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Onion Soup

posted by Elizabeth Warren

Angie Littwin pointed out The Onion's pseudo-survey of what people who are trapped in subprime mortgages are planning to do. Great sport, but what ARE families going to do?  For all their fulminations, most of the Washington crowd is focused on developing regulations to stop the next credit bubble--not to help millions who will be hurt by this one. 

Bankruptcy law is the final arbiter of debtor-creditor rights, but it is always tough to teach this particular asymmetry in the law:  If a corporation can no longer afford the mortgage on its factory, it has powerful tools to rewrite the mortgage in bankruptcy.  But if a homeowner is in exactly the same trouble following an interest rate hike, those same tools are unavailable.

Most readers of this blog will know the details:  A company that cannot pay its mortgage can declare Chapter 11 and do two things:  1) separate the mortgage into its secured and unsecured portions (called bifurcation), and 2) pay the secured portion at current market rates under a new mortgage and discharge the unsecured portion.  So, for example, a $1.2 million mortgage at 12% on a factory worth only $1 million will be bifurcated into a $1 million secured mortgage at, say, 7% interest, and the remaining $.2 million can be discharged.  The economic insight behind permitting this move is that the mortgage company will get 100% of the value of the property paid over time, which is a LOT better than the much lower amount it would get in foreclosure.  The second insight is that this is precisely the risk the lender took:  that the property would decline in value and the debtor couldn't pay.  The Chapter 11 bankruptcy forces the lender to revalue the mortgage to the actual market value of the collateral. 

But notice:  If a homeowner can no longer afford her mortgage, the homeowner can declare bankruptcy and get rid of the credit card debt and doctor bills, but she cannot force the lender to write down the mortgage to the value of the home or to accept payments at the current market rate. All the homeowner gets is the right to make up past-due payments--in full, with interest. So, for example, a $120,000 mortgage at 12% on a home worth only $100,000 must be paid in full at 12%.  In other words, homeowners get a lot less protection in bankruptcy than do businesses.

Perhaps the difference is historical accident.  The distinction was in the 1978 Bankruptcy Code, advanced at a time when the median first-time buyer put down 18% of the purchase price on a home and the typical mortgage was a fixed-rate 20 year loan.  Moreover, the lenders were largely Savings & Loans and other heavily regulated companies.  At the time, a home mortgage stabilized most family budgets. Exploding ARMs, Liar's Loans, and other exotics were unheard of. 

Mortgage markets have changed, but the bankruptcy laws that balance the rights of debtors and creditors have not.  For homeowners, the exit doors usually provided by bankruptcy are blocked.  Does that mean the Onion Plan is all that's left?

Comments

Well, not the only plan. The homeowner can a) do a workout, b) do a short sale and move to a more affordable dwelling, but both of those require the lender's consent. C) if the homeowner was lured by some misconduct into the financing, there may be defenses or claims to be asserted, or d) they can file bankruptcy and turn the house over to the lender and move to a more affordable dwelling, and use bankruptcy to write down the debt. (In the old days, I would have written "wipe out").

It sounds harsh to suggest moving out of one's house as a solution so let's evaluate the harshness but let's try to do so without rhetoric and emotion. Based on the media reports, in the cases of many subprime mortgages, the homeowner only became a homeowner by virtue of the subprime mortgage, which, by hypothesis, they can't handle. So by hypothesis, they couldn't afford the house in the first place because they couldn't come up with a 20% downpayment or couldn't qualify for a prime rate or whatever.

If they were tricked into the subprime mortgage, they have an argument for damages or conceivably reformation that may allow them to remain there. And they definitely have a right to be discharged from the debt thru bankruptcy, which ought to be a chapter 7 but for BACPCA.

But, if they weren't tricked and were just overconfident, foolish, gamblers, or poor with financial math, i do not see a principle that renders someone entitled to occupy a house they could never have purchased in the first place. Better that the house should go back on the market and hopefully it will now be cheaper so the more prudent people who were priced out of the market until now can come in and acquire it. Otherwise, are we not devaluing prudence and financial judgment and education, and ratifying imprudence and financial recklssness or ignorance?

When we're talking about homes bought using subprime mortgages, this isn't Grapes of Wrath. A climate change beyond human control didn't blow into town and drive a subprime mortgage into the equity of an existing homeowner. We are talking about very recent voluntary transactions to acquire a home otherwise out of reach with little or no money down.

