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Reporting on the "Mortgage Meltdown"

posted by Katie Porter

Journalists have produced some really excellent stories about the rising foreclosure rate and the struggles of families to save their homes. I've previously blogged about an interesting LA Times piece about the lack of reliable data about foreclosure numbers; another favorite article is the NY Times story, Can These Mortgages Be Saved?, about difficulties that consumers have in obtaining loan modifications from servicers.

In recent days, however, the Wall Street Journal has published pieces about bankruptcy that contain inaccuracies. An editorial on October 24th, The Mortgage Meltdown, grossly mischaracterizes pending bankruptcy legislation. The bill, the Emergency Home Ownership and Mortgage Equity Protection Act of 2007(HR 3609), would reverse the existing preferential treatment in Chapter 13 bankruptcy law for home mortgages and permit debtors to modify their home loans in certain ways. The Wall Street Journal says that the legislation will "allow bankruptcy filers to treat home loans as similar to unsecured credit-card debt." The editorial then sarcastically posits "Guess how eager lenders will be to offer low mortgage rates if they have no better chance of collecting on a mortgage than they do on a credit card?" This characterization isn't mere alarmist hyperbole. It's flatly wrong. Mortgages are liens; they give the lender a security interest in the debtor's real property. Absent unusual circumstances, secured creditors retain their property interestsin the collateral. If they aren't paid--inside or outside of bankruptcy--they can foreclose on the property. In contrast, credit cards are normally unsecured debt. The lenders have no collateral. Unsecured debt and secured debt are treated differently in bankruptcy law, just as they are in state law. The apt comparison for HR 3609's proposal is that home mortgage lenders would be treated just like lenders whose collateral are vacation homes, or commercial property, or rental houses, or whose collateral are cars, motorcycles, or appliances. The Wall Street Journal should print a correction, making clear that the bill would not put mortgage lenders on par with credit card companies, and retracting its suggestion that the legislation would thereby cause mortgages to have the same interest rates as credit cards. Perhaps some would excuse the Journal because these statements were in an editorial. But a recent news article on bankruptcy as a home-saving device was also misleading.

The article appeared on October 23 as a front page story. The problems began right away--the article's very title, More Debtors Use Bankruptcy to Keep Their Homes, does not appear to be squarely supported by any evidence in the story. The truth is that the government does not track how many people who file bankruptcy are homeowners. These data simply don't exist. In an apparent remedy to this problem, the article offers the rise in Chapter 13 bankruptcy cases as evidence that bankruptcy is increasingly the refuge of choice for families facing foreclosure. While studies do show that the proportion of homeowners in Chapter 13 is higher than in Chapter 7, the article's statement that "an increasing number of homeowners have filed for bankruptcy in Chapter 13" doesn't actually show that foreclosures are driving bankruptcies. As absolute numbers, both Chapter 7 and Chapter 13 bankruptcies are higher last quarter than in the same quarter in 2006. So while there are an increasing number of Chapter 13 cases, that same statement is true for Chapter 7 bankruptcy. Indeed, the percentage growth in Chapter 7 cases is actually higher than Chapter 13. Using the very figures in the Journal's graphic in the article, one can see that the share of cases that are Chapter 13 filings has actually fallen from 39% in 2006 to 37% in 2007. How is this credible evidence that "Chapter 13 Filings Gain in Popularity?" As most law students will tell you, bankruptcy isn't an easy subject. The law is hard to understand, and the policy tensions in the statute are complex. I'm glad to see journalism on bankruptcy and foreclosure, but inaccuracies or unsupported assertions create obstacles to informed policymaking.

Comments

Katie, the issue is not whether home loans will have the same legal moniker as the credit card debt, but whether the rate of lender recovery on home loans will plummet to the rate of recovery on credit card debt. It's the rate of recovery that determines interest rates, not legal monikers. There is no question that the rate of lender recovery will go down if the bill goes through -- that's the whole point of the bill, after all. The question is, by how much? If you have some data on this, please share. If not, your comment is just as speculative as the one in the WSJ.

