full sales price, which "assets" they've probably already borrowed against. Guessing further, if they were to sell them at 80% of book value, they'd have to make up the remaining %20 to meet capital requirements. Where are they gonna get it?

This dynamic probably extends upstream to all holders of securitized mortgage debt.

[Bernard Yomtov]

Model 62,

Could be something like that, though I think you mean the mortgage face value, not the selling price.

Still, at some point doesn't (shouldn't) the examiner come in and say, "You can't carry this house at this value?" Maybe they hope to get out before that happens, or when profits have recovered and they can stand the hit. Don't know.

[John Thullen]

Didn't the Supreme rule some time in the 19th century that corporations are people....... and that people are Soylent Green?

You're not an individual and you do not get bailed out unless you are people.

You're not.

[now_what]

Great idea.

The prudent person who didn't buy a house he couldn't afford? Let's f*ck 'em.

The first time would-be home buyer who is locked out of buying a house because we need to keep people who bought houses they couldn't afford living in said houses? Let's f*ck 'em.

The renters who would be glad to live in the houses constructed during the boom at a reasonable rent? Let's f*ck 'em.

The people who bought houses they could not afford, the people who helped, with much support, to screw over an entire economy out of selfishness and greed? They can't be made to suffer, now can they? Let's take good care of them. The people who lied about their income to get in to a house they had no chance at all of paying for, why should they suffer?

Then go wonder why the savings rate is so low.

Cancer and madness.

[John Thullen]

Actually, what corporations do in America is organize American consumers into frenzied, desperate corporate mobs so that they can trample their own employees and keep overhead costs low.

America's a funny place.

It's like Mombai, but death here has no political point. People croak for the greater cheeseburger.

It's just a guy standing between me and the half-off table.

The only difference between a frenzied American consumer and an al Qaeda terrorist is the first is happy as hell and the latter is bitter.

Unless the store runs out of stuff.

Then watch out!

[Fraud Guy]

As one of the people who could use this remedy; I am all for it.

In addition, when the banks claim they "can't" modify mortgages because of their securitization agreements, apparently the http://executivesuite.blogs.nytimes.com/2008/11/18/what-securitization-problem-the-fdic-weighs-in/>FDIC disagrees with them.

Regarding the banks being screwed up?:

--Between 3 months ago and Wednesday, I have added a foreclosure, 6 charged off credit cards, and a recurring 30 day delinquency on my current home mortgage to my credit report. My credit score jumped from 498 to 522, and is better than my wife's where she only has a handful of late card payments and lower balances as a percentage of the total owed.

--The equity loan on my previous home has been charged off, and since that bank apparently never put a lien on the home, they were shut out by the primary mortgagor on that home during the foreclosure. (Actually, the primary told me that they were willing to offer up to $5K to the equity bank, but were never approached.)

--The bank which sold the mortgage four years ago to the current primary mortgagor never took their lien off, and so had to get paid $10 to clear their lien.

--The primary mortgagor hired a service company to break into the home in August to change the locks, without court authorization; even their attorney called in criminal trespass (though the police would not file charges as the crime was committed by a company rather than an individual).

I could go on, without going into the things I have seen as a fraud prevention professional on the fringe of the financial industry, but I think you get the drift.

[DonQuiKong]

now_what:

And so you don't favor punishing the unscrupulous lenders who gave mortgages to people they should have known couldn't afford them? People who did no due diligence or who outright lied to unsophisticated borrowers in order to get them to sign? They were in a better position to assess the risks, and they chose not to. There are two sides to this.

What I've found in a lot of discussions of the financial crisis and the bailout is that so many people are so eager to make sure someone gets punished, that they advocate actions that would cause pain to innocent parties or to the economy as whole in order to make that happen. I don't see how that's rational. Consider the last quoted sentence:

"No one has been able to explain to me why it is not better for mortgage holders to get a fair return of principal back, albeit at a lower interest rate, than to take a lump sum through foreclosure that is probably much less than the value of the note."

But if he's right, and it's a win-win for everyone, that doesn't satisfy the retributive demand that someone had better suffer for this... no, a lot of people would rather we all lose as long as somewhere in there the bad actors suffer too.

Now, I'd be quite happy if the renegotiation rights were limited to the bankruptcy filer's primary residence--i.e. not save "greedy" speculators.