I don't buy the corporate analogy for 2 reasons: 1) it elevates form over substance, because most corporate bankruptcies separate the corporation's owners - the economic owners of the asset as opposed to the formalistic owner - from the underlying assets quite completely; and 2) it is actually quite rare in a business bankruptcy to retain real property that is worth less than the debt it secures and to restructure that debt over the holder's objection. To use your hypo of 120K debt and 100K value, for the debtor to hold on to the property, you'd have a secured claim of 100, a deficiency of 20, both to be satisfied in full, and under most cramdown interpretations, you'd have to satisfy postpetition interest on both of them, and (overlooked in your post) you'd have to show feasibility -even though, by hypothesis, the debtor couldn't service those claims prepetition (I am ignoring the need to find an accepting impaired class for now). That confluence hasn't happened too often in chapter 11 with the values you hypothesize and I doubt applying these rules to individual debtors on subprime mortgages would get you a different result.

MT makes some interesting points. But I disagree.

Firstly, a debtor's ability to simply move presumes that all the other aspects of moving are 'mere externalities' that have no real place in a policy discussion on consumer bankruptcy. But that overlooks the reality that moving is not easy because, with a just-lost foreclosed home, most under-median income debtors will not qualify for a new mortgage -- which means they'll be renting. And if they rent, that often means (though certainly not always) moving into a different neighborhood, with different schools and different crime rates. If you have kids, you know that that is not a choice you would welcome.

Secondly, the picture of the subprime borrower offered by MT is unnecessarily cramped. While some of these buyers are first time buyers, many others are second lien financings, refinancings, and home equity loans. The wisdom of the borrowing decision may be just as flawed, but then the wisdom of the lending decision was also flawed (and made easier because the risk of loss was chopped up, passed up, and otherwise rendered distant by the re-packaging of mortgages into CDO's).

MT overstates the value of "defenses" as well, because the ultimate holder of the mortgage is probably not liable for whatever fraud was committed in getting the borrower to borrow. Indeed, it is likely that the wrongdoers will have disappeared by the time it comes time to find someone to sue.

The idea of putting the houses back on the market reminds me of the argument advanced some years ago for doing away with chapter 11 -- better to redeploy the assets to maximize their efficient economic use. But in a falling market, the only buyers are vultures, who only drive prices lower. And in a free fall market, where there are no buyers, and the only comparables are foreclosures, the lenders aren't exactly enjoying themselves. Take a look at what's going on in Cleveland for an example.

Finally, the corporate analogy does hold up. It doesn't matter that the original residual owners are displaced by new residual owners in the corporate context (assuming that is the case) -- the consequences for the residual owners vis-a-vis the secured creditors is still the same. Moreover, it is simply not the case that the sort of thing suggested by Prof. Warren "never happens" in chapter 11. I can most assuredly tell you that it does -- and with far greater frequency than you might think.

Judge, your quotation marks around "never happens" suggests that you are quoting me but I did not say "never happens." I wrote "it is actually quite rare in a business bankruptcy to retain real property that is worth less than the debt it secures and to restructure that debt over the holder's objection." and "That confluence hasn't happened too often in chapter 11 with the values you hypothesize...." Timbers or Greystone-type cases are very hard to confirm over the objection of the secured creditor. You have issues of admin insolvency, feasibility, gerrymandering, accepting impaired class, postpetition interest, all of which have to be hurdled to get to a confirmed plan that is a true reorg (as opposed to a liquidating 11, which won't do much good for the argument by analogy).

Certainly there are cases where the unsecureds or the secureds and the unsecureds wind up as the new residual owner of the enterprise. But that is of little value to the argument by analogy that Prof Warren makes. Your observation that the corporation's other creditors often wind up with ownership of assets proves my point. If we carry that paradigm over into the individual cases she is focusing on, we would wind up with the bank and the credit card company and the other unsecureds owning the house. But the homeowner doesn't and that is where the analogy dies for Prof Warren. Prof Warren desires that the homeowner, not the homeowner's other creditors, should be able to emerge from an 11-type restructuring with title to the real property and modified debt terms. Prof Warren implies that corporate owners get a better deal than the individual owners from bankruptcy law. I think that is clearly wrong. Try this simple test: if the homeowner had acquired her property and financed it via a legal entity, would she not wind up in exactly the same place as she does owning it directly and going thru a 7 or 13.

I realized I forgot to respond to some of the Judge's other well written points.

1) "the ultimate holder of the mortgage is probably not liable for whatever fraud was committed in getting the borrower to borrow."
I think that's wrong unless the law has changed since I was in texas 20 years ago. Fraudulent inducement is a defense to a suit on a contract, I think.
2) "Indeed, it is likely that the wrongdoers will have disappeared by the time it comes time to find someone to sue."
Judge Gonzalez ruled in Enron that claims acquired in the secondary market from tortfeasors remain subject to defenses and equitable subordination remedies that could be asserted against the tortfeasor. The appeal is sub judice in SDNY.

