A Non-Bankruptcy Bankruptcy Solution?
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?