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A Non-Bankruptcy Bankruptcy Solution?

posted by Elizabeth Warren

The rumor mill is starting to sketch in details of a deal negotiated Treasury Secretary Paulson and a coalition of big lenders to stop the subprime mortgage meltdown by leaving borrowers in their current teaser rates longer.  The idea is that homeowners in trouble will be divided into three categories: those who can continue payments after an increase, those who can continue payments only on the teaser rate, and those who can't even pay the current teaser rate.  The plan is that first group pays, the middle group gets help, and the last group gets moved out. 

The economic idea behind the plan is that dumping all the foreclosed properties on the market at the same time will chase the market down further, further depressing prices in the real estate market, so holding people in their teaser-rate mortgages will stop the freefall in prices.  The tool looks a lot like something the Chapter 11 folks are familiar with:  a non-bankruptcy bankruptcy in which the parties negotiate something that has many of the features of a bankruptcy, but it is all handled privately.  As the plan emerges, there are at least three things to watch out for:

1.  Will the plan stop the slide in the real estate market?  The implication of the early reports is that the freezes are temporary.  If that means the mortgages will be frozen until these people can be shifted into fixed, 30-year mortgages they can afford then it should have a stabilizing effect on the market.  Instead, if the plan is to jump up rates in six months or a year, then the real estate market is unlikely to stabilize.  Buyers will wait, knowing that more distressed buyers will be selling soon. 

2.  Are the losses confined to the bad guys?  The good news about this plan is that it shifts the losses directly onto the investors who took the bad mortgages.  The bad news is that there is no clear legal basis for doing this kind of wholesale revision of the value of the collateral and forced revision of the mortgage terms.  The lawsuits will fly thick and fast, enriching the lawyers and tangling up the homeowners. 

3.  Are the benefits confined to the good guys?  The first reports indicate a sorting based on ability to repay the mortgage.  This puts the mortgage lender squarely at odds with every other lender.  This plan may send a message:  If you dump the credit cards and quit paying the car loan, you can keep a great deal on a home mortgage.  So far, the deal doesn't seem to be available to people in the worst mortgages (homeowners whose homes are worth less than their mortgages) and for those who are already in extremis (homeowners who have already defaulted and whose credit is wrecked).

What makes this deal particularly interesting to me is that it creates a kind of non-bankruptcy bankruptcy for homeowners in trouble on their mortgages.  The differences, however, are important:

1.  In bankruptcy, the workout is permanent.  The legislation currently pending would permit rewriting mortgages, but once they are rewritten--that's the deal.

2.  If congress gives courts the power to rewrite the mortgages, then there are no dollars wasted on lawsuits. 

3.  Bankruptcy screens debtors differently (see, for example, the means test) and would undoubtedly provide relief to a smaller group of people  Of course, once debtors had the power to rewrite their mortgages in bankruptcy, their negotiating leverage outside bankruptcy would change as well.  Bankruptcy highlights the same competition among creditors and permits debtors to decide whether to keep the car or the home. 

This negotiation over mortgage looks like a giant non-bankruptcy bankruptcy.  By doing it as a one-time negotiation, perhaps it will be better suited to the immediate problem presented.  On the other hand, by making this a one-time deal, does it stall the kind of legal change that would clean up the mortgage industry and that would help families whether they are the only one in trouble or one of two million? 

Comments

As a consumer bankruptcy lawyer, I have serious trouble envisioning such a scheme working with adequate promptness and efficiency to serve its purpose. It appears to require complex judgment calls to determine that debtors are neither too hot nor too cold. Who will make those decisions, in often murky and complex situations? What will their authority, discretion and incentives be? Recall the "no decider available" problem addressed here by John Rao on October 15; what has changed or will promptly change as to that? Will the mortgage holders -- often hard to identify these days --have case-by-case discretion, or will changes be imposed on them? If so, with what procedural and appeal rights? Maybe I need a better imagination, but I have trouble seeing it.

This will sound cruel at first, but I want prices to come down. I don't have a house, and the rent/price ratio is absurd right now.

The tragedy of this housing bubble is that one of two parties will feel pain:
those who don't own, OR
those who do

It amazes me that we as a nation let the bankruptcy law change, moved into zero savings, eroded the estate tax, encouraged this bubble [it seemed like a free lunch].
(I could also add what we have done to the climate).

Who are the bad guys in the first point two? Is it the pension funds that bought SIVs backed by these loans? If so, what happens to the people who depend on those pensions?

Very simply - the courts are allowed to rewrite legal documents that screw lenders, even on a large scale so that subprimer borrowers get rollover to 30 yr loans, the problem is that no one would invest in mortgages in the future.

So if you screw the investor now, he will screw everyone back times 10 in the future when there is no liquidity for new purchase money anything.

This Paulson plan is stupid.

Much as I would like to see some sort of "fix" happen to the mortgage market, I find it ironic that the borrowers it would help most are those who are not already in default, i.e., the ones who have the least urgent need for relief. The lenders really need to address the problems of those whose rates have already re-set, and who may have already missed a payment or two.

I say leave it alone and let the cards fall. Government stay out of it! Those who speculated or took on excessive risks in the form of the actual ARM mortgages will have to bite the bullet. Learn the hard lessons and move on.

The reference to bankruptcy is interesting - why not modify the Code to allow a stripdown on a home mortgage? Judging by the content of several blogs there's already a huge backlash swelling against this plan as it appears to reward the stupid and careless who bought more house than they could afford. As one poster who skipped the ARM and took a 30 fixed stated, "I want my rate dropped 3 points for the next 5 years." As another stated, "If the government is handing out candy, I want mine, too."

On the other hand, allowing mortgage stripdown in bankruptcy would seem to be the most balanced response: The lenders end up with a claim equal to what they could get in foreclosure (actually better because of none of the transaction costs of a f/c proceeding), the taxpayers aren't stuck with the bill (as they could be if some of the suggestions for upping the Fannie/Freddie conforming loan limit to $1MM, and the subsequent potential bailout), and the borrower pays a price for financial irresponsibility (bankruptcy filing on record and to the extent they used home equity to buy toys, having to give them up if they're non-exempt).

Granted, this result doesn't help those who simply can't afford their mortgage, but then the Administration's proposed plan doesn't either.

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