3)"But in a falling market, the only buyers are vultures, who only drive prices lower." This is not a realistic picture of the housing market. When someone moves into town or when their family reaches a certain size, they are going to want to buy a house. Household formation is a constant source of demand. There aren't that many vultures in residential real estate - it is too hard to keep the property up.
4)"And in a free fall market, where there are no buyers, and the only comparables are foreclosures, the lenders aren't exactly enjoying themselves."
I am not pro-lender if that is the reason for your switch of focus to lenders. I am pro-prudence and pro-education; if a debt holder was imprudent, its lack of enjoyment is deserved and should remain with it. From a policy perspective, if you look at Japan's experience in the 90's, or other countries that have had major financial problems, forcing lenders to realize losses rapidly even if they then went out of business, as opposed to propping up bad loans for years on end, was a key turning point in getting their economies back on the growth path.
5) "a debtor's ability to simply move presumes that all the other aspects of moving are 'mere externalities' that have no real place in a policy discussion on consumer bankruptcy. But that overlooks the reality that moving is not easy" - i don't mean to overlook it. I suggest it is narrow minded to focus on it just because the person who might have to move out is in front of the bench, the legislature or the media. There are a lot of other externalities I have tried to point out that ought to weigh in the policy discussion. For everyone allowed not to move out, there is someone denied the ability to move in; they just have a hard time getting into the media. There is the externality of keeping asset prices high by intervention. There is the externality of devaluing prudence and education by ratifying imprudence. Instead of reading the tortoise and the hare as bedtime story, should we tell our children, remember, the squeaky wheel gets the grease? Prudently deciding not to take on debt beyond one's means is not good fodder for the media or a blogger. The prudent do not have an advocacy organization. Hopefully my thoughts will encourage you to keep them in mind down the road.

Well, I can hardly improve on your excellent and well thought out responses to my comment.

The only thing that I do think I ought to add is that your final point is one that ought to be decided with empirical data. It incorporates the assumption that consumer debtors make their imprudent borrowing decisions at least in part with the thought in mind that they have bankruptcy as an out. I'm in no position to say whether that is the case or not. Perhaps Prof. Warren can enlighten us.

On another blog, someone commented that in many states, mortgages were non-recourse loans. Any thoughts on how prevelant that is and how it effects this discussion?

Thanks

In CA, purchase loans on 1-4 units homes for owner occupancy are non-recourse, meaning the lender cannot come after your assets if you default. The house is collateral for the loan.

However, as mentioned above, many people refinanced, or took out home equity lines and then they lose that protection. Still, I have never heard of a deficiency judgment foreclosure in CA. All foreclosures are done on the courthouse steps, so any debt is wiped out.

In a quick study I did of one neighborhood, 75% of people refinanced. And this is the worst part: they all refinanced in 2004-2006, which is bad for 2 reasons. 1) They had the most lax terms, and 2) they refinanced to the temporarily inflated value of their homes. Now they have neg-am loans that are higher than their homes are worth today.

Every REO was either 100% financed at purchase or a refinance, all done in 2004-2006.
Of course, the IRS will want you to pay taxes on the money that the lender lost. This gift income is taxed at your normal personal income tax rate. Some legislation is being proposed to eliminate this tax.

"1) 'the ultimate holder of the mortgage is probably not liable for whatever fraud was committed in getting the borrower to borrow.'
I think that's wrong unless the law has changed since I was in texas 20 years ago. Fraudulent inducement is a defense to a suit on a contract, I think."

It has been a while since I studied commercial paper, but once the mortgage is packaged and sold on the secondary market (often just days after closing), I would imagine that the purchaser becomes a Holder in Due Course (yes?).

The HDC subject to real defenses, but the personal defenses are stripped.

Personal Defenses: Breach of contract; Fraud in the inducement; Mental illness (voidable not void); Illegality (voidable not void); Ordinary duress or undue influence; Discharge of an instrument by payment or cancellation.

Real Defenses: Minority; Extreme duress; Mental incapacity; Illegality; Discharge in bankruptcy; Fraud in the inception; Forgery; Material alteration.

(Okay--I confess, I had to look those up.)

So, it seems fraudulent inducement would not be actionable if the loan has been sold in the secondary market. Throw in the shelter rule, and me-thinks you have a tough time making out a defense that the mortgage broker defrauded the borrower.

I am cynical enough that I frankly assumed the secondary market is attractive in large part because the personal defenses fall away...

Thoughts? Am I off base here?

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