(And before anyone says Congress made Freddie or Fannie do it: http://krugman.blogs.nytimes.com/2008/11/16/fannie-freddie-phony/ )

[russell]

The prudent person who didn't buy a house he couldn't afford? Let's f*ck 'em.

How does letting people renegotiate the terms of their mortgage as part of a bankruptcy proceeding harm anyone who didn't buy a house?

Thanks -

[Rune]

How does letting people renegotiate the terms of their mortgage as part of a bankruptcy proceeding harm anyone who didn't buy a house?

Agreed, but I suppose a banker would argue that the mortgage was bundled with others and sold on the market to investors who assumed that the product was securized at its roughly stated value. If the interest rate and value of the mortgages are renegotiated down, then those buyers have been harmed by a loss on their investments.

Not that I'm sympathetic, mind you. Investors were taking a huge risk in assuming that real-estate values could increase indefinitely.

Those investors would still get some return, of course, if the stressed buyers stay in the homes and continue to pay on the renegotiated mortgages.

[now_what]

How does letting people renegotiate the terms of their mortgage as part of a bankruptcy proceeding harm anyone who didn't buy a house?

It keeps housing prices from falling to affordable levels by preventing or delaying foreclosures. Houses still cost too much compared to wages. Prices need to come down. That process will be painful, but anything that delays that process will be even more painful.

[bobbyp]

It keeps housing prices from falling to affordable levels by preventing or delaying foreclosures. Houses still cost too much compared to wages. Prices need to come down.

If the terms of the mortgage are renegotiated doesn't the value of the underlying asset necessarily fall? The real question is whose ox gets gored. Currently we are witnessing the bloated financial sector fight tooth & nail to make sure taxpayers take the hit. Underwater home owners are just fodder.

Alternatively, wages could be raised to a level that reflects the labor productivity gains experienced since the 80's. Those gains have largely been expropriated by the wealthy.

[russell]

If the interest rate and value of the mortgages are renegotiated down, then those buyers have been harmed by a loss on their investments.

They can join the club. It's a pretty big club at this point, they'll have lots of company.

It keeps housing prices from falling to affordable levels by preventing or delaying foreclosures.

This, I do not get.

Is a foreclosure the only way to discover the real current value of a property?

If a mortgage is renegotiated because the market value of the house has declined, hasn't the same goal been met? The new terms reflect a more accurate value for the home.

Also, letting the air out of home prices quickly rather than more slowly may not actually be that great of an idea. Doing so via foreclosure, even less so.

Thanks -

[Matt Bilinsky]

Spot-on analysis. The degree to which lenders still fail to act in their own best interest is stupefying. At this point there is simply no legitimate argument to object to modifying the loans (whether through bankruptcy or direct dealings).

It's pure avarice, greed, and mismanagement. The mortgage lenders are intent on forcing you to liquidate your savings and 401K before you giving you a modification to save your home and prevent another dead loan from occupying their books. The fact that it is ultimately self-destructive is simply lost on them.

http://chaosoutoforder.wordpress.com/

[d'd'd'dave]

ocsteve
//I offered 80 cents on the dollar...and the bank turned their nose up - didn’t even want to negotiate. I thought that recouping 80 cents on the dollar was a pretty good deal//

...and since I thought it was a good deal the bank should have. We really should give the courts a mandate which forces owners (who are banks) to reduce their expectations in regard to interest rates, principal recovery, and values.

Because, darn it, I thought I made a reasonable offer.

[d'd'd'dave]

I was very hungry and ordered a $100 dinner at a restaurant. It was tasty. But when I finished and wasn't hungry anymore the $100 seemed a little high. I think the restaurant should have decreased the bill. Don't you?

There should be a court to adjudicate this stuff. What is a meal really worth anyway? It's just a little meat and butter and spices and stuff.

[Nick Kiddle]

I was very hungry and ordered a $100 dinner at a restaurant. It was tasty. But when I finished and wasn't hungry anymore the $100 seemed a little high. I think the restaurant should have decreased the bill. Don't you?

If the price of the meal was advertised in such a way as to obscure the true cost, that might be an appropriate analogy.

[russell]

I was very hungry and ordered a $100 dinner at a restaurant. It was tasty. But when I finished and wasn't hungry anymore the $100 seemed a little high. I think the restaurant should have decreased the bill. Don't you?

Hey, good point.

