Credit Slips

The Good, the Bad and the Ugly of Mortgage Servicing and Implications for Mortgage Modification

It looks as if the mortgage cramdown--er, modification--legislation will be sitting around for a while, at least until the stimulus package gets through Congress. So it seems worth talking about its reference to making "payments of such modified loan directly to the holder of the claim" instead of through the Chapter 13 trustee. Although this language was still in the manager’s version of the bill (H.R. 200) as of last week, apparently discussions continue in Washington about whether this is the best policy approach.

A big reason for needing trustees in the picture is to keep track of mortgage payments, because servicers make a lot of errors. There are apparently new servicing companies that are trying to avoid the problems that have been rampant in the industry in the past—dare we hope that some good servicers are coming on line? But no doubt there are still many of the bad (careless) and the ugly (those who are deliberately charging unreasonable or illegal fees during bankruptcy). I'd be interested to hear whether anyone is seeing improvement in this industry since the new focus on its shortcomings.

As a policy matter, the argument for payment of mortgage obligations through the Chapter 13 trustee, rather than directly, is that this approach likely makes it easier for debtors to complete their plans and keep their homes without an expensive fight at the end about whether they are up to date on payments. Putting Chapter 13 trustees in charge of disbursements gives debtors the benefit of their superior record-keeping ability and understanding and their leverage with servicers because of their continuing relationships. While lawyers in areas that have not had a practice of conduit payment of regular mortgage amounts through the trustee often oppose that approach on the assumption that trustee fees will make plans infeasible, the evidence seems to be that conduit payments result in the percentage fee going down. Most trustees already top out on the compensation they are allowed by law. Lower percentage fees in conduit trusteeships may mean that most debtors do not have a problem with feasibility, although unsecured creditors may get paid less. There may be some debtors at the margin who won’t be able to afford a plan if they have to pay trustee fees, but courts could make exceptions in such cases on feasibility grounds (feasibility can cut in different directions depending on the case).

Calling All Article 9 Supernerds--Negative Equity and State Law

What’s a blog for?  For law professors, a key attraction is to float a question you don’t have time to write a law review article about.

As a matter of state (not bankruptcy) law, should a loan be considered all purchase money if the lender makes a consolidation loan for purchase of collateral and also for paying off an old obligation, all secured by the collateral being purchased?  In particular, what are the policy implications for Article 9 purposes of defining purchase money obligation that broadly?

In bankruptcy, the definition of “purchase money security interest” determines the scope of the “hanging paragraph” in chapter 13--specifically, if “negative equity” on an old loan is rolled into a new purchase money loan, whether the whole loan should be treated as a purchase money obligation so that it can’t be crammed down (assuming that is the treatment under the hanging paragraph).

Under state law, the question of the meaning of “purchase money obligation” is not confined to car loans or even consumer loans.  The definition sets the scope of special purchase money provisions in Article 9 that extend to commercial finance for purchase of equipment and inventory.  Should the leap-ahead priority for purchase money obligations apply to rolled in negative equity?   Could this have perverse effects?  In the case of consumer loans for items outside certificate of title laws’ reach (i.e., collateral other than cars and boats), should automatic perfection extend to “negative equity” on some other old loan the balance of which is rolled into a loan for purchase of a washing machine or a diamond ring?

Mortgage Cramdown--Layering On Complexity

Chapter 13 is already too complicated, and cramdown legislation will make it more so and lead to a new round of litigation and expense that will stand in the way of keeping people in their homes. By all means, Congress should enact mortgage cramdown, but it should take up bankruptcy simplification immediately after that if it really wants people to hold on to their homes in chapter 13.

Katie Porter has already noted the problem of high noncompletion rates in chapter 13 as a reason for suspecting that mortgage cramdown will not “save” many homes. See Cramdown Controversy #2--Will I "Succeed?" The problem is that the impact of the pending cramdown legislation could be small given the messy state of bankruptcy law since the 2005 changes.

The 2005 law has substantially increased the expense of bankruptcy, deterring and delaying its use among the worst off. The chapter 13 filing fee has gone up to $274.  “No look” attorneys’ fees of at least $3,000 are the norm in chapter 13 (see http://www.gao.gov/new.items/d08697.pdf at 25-26), and this is a bargain price considering what lawyers are expected to do under the new law.

Mortgage cramdown will add the difficulty of a valuation hearing, with experts engaging in a swearing contest about the value of a home for which, in many cases, there currently is no market. Cars have various “book” values that can be used to set default measures of value in bankruptcy, but there is no similar simple approach to valuing homes to save on litigation costs.