The WSJ is entirely right as an economic matter, and I see no reason for them to issue any corrections. You, on the other hand, seem to fetishize words and miss the economic substance.

some intersting comments at http://calculatedrisk.blogspot.com/2007/04/ranieri-on-mbs-market-its-broke.html ( aka http://tinyurl.com/2jpafl :

Says Ranieri:
"The subprime mess ... starts at the end of the third quarter of '05 and carries through, principally, the fourth quarter of '05 and '06.... the subprime production, in those five or six quarters that as much as 50 percent of that production could have gone to the agencies, meaning, Fannie, Freddie and FHA. "

That 50% could have gone for conventional mortgages - and probably could have continued making the payments if they were qualified for GSE conforming loans. Instead, because the securitzers were paying hugely more for the loans with the big interest numbers attached, that's what these people were steered to.

So if bankruptcy judges can force these toxic loans into some non-toxic form, many people can stay in their homes and the "recovery" is not an issue for them.

I find most of the journalism on this issue to be naive, excessively anecdotal and generally useless. The Times article you cite is better than the average local newspaper reporter although they too have published a number of pieces that share the qualities referenced above. It is always worth noting that legal barriers prohibit a lender from commenting to the press on a specific borrower's situation, so the reporting on the making of the loan is always onesided (maybe that is why you like it) but the reporters seem to either not know that or not care enough to report it. The stories are always bereft of examination of source documents, like the mortgage application or the borrower's credit score, and the reporters seem to be unwilling to question the borrowers' integrity or decisionmaking. For example, there is a Business Week article from the summer that starts off with the borrowers basically confessing to bank fraud in their mortgage application for a tradeup house, but the story goes on to suggest it was not their fault they lied, their broker encouraged them to do it. (Poor Bernie Ebbers, he didn't have a broker to blame when he lied.) Nor is there often any report of how much of a down payment the borrowers made, if any.

As far as the law goes, I see no reason why our current system that says, if you made a mistake borrowing money to buy a house, we'll give you a discharge from the debt and a fresh start, please put the house back to the lender if you can't afford it, is not sufficiently kind and generous to the borrower, whereas saying, keep the house and pay what you can, penalizes every person who is waiting to buy a house at a fair market price and penalizes those who make sacrifices to pay their debts without adjustment. Those facts seem to be lost on the media - probably because they can't find the injured people, there being no advocacy organization for the prudent in America, although they seem to be an endangered species. And for the overall economy, I think there is ample empirical evidence from the S&L cleanup and the Japanese experience of the 90's that the best economic policy is to take the hit fast and move on, rather than have a slow, grinding readjustment with constant regulatory intervention over several years. To the extent laws were violated in the making of the loans, which has doubtless happened, then Congress should fund enough money to hire some more prosecutors to enforce them rapidly and aggressively, and I am sure there are plenty of young law school graduates who would love to have that job opportunity. But the idea of just passing more laws and leaving them to bankruptcy judges to sort them out seems a suboptimal policy choice to me.

Prof. Porter is certainly right to criticize the WSJ editorial for saying that the bills would treat home mortgages the same as credit card debt. And I think she is right that a closer analogy is to the way other secured debt (e.g., a car loan) is treated. But it's not a very close analogy or even, I think, a good analogy.

Other secured debt that is provided for in a plan must be paid off with interest during the three to five years of the plan. Of course few persons who need bankruptcy relief can afford to pay off their home mortgages in 3-5 years (even if the amount is reduced as noted below due to "strip down"), and thus the House and Senate bills permit payment over a much longer period of time. The need for explicit provision for paying the mortgage over longer than 5 years was recognized, at least on the Senate side, as the bill was being drafted in Senator Durbin's office. The Miller bill coordinates its provisions with the discharge in such a way as to make clear that the mortgage debt can be paid off over more than 5 years.