Should we apply your "no backsies" rule to everyone, or just consumers?

Thanks -

[OCSteve]

d'd'd'dave: ...and since I thought it was a good deal the bank should have. We really should give the courts a mandate which forces owners (who are banks) to reduce their expectations in regard to interest rates, principal recovery, and values.
Because, darn it, I thought I made a reasonable offer.

Well, actually the listing agent did, my agent did, and everyone but the bank thought it was reasonable. As I mentioned, I made an offer based on 2004 prices, which is where I expect things to stabilize eventually. Should I offer peak market prices? That seems to be a bit self defeating to me. I mean, being underwater from day one and knowing that’s what you are doing – does that make a lot of sense to you? Did I mention anything about the bank being coerced to take the offer? Of course not…

I’m a capitalist all the way. The bank was perfectly within their rights to disregard my offer. I just found it odd that they would pass on 80 cents/dollar when no one in their right mind will give them $1/$1. Screw the courts – do they have a duty to their stockholders? Would you cut your losses at 20% if you saw nothing but indicators it was only going to get worse?

Whatever. They passed, now they can pay the utilities and taxes, and keep it maintained (or not). It’s really no skin off my a**. If I was a stockholder however I might feel differently.

[Jack Robles]

I don't know exactly what policy I favor in this situation, but I do think that some rather important issues are being glossed over here. Let me take a step back from the whole mortgage situation, speak in simpler terms for moment.
Consider a situation in which Smith and Jones enter into a partnership. Smith and Jones both need each other, but they also need Smith to make an investment which is of value only so long as the partnership continues. Smith and Jones sign a contract specifying the investment that Smith will make, and the manner in which they will share the profits from the relationship. We should expect that the contract that they sign will take into account the costs that Smith will bear in making his investment. In this situation, everything proceeds smoothly, Smith makes the right investment knowing that he will be compensated when the profits are shared out.
If we add the ability to renegotiate into the mix though, things change. Now, once Smith has made his investment, Jones knows that he can't take it back. Now Jones can say something like "Look, you have already made your investment, and you can't do anything about it. I can walk and get nothing myself but leave you out the cost of your investment, or we can agree to give me a larger share of the profits than we had initially agree upon." Of course, Smith is no dummy; he can anticipate this event. That means that he knows that he can't get fully compensated for his investment. Hence, he will not be willing to make as large of an investment as he would have if he could have been certain that the original contract would hold.
This is the hold up problem, a pretty central feature of contract theory and a large reason why Coase won a Nobel prize.
Now we see renegotiation all the time (as has already been observed.) I think that many contract theorists would say that this is because i) renegotiation is pretty hard to prevent in many situations, and ii) there are circumstances in which even the investing party would like to allow it as a possibility. Having said that, it has costs. The two which are illustrated in the above story, are both relevant for the mortgage crisis:
1) SMith (the investing party) is often hurt by renegotiation
2) Renegotiation often leads to underinvestment.
So clearly, when a bank makes you a loan, they are making an investment. Should you decided to end your relationship (stop making payments) they can seize the home. If the home is worth more than the the loan, then they can recoup the cost of the investment. However, there is some probability that the value of the house will be less than the value of the loan, in which case at least a portion of the investment is not retrievable. So the story above does apply, at least as a downside risk that the bank must face if renegotiation is possible.
There are two ways (off the top of my head) that the bank might under-invest. It might require a larger share of the house price be paid by the borrower on loans made, or it might simply make fewer loans. It is likely that these two outcomes would be somewhat mitigated by higher interest rates. All three of these likely outcomes are not good for people looking to purchase homes. I can't really say that I agree with now_what, but I think that one can't say that these outcomes do not constitute a cost imposed on future home buyers.
But you say "We are not talking about future loans we are just talking about current loans and only those which have gone bad." The problem is that, once the banks start renegotiating contracts, it is going to be very hard for them to stop. Right now they simply say, "We can't do it." Even if we were somehow magically not talking about future loans, there are people out there who are on the margin. These people are continuing to pay their loans, but might be able to successfully renegotiate their loans if they considered that to be an option. Now the banks may very well be making a huge financial mistake in choosing to keep these people paying the higher rates at the cost of not getting payments from those who have been forclosed, but who would have been able to keep making payments at a renegotiated rate. But I don't know, and from what I have read, neither does anyone else on this list.
When the quoted Judge makes his statement about a "win win" situation, he is looking at a single loan. I don't doubt for a second that there are such loans out there. But the banks can't really make the decision on allowing renegotiation on a loan by loan basis.
So, I abhor the bail out as it is designed.
I think that credit laws in general screw the consumer.
But lets not dismiss the other side of the argument. Allowing renegotiation will hurt future home purchasers. Also, there are some very good reasons, beside being mismanaged, why a bank might not want to start renegotiating it's loans.
Jack

