Don't Cave On Cramdowns

by hilzoy

From CongressDaily, via the Wonk Room:

"Senate Majority Leader Reid said today he would drop a cram-down provision from a House-passed banking bill if the language threatened to keep the Senate from passing the overall bill. The provision would allow a bankruptcy judge to reduce a homeowner's mortgage principal. "If we can't get the votes for that, and I am hopeful we can -- I am semiconfident we can -- then what I'll do is take that off [the bill] and do the other banking provisions," Reid said at a Christian Science Monitor breakfast. Reid said he would work to keep the package intact, but raising the prospect of pulling the provision seemed to acknowledge assertions by Sen. Evan Bayh, D-Ind., and others that the cram-down bill cannot pass due to opposition from Republicans and some Democratic moderates."

As I've said before, caving on cramdowns would be a big mistake. Presently, every other form of secured debt can be written down to its present value in bankruptcy, provided the borrower can make payments on it at its new, reduced value. Allowing cramdowns would simply treat mortgages like any other form of secured debt. This matters for a number of reasons.

Often, the alternative is foreclosure. Foreclosures are not good for anyone: not the homeowner, not the neighborhood, not the bank. Banks are now starting to walk away from foreclosures: this means that after a homeowner has gotten a foreclosure notice and moved out, after the now-vacant property has been vandalized or turned into a crack house and lost a lot of its value, the bank refuses to take title, and the homeowner is stuck with both the house and the debt s/he can't pay. 

One reason this happens is that if the mortgage has been securitized, it's very hard to locate all the people who now own a tiny little piece of it, let alone to get them all to sign off on renegotiating it. Cramdowns would get around this problem: bankruptcy judges can write a mortgage down to the present value of the home unilaterally, without having to get all the people who own some part of the mortgage to sign off. 

Another is that banks are sometimes unwilling to write down a mortgage because they do not want to have to write down any comparable mortgages they might have on their books. If the mortgage is, in fact, not worth as much as they value it at, then they ought to write it down, along with any comparable mortgages. Bankruptcy judges do not take into account banks' desire not to acknowledge losses they have already taken, nor should they. 

Besides all that, though, there's a good economic case for allowing cramdowns. We seem to be rescuing a lot of companies lately. But it's no good trying, for instance, to save GM if we don't have customers who are able and willing to buy cars. As any number of commenters have said, we need to shore up the not just businesses' balance sheets, but consumers', since if they are not able and willing to spend, then even the best-run businesses will fail.

Some ways of doing this -- e.g., putting people to work doing things that need doing -- don't involve problems of moral hazard. But any attempt to try to reduce people's debts does. However, in the case of cramdowns, these concerns are a lot smaller than they would be otherwise, since in order to get this kind of debt relief, you need to declare bankruptcy. And no one likes declaring bankruptcy. No one declares bankruptcy just for fun. So the problem of moral hazard is, in this case, a lot smaller than it would be otherwise.

Allowing cramdowns is good for everyone. It's good for homeowners, since if they could make payments on their house if it were written down to its present value, they get to stay in it. It's good for the neighborhoods in which these homes are found, since it prevents abandonment and blight. It's good for the housing market, since it means fewer foreclosed homes for sale. It's good for the banks, except that they will have to acknowledge losses they ought to acknowledge anyways. 

Caving on this would be a serious mistake. If your Senator is among those who are wavering, let him or her know how you feel.

Comments

[Dave C (the uppity newcomer)]

Please don't start that trend here, CWC.

[Mr Duncan]

Are they really being left with a note in place as well as the house and taxes? In that article, it seems like the bank is foregoing the note, but only after running the foreclosure process nearly out.

[Gary Farber]

"First!"

Try having something to say worth saying.

[farmgirl]

The Kitteh has been called.

[Warren Terra]

Oh great, the crudest troll in recent memory is back. Any guesses on whether he's actually eleven years old, or only emotionally eleven years old?

Although I will admit that it was a bit clever to start with the "First" thing, as that is a bit of pollution that damages threads but that unlike the rest of CWC's posts it isn't actually actively repulsive.

Oh, and for anyone who hasn't encountered this particular specimen before, don't click CWC's links unless you're well supplied with brain bleach.

[(The Original) Francis]

Returning to the topic at issue, I think Hilzoy's missing a key step or two, involving the role of the servicer.

As I understand it, servicers are gunshy about negotiating haircuts on non-performing mortgages. A. They lack the expertise. B. They're afraid of getting sued by the trustee.

Giving bankruptcy judges the cramdown power essentially gives the servicer a safe harbor to accept a renegotiated loan term, insulated from their own ignorance and threats from the trustee.

[Slartibartfast]

The kitteh has responded.

[gwangung]

As I understand it, servicers are gunshy about negotiating haircuts on non-performing mortgages. A. They lack the expertise. B. They're afraid of getting sued by the trustee.

Giving bankruptcy judges the cramdown power essentially gives the servicer a safe harbor to accept a renegotiated loan term, insulated from their own ignorance and threats from the trustee.

Interesting. Then it's all the more reason to support such a tactic.

[Fraud Guy]

The other side is that allowing cramdowns would raise the costs of mortgage financing significantly (from the crowd that feels we pushed the ownership society too far). IIRC, Dean Baker at TAP did a back of the envelope calculation a few months back, and figured that the actual possible cost, at current figures/default rates/et al., would cause a 0.1% rise in interest rates.

Now based on my current situation, I am in favor of cramdowns, and rewinding to pre 2005 BK law. Because bankruptcy should allow a fresh start, and not continue the collapse.

