The Atlantic's Megan McArdle recently wrote that allowing bankruptcy judges to lower a homeowner's mortgage payment, known as a "cramdown," is "no panacea" for the tide of foreclosures sweeping the U.S. Well, true. But while she was perhaps speaking figuratively, holding public policy (and just about everything else) to that idealized standard is a recipe for paralysis.
The better litmus test is, would cramdowns help stem foreclosures by increasing the number of loan modifications? A related question might be, anyone got a better idea? Answers: Yes, and -- judging from the weakness of HAMP, the feds' flagship anti-foreclosure program -- no.
In a cramdown, also called "lien stripping," a bankruptcy court writes down a mortgage to the face value of the collateral, such as a borrower's home. Although there's relatively little research on whether cramdowns are an effective antidote to foreclosures, we can turn to something else: history. Because as a couple of economists with the Federal Reserve Bank of Cleveland point out, we've been here before.
In the 1980s, U.S. farmers went through a period of boom and bust similar to the recent housing crash. Beginning in the early 1970s, a surge in agricultural exports drove a big hike in farm lending. The price of land soared 350 percent over the following decade. Farmers borrowed heavily to buy more acreage on the expectation that prices would continue to rise, especially favoring variable-rate loans (similar to the kind that fed the subprime mess). Lenders jettisoned their underwriting standards to get in on the action. Speculation was rife.
When the bubble burst in 1981, lots of farmers found themselves underwater on the loans they'd taken out to buy land (click on chart to expand). Foreclosures spiked, as lenders resisted modifying mortgages. Declaring bankruptcy wasn't much help for smaller farms because Chapter 13 of the code barred farmers, as it does homeowners today, from modifying debt secured by a primary residence. And Chapter 11 bankruptcy, which is designed for corporations, was unwieldy, while also giving creditors the legal means to block cramdowns.
After several years of debate, Congress responded to the crisis with a new law and new bankruptcy provisions geared directly to the plight of farmers: Chapter 12, which allowed judges to restructure their mortgages.
Cramdown Risks Overblown
These days, critics of cramdowns for homeowners oppose the practice for the same reasons people objected to court-supervised modifications for farmers 25 years ago. They claim it would spur lots of borrowers to declare bankruptcy, bogging down the courts, and make credit more expensive.
But in the agricultural sector, Chapter 12 did neither, the GAO concluded in a 1989 report. Perhaps most interesting is that the mere availability of court-ordered restructuring seemed to encourage lenders to negotiate with borrowers to arrange a modification. According to the Cleveland Fed's Thomas Fitzpatrick and James Thomson:
The actual negative impact of the farm stripdown legislation was minor. Although the legislation created a special chapter in the bankruptcy code for farmers and allowed stripdowns on primary residences, it did not change the cost and availability of farm credit dramatically. In fact, a United States General Accounting Office (1989) survey of a small group of bankers found that none of them raised interest rates to farmers more than 50 basis points. While this rate change may have been a response to the Chapter 12, it is also consistent with increasing premiums due to the economic environment.As the authors acknowledge, of course, yesteryear's farm lending market is very different from today's housing sector. For one thing, agricultural loans weren't securitized, while the farm bust was mostly quarantined within the Midwest, as opposed to the current disaster's nationwide scale.
The effects of that stripdown provision, in place for more than two decades, on the availability and terms of agricultural credit suggest that there has been little if any economically significant impact on the cost and availability of that credit.
Some cramdown skeptics also question whether judges are more qualified than bankers to make modification decisions. "What makes us think that judges are any smarter than bankers when it comes to understanding the real estate market?" said independent banking consultant Ken Thomas in an interview. "Unfortunately, many judges are more driven by political or media considerations than anything else."
Law Biased Against Average Homeowners
Then again, the same charge could be leveled at some bankers. And unlike lenders and loan servicers, the courts don't have the same financial disincentives to modifying mortgages, a dynamic HAMP has failed to correct. As Alys Cohen, a staff attorney with the National Consumer Law Center, told me by email:
"The main reason the foreclosure crisis continues virtually unabated is because mortgage servicers profit more from foreclosure than they do from loan modifications," she said. "While investors would do better with mass assistance for homeowners, as would communities, the servicers have a different set of incentives. Current programs to address foreclosures, including HAMP, do not address this fundamental problem. Court-supervised loan modifications, or mandatory loan modifications to qualified, distressed homeowners, would change that balance and save many homeowners and communities."
Irvine, Calif., bankruptcy lawyer Gerald Wolfe also underlined what he regards as a legal bias toward more affluent borrowers. A court may cram down any other loan, such as for, say, a vacation home or yacht -- it's only mortgages secured by a homeowner's primary residence that a judge is prohibited from altering.
As a result, "Cramdown benefits the wealthy, but not the average homeowner," he told me. "It is quite backwards, as bankruptcy should protect the average individual, too."
Citing the difficulty of securing Chapter 13 bankruptcy protection, McArdle says that not enough homeowners will benefit from cramdowns to warrant changing the law. Unless, she writes,
... it came in the context of some broader bankruptcy reform.And what's wrong with that? Bankruptcy law has long favored businesses, which are allowed to modify commercial real estate mortgages in court, over homeowners. Cramdowns are no silver bullet. But as the farm crisis showed, they are one tool among several that can help borrowers stave off foreclosure. The alternative is to just grit our teeth and hope it doesn't happen to us.
"The very reason for bankruptcy rules is to reset the economic clock following an economic failure," Roberto Quercia, director of the Center for Community Capital at the University of North Carolina in Chapel Hill, said by email. "The alternative is to let economic failures fester and metastasize so that nothing ever gets resolved, and pain, suffering and misallocation of assets continues."
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