The bills add a lot of complexity of various sorts. S. 61 and H.R. 200 both would layer on a ridiculous, unnecessary third "good faith" test in chapter 13. The debtor already must file in good faith and propose a plan in good faith, yet the bill’s drafters felt compelled to add an additional requirement that the modification be in good faith. This would stoke litigation over whether it is bad faith to pay the value of the home if the debtor could "afford" more ("afford" always being a malleable concept), with an open question about what other expenses should be taken into account when deciding what the debtor has available to pay for an underwater home.

It would be much better for Congress to explicitly state what it wants—for example, whether just paying the home’s value is fine, with excess disposable income (if any) going to other secured debts (such as cars) and then unsecured debts.  Furthermore, it would be a good idea for Congress to state that if home and car payments use up all the available income over regular expenses, it is not “bad faith” to pay zero to unsecured creditors.  Congress should be heading off the inevitable arguments that just paying for collateral in chapter 13 is not good faith.  If chapter 13 is going to be a mechanism to save homes from foreclosure, many debtors will have nothing left to pay old unsecured debts.  Unfortunately, some judges and trustees have used a good faith test to push for rule-of-thumb amounts of unsecured debt repayment in chapter 13 whether or not that is feasible, contributing to a high noncompletion rate (historically, about two-thirds of chapter 13 cases).

I agree with Katie Porter that the provision in the bills for direct payments by debtors to claim holders is a mistake.  It is unclear whether this would always be required, or whether this language just gives courts discretion to allow direct payment.  In most cases, Chapter 13 trustees are needed to make sure that payments actually get credited appropriately to debtors’ accounts.  If the problem is feasibility of plans due to paying trustee fees on mortgage amounts, Congress could provide for a lower trustee fee on those payments. Without the trustees involved in record-keeping, debtors will face huge cost and difficulty at case closing to try to show that they really are current on their mortgages.  Most trustees now make it a default practice that mortgage payments be made through them, and this has saved on trouble for debtors, trustees and judges.    

Another aspect of the bills that is troublesome is that the debtor must have already received a notice of foreclosure in order to cramdown.  This prevents debtors from taking charge of a hopeless situation and getting it resolved; they would have to wait for the lender to send a foreclosure notice before they could make use of chapter 13 to modify their mortgages.

The elimination of credit counseling for debtors who have received a notice of foreclosure is a step in the right direction, but if Congress paid attention to GAO reports, it would repeal the credit counseling requirement entirely. http://www.gao.gov/new.items/d07778t.pdf   It represents a cost in money ($50 per debtor) and inconvenience way in excess of very minimal benefit.

Mortgage cramdown would also add to the complexity of other issues currently making their way through the appellate system, particularly issues concerning means testing and treatment of car loans.  (For more discussion of these issues, see my recent paper, A Guide to Interpretation of the 2005 Bankruptcy Law at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1307250.)

Means testing allows above-median-income debtors in either chapter 7 or chapter 13 to include their secured debt obligations as part of their expenses, yet with cramdown on a home possible, the debtor might not have to pay the full secured debt in chapter 13.  This will lead to a new round of litigation over additional layers of means testing, whether under the “good faith” or “totality of the circumstances” tests in chapter 7 or the “projected disposable income” or various “good faith” tests in chapter 13 when the debtor might be able to cramdown.

And then there will be the ironies of allowing cramdown on underwater home mortgages while perhaps not allowing cramdown on seriously underwater car loans, particularly the most risky subprime ones.  If the car lender rolled in a big wad of debt from the last car (known as “negative equity”), making the debt severely undersecured from the outset, it doesn’t make a lot of sense to treat that debt as fully secured under the “hanging paragraph” while cramming down a similarly undersecured home loan.  I am among those who think it is ridiculous—both as a matter of law (see http://www.nacba.org/s/45_50fc1f2acc4e329/files/PeasleeSupportBrief.pdf) and policy—to treat paying off your last car as part of the purchase money for your next one. As a policy matter, this is very risky credit, and it does not deserve preferred status (disallowing cramdown).

All this is to suggest that we desperately need a fresh start for bankruptcy reform, and layering mortgage cramdown on the 2005 mess will just make this more apparent.  The complexity of the law stands in the way of its use at an affordable price and makes it hard to mobilize the bankruptcy system for this crisis.