[wj]

The good news is that the problem is hitting the MSM already. Just this morning, KCBS is reporting in the San Francisco area that the tactic of just walking away from underwater mortgages (by homeowners) "is now being copied by banks." I suspect it will be a couple of months before we see how common this becomes, and how bat the side effects are. Some of the foreclosures, after all, are in areas which don't suffer from vandalism and crack houses.

I can see, for example, someone getting a foreclosure notice, and simply not moving out. The hope being that the bank will drop the lien and just go away. Who knows, it might happen -- and if you have nowhere else to go, what's to lose?

[KCinDC]

Can someone explain to me what politicians are thinking when they talk to the media and explain in detail which parts of their current stated positions are only for show and can be bargained away? I'm no expert on negotiations, but isn't it generally a good idea to keep your opponents guessing about such things? I'm also no expert on electoral politics, but don't voters generally prefer it when you don't spell out quite so obviously how little you believe in some of your positions?

[Gary Farber]

"The good news is that the problem is hitting the MSM already."

For instance, today's NY Times: Banks Starting to Walk Away on Foreclosures.

[Simon K]

Its really hard to see how mortgage cramdowns in bankruptcy would cause anyone any real loss. In most states, and most especially in the most affected states, mortgages are non-recourse loans. The lender can't recover anything other than the collateral - the best deal their going to get is that the borrower might re-affirm the debt and continue to pay, so they get a choice betweem:

1. The net present value of the payments, which if the borrower chose to reaffirm the note is presumably not much more than the value of the collateral.

2. The collateral.

I don't really see the problem with adding option 3:

3. A new note, for the current value of the collateral.

In the current environemnt, 3 might even be a better deal than 2. What am I missing here - is this to do with the very small number of states where mortgage lenders have recourse (and which don't have many foreclosures - funny that), or is it just that the lenders would feel more pressure to write down the loans to their true value, thus exposing them as miserbly insolvent (which they are anyway).

[liberal japonicus]

Gary's link, coupled with this earlier piece that I posted here from Balloon Juice a while back makes me wonder if the idea that banks are 'walking away' as being the best description. Here is part of the above link

Mayra Caraballo, a 39-year-old mother of two, appeared in court in response to code violations on her home. She explained to Pianka that she no longer owned the house. She had lost her job at a processing plant, and an adjustable rate had kicked in on her mortgage, boosting her monthly payments to $1,100, from $800. She had left after receiving a foreclosure notice. The house was quickly stripped of everything but the furnace. Pianka asked a clerk to check into the house’s ownership; he suspected that the lender had withdrawn the foreclosure at the last minute, as is becoming more common. The clerk tracked down the trustee on the mortgage, Deutsche Bank, and confirmed that the foreclosure had indeed been withdrawn. Pianka calls these situations “toxic titles.” “You’re in limbo,” Pianka told a shocked Caraballo. “There’s no hope in your getting out of this property as a result of foreclosure. We’re seeing this more and more.”

Pianka sees these toxic titles as an effort by lenders to dodge responsibility for vacant houses. Later, I called Deutsche Bank to ask about Caraballo’s house. “We don’t own the property,” a spokesman told me. “We’re the owner of record, but the investors who bought the mortgage-backed securities own it.” Pianka chuckled when I told him of the bank’s response. “That’s their mantra: we don’t own it,” he said. “It’s handy for them to say, ‘Oh, it’s not us.’ It’s part of this big shell game they’re playing.” I checked in with Caraballo, too. She’s now renting and working part time at a day care center. She told me that she would like to move back into the house, but she’s not sure she has the money to replace all the hardware that has been stripped by scavengers or to make the necessary repairs.

Walking away seems to imply, at least to me, that the banks now have no interest in it, so it should be up to the government to decide what should be done with the property. However, it seems that the bank pretends to walk away and then, at the last minute, comes back, shedding a certain level of responsibility, but still able to demand some recompense if some sort of turnaround occurs.

[yoyo]

So why can't the former mortgager just live in the house and not make any payments to the bank? I thought the threat of forclosure was why one had to pay the bank every month.

[Nell]

@KCinDC: don't voters generally prefer it when you don't spell out quite so obviously how little you believe in some of your positions?

In this kind of signaling, the politician is usually sending the message to their real rather than nominal constituents: the funders. Message to them: it's cool, I'm not crossing you. Message to constituents (if they read these pieces at all, which tend to be in things like Congressional Quarterly or blogs): You're nobody.

[liberal japonicus]

So why can't the former mortgager just live in the house and not make any payments to the bank? I thought the threat of forclosure was why one had to pay the bank every month.

Because most people wouldn't want to live from day to day, waiting on a knock on the door and someone to come and kick them out of their house. And, if I knew that the house wasn't mine, I would be very unlikely to treat the house in any way that would maintain its value.

[Bob Soper]

Harry Reid: "If we can't get the votes for that, and I am hopeful we can -- I am semiconfident we can -- ..."

What a toadie. Just seeing his obsequious face makes me angry now.

[Jim]

"However, it seems that the bank pretends to walk away and then, at the last minute, comes back, shedding a certain level of responsibility, but still able to demand some recompense if some sort of turnaround occurs. "

They might try. But if Deutsche Bank - DEUTSCHE Bank! - tried that in this atmosphere, a mob would be burning copies of Goethe and Mein Kampf in front of the German Embassy.

If lenders do walk away eventually municiplities will end up seizing the properties. They will do all kinds of things with them - even force-house homeless in them. They will preferentially find the original occupants if they can and sell them the house for a dollar, just to get it off their hands. That will be that - they'll have people paying locla taxes again and the new'old owners will have clear title.