[Jack Robles]

I don't know exactly what policy I favor in this situation, but I do think that some rather important issues are being glossed over here. Let me take a step back from the whole mortgage situation, speak in simpler terms for moment.
Consider a situation in which Smith and Jones enter into a partnership. Smith and Jones both need each other, but they also need Smith to make an investment which is of value only so long as the partnership continues. Smith and Jones sign a contract specifying the investment that Smith will make, and the manner in which they will share the profits from the relationship. We should expect that the contract that they sign will take into account the costs that Smith will bear in making his investment. In this situation, everything proceeds smoothly, Smith makes the right investment knowing that he will be compensated when the profits are shared out.
If we add the ability to renegotiate into the mix though, things change. Now, once Smith has made his investment, Jones knows that he can't take it back. Now Jones can say something like "Look, you have already made your investment, and you can't do anything about it. I can walk and get nothing myself but leave you out the cost of your investment, or we can agree to give me a larger share of the profits than we had initially agree upon." Of course, Smith is no dummy; he can anticipate this event. That means that he knows that he can't get fully compensated for his investment. Hence, he will not be willing to make as large of an investment as he would have if he could have been certain that the original contract would hold.
This is the hold up problem, a pretty central feature of contract theory and a large reason why Coase won a Nobel prize.
Now we see renegotiation all the time (as has already been observed.) I think that many contract theorists would say that this is because i) renegotiation is pretty hard to prevent in many situations, and ii) there are circumstances in which even the investing party would like to allow it as a possibility. Having said that, it has costs. The two which are illustrated in the above story, are both relevant for the mortgage crisis:
1) SMith (the investing party) is often hurt by renegotiation
2) Renegotiation often leads to underinvestment.
So clearly, when a bank makes you a loan, they are making an investment. Should you decided to end your relationship (stop making payments) they can seize the home. If the home is worth more than the the loan, then they can recoup the cost of the investment. However, there is some probability that the value of the house will be less than the value of the loan, in which case at least a portion of the investment is not retrievable. So the story above does apply, at least as a downside risk that the bank must face if renegotiation is possible.
There are two ways (off the top of my head) that the bank might under-invest. It might require a larger share of the house price be paid by the borrower on loans made, or it might simply make fewer loans. It is likely that these two outcomes would be somewhat mitigated by higher interest rates. All three of these likely outcomes are not good for people looking to purchase homes. I can't really say that I agree with now_what, but I think that one can't say that these outcomes do not constitute a cost imposed on future home buyers.
But you say "We are not talking about future loans we are just talking about current loans and only those which have gone bad." The problem is that, once the banks start renegotiating contracts, it is going to be very hard for them to stop. Right now they simply say, "We can't do it." Even if we were somehow magically not talking about future loans, there are people out there who are on the margin. These people are continuing to pay their loans, but might be able to successfully renegotiate their loans if they considered that to be an option. Now the banks may very well be making a huge financial mistake in choosing to keep these people paying the higher rates at the cost of not getting payments from those who have been forclosed, but who would have been able to keep making payments at a renegotiated rate. But I don't know, and from what I have read, neither does anyone else on this list.
When the quoted Judge makes his statement about a "win win" situation, he is looking at a single loan. I don't doubt for a second that there are such loans out there. But the banks can't really make the decision on allowing renegotiation on a loan by loan basis.
So, I abhor the bail out as it is designed.
I think that credit laws in general screw the consumer.
But lets not dismiss the other side of the argument. Allowing renegotiation will hurt future home purchasers. Also, there are some very good reasons, beside being mismanaged, why a bank might not want to start renegotiating it's loans.
Jack

[herenhuis te koop]

I find it a great work. Thanks, I hope to see better reports in the future.

[hypotheek afsluiten]

Yes, I am in total agreement to believe that Homeowners are the only ones who cannot modify the terms of their secured debts in bankruptcy.