In addition many debts secured by property other than homes are not subject to strip down (reduction of the amount of the lien to the value of the collateral, where that is less than the amount of the debt) because of language added by the 2005 BAPCPA to the end of section 1325(a). For example, an auto loan cannot be stripped down if the car was purchased by way of the loan within 910 days before the filing date. Many of the subprime home mortgage loans that the bills would affect were used to buy homes recently enough that a 910 day rule would likely prevent strip down of them, if they were treated the same as purchase money auto loans.

That's not to say that the Miller or Durbin bills should be rejected, though I think there is reason here to be cautious. It is to say that neither analogy (to credit card debt or to other secured debt) is accurate (though, as noted above the analogy to other secured debt is somewhat closer).

Mark S. Scarberry
Professor of Law, Pepperdine Univ. School of Law, and the Robert M. Zinman Scholar in Residence, American Bankruptcy Institute

Statements made on editorial pages can be powerfully persuasive. Little wonder that Murdock wanted the WSJ. Given his track record with other news media, we should not be surprised that accuracy might be a first casualty on the editorial pages of the WSJ. Little likelihood, it seems, that this gaff will be corrected.

It seems to me that the critical issue with regard to these mortgages should not be the value of the collateral (and an ability to "strip down" the mortgage to current market value, as with many other secured claims). The critical problem to me is that the current version of the statute that prohibits modification of mortgages is incapable of fixing the biggest problem facing many current borrowers -- they have ARM's.

The existing scheme does not permit write-down of the mortgage to the value of the collateral. Yet the existing statute has worked pretty well over the years to allow borrowers to cure arrearages and to get back on track. But that same scheme proves useless or ineffective when the problem faced by the borrower is an ARM. It is the upward rate adjustment, and the resulting impact on cash flow, that poses the problem for these borrowers, and current law cannot fix that.

Professor Porter,
Re the Gretchen Morgenson article about your study:
It showed even more than I thought before that there is a big public interest in finding more ways to avoid the bankruptcy route.

Could we construct a pre-bankruptcy pools of properties which would permit borrowers to downsize? I guess that this would involve assuming the existing mortgage on a more modest property that the borrower could afford. Perhaps the authorizing law would permit the mortgage to metamorphose into fixed-rate at the same time. The procedure should be devised to reduce or eliminate the usual fee structure. Call it "musical houses".

As for the CDO/SIV problem, that's probably not your focus, but anyway this is a closely related problem in the sense that this construction may complicate the resolution of mortgage problems outside of bankruptcy. There really should be a database with data consolidated from the regulating agencies and probably under the control of the Fed. The concept would be to distribute down the line the current valuation of undelying property (based on local market data), the payments status of mortgage, information on borrower's credit status, etc, which would permit modeling of the default risk, thus giving a rating or valuation on that loan. This would require the purchaser of mortgage debt at each stage to report how it aggregated loans or obligationst, what tranches if any were created, and to whom it distributed the new securities. Terms of tranches would have to be clearly defined. This would be monumental, but data professionals should have no problem integrating data with diverse parameters. The main problem might be originators or servicers that are themselves in bankruptcy! The end goal of this exercise is to have a transparent valuation of the debt at any point in the line so that the trading of debt can occur with a normal spread and that interest rates will not be forced higher by exceptional uncertainty. This will permit the Fed to have a real handle on this otherwise murky situation. A somewhat censored derivative of this database could be used by the rating agencies.

One statistic I read today claimed that there might be two million bankruptcies during this cycle. Can the courts deal with this?

I am not a technician, but this stripping issue seems not to take into account that over the life of a mortgage the value of the property might well recover. If there are millions of foreclosures, this will have quite a depressing effect on real estate valuations. This could become a vicious circle. Therefore workouts which prevent distress sales should be a priority. When it is too difficult to renegotiate terms (for example when CDOs are involved), perhaps the odd solution I proposed above might look better than at first sight.

Sincerely,
Richard Weller
private investor (not owning any mortgage debt nor owing on a mortgage!)

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