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Bankruptcy Modification and the Emperor's New Clothes

posted by Adam Levitin

A new argument being advanced against bankruptcy modification is that it will result in trillions of dollars of losses and the collapse of the financial system.  This is the "the sky will fall" argument.  

Leaving aside the grossly inflated numbers, let's be really clear that these are not losses that would be caused by bankruptcy modification.  These losses exist with or without bankruptcy modification.  All bankruptcy modification does is force these losses to be recognized now, rather than at some point down the road.  Bankruptcy modification doesn't change the underlying insolvency of many financial institutions.  One way or another, there are a lot of financial institutions that have to be recapitalized. 

Financial institutions want to delay loss recognition as long as possible.  Maybe they're hoping that the market will magically rebound.  Maybe they think that 2006 prices are the "real" prices and "2009" prices are a very short-lived aberration.  But here's the crucial point:  homeowners bear the cost of delayed loss recognition by financial institutions.  Delayed loss recognition means homeowners floundering in unrealistic repayment plans and then losing their homes in foreclosure.  Delayed loss recognition means frozen credit markets because no one trusts financial institutions' balance sheets.  Delayed loss recognition means magnifying, shifting, and socializing losses.  We only make matters worse when we try to pretend that these losses don't exist.  

We all know the story of the Emperor's New Clothes, and how everybody plays along with the emperor's conceit until a little boy points out that the emperor is stark naked.  To suggest that widespread financial institution insolvency would be caused by bankruptcy modification is akin to blaming the little boy for the emperor's nudity. 


I do agree that loss recognition is part of the reason lenders are resisting; a cramdown modification clearly triggers Troubled Debt Restructure regulatory treatment, which is something banks try to avoid. In my personal experience another reason lenders oppose cramdowns is because modified mortgages frequently redefault, whereas once the lender forecloses and sells the property it is done with it. Cramdowns and modified mortgages are perceived as ongoing problems, while foreclosure and REO is a permanent solution.

Foreclosure is a permanent "solution" that puts another vacant house out on an already saturated housing market. It perpetuates a vicious cycle, degrading the desirability of the neighborhood, lowing surrounding home values, putting more mortgages underwater, and causing more homeowners to default.

I believe the phrase "self-interest, rightly understood" was coined by Alexis de Tocqueville. It's a concept some banking interests need to take a look at.

Re: "The sky will fall" argument.

The fact of the matter is that nobody knows what will happen if mortgage cram downs are allowed. Any historical analysis is useless because historical cram downs were subject to the 3-5 year repayment requirement, which is a significant control against re-default risk and moral hazard. Current proposals will allow courts to modify loans for extended terms of up to 30 or 40 years. Nor do we have any idea what re-default rates will be for the crammed-down mortgages.

The fact is that more than half of even the worst subprime deals are current - those mortgagors continue to make payments despite the property being under water. There is a significant risk that by allowing borrowers to write down their debt while keeping the property and potential for future appreciation, Congress will create the quintessential moral hazard.

Do I know what will happen? No, but if the risk exists that "the sky will fall", I sure will look for ways to mitigate it. However, no such controls exist in the current proposals.

There is yet another unforseen benefit of permitting "Bankruptcy Modifications": By reducing the mortgage balance to the the true, present-day fair market value of homes now through the bankruptcy process, any small to moderate upswing in real estate prices in the future will be more readily recognized and *real* equity in the property will build that much faster. Hence, by reducing mortgage balances to FMV, the debtor's ability to refinance the real estate at a potentially better rate due to a faster increasing Loan-to-Value Ratio increases as well.

For example, if a Debtor owes $350,000 on a 30-year mortgage of residential real estate with a true present fair market value of say $250,000 at 9.5% variable interest and mortgage arrears (as many of them have)of $10,000, under the present bankruptcy regime, the only alternatives would be to try and cure the arrears of $10,000 over a 3 to 5 year period while making P & I payments of $2,942.99 based on the inflated interest rate based upon an inflated principal balance. Assuming that real estate prices stabilize and ("hoping the creek don't rise") slowly rise by 3% per year on average over a 5 year period, the value of the residence will still be only $287,500. This circumstance would result in (a) no net equity available to refinance because of the amount of the remaining mortgage balance would far exceed the value of the real estate(b) continuing a high interest rate on an artificially higher balance continuing to keep the mortgagor at greater risk for future default without the practical ability to refinance and (c) no new economic activity because of limited credit availability.

By comparison, if the mortgage is "crammed down" to the true present-day fair market value of $250,000 and the interest rate is adjusted downward to say 6.0% with a 30-year amortization the P & I payment would be $1,498.88. reducing the debtor's financial burden by approximately 49%. Moreover, over the same five-year period, the Debtor would realize new equity in the real estate of approximately $54,864.34 or an LTV of approximately 81% allowing the mortgagor to refinance the real estate and creating new opportunities for new mortgage activity in the economy.

I therefore believe that although the initial "sting" of immediate recognition of loss would be painful to mortgage lenders, there is much greater "upside potential" for new constructive mortgage activity and business by permitting residential mortgages to be "crammed down" in Chapter 13. Furthermore, if real estate prices recover faster over that same five-year period, the Debtor might have sufficient equity to refinance earlier than at the end of year five.

Val, the usefulness of historical data in predicting future markets is always questionable, and I'll be the first to admit that's the case with cramdown. Mortgage markets from 1979-1993 were just different. But I'm not sure that historical cramdowns were subject to 3-5 year repayment requirement. We only have a handful of reported decisions, they are not uniform, and the statutory language of 1325(a)(5) doesn't compel the conclusion that a secured claim be paid off in 3-5 years. It requires "value" (cf. "deferred cash payments" in 1322(a)(2)), and value could certainly be in the form of a new note (as is done in 11s). In any case, the uncertainty about how cramdown would work means that nuances are unlikely to have made their way into underwriting models, thus I don't think that this factor undermines the historical experiment.

I think the moral hazard case is overstated. First, if the property is sold during the plan period, any appreciation would go to the unsecureds Second, bankruptcy's not a free lunch--is it worthwhile filing for bankruptcy for the possibility of escaping say $30K (15% of a $200K mortgage)? I'm not sure how that calculation plays out for a lot of people. The default rates on subprime are already quite high (even if under 50%, that's not saying much), and when interest rates rise, the subprime ARMs will default at even higher rates. The only way to get people out of unaffordable mortgages is to modify or refinance the mortgage. Voluntary modifications aren't happening for all kinds of reasons, and refinancing isn't possible with negative equity. Bankruptcy modification isn't the ideal solution to the mortgage crisis, but it is by far the best option on the table.

Wow Richard, I never looked at it in that light. Makes sense. The debtor/s get/s rid of the extra baggage along the way. (unsecured debt). There should be more income than debt to lend to afterward as well.

This article puts the "spin" that foreclosures lead to economic down turn that lead to unemployment instead of the other way around.

The article is ok: http://realestate.msn.com/article.aspx?cp-documentid=16876962&GT1=35000

Richard my husband and I have been trying for over a year to get a suitable loan modification. One that is not going to leave us broke for 30 years, but our mortgage company is determined to do just that. Take every penny that we have and leave us with very little to take care of a family of 5 on. It would be nice if our mortgage company would say lets set your payments over 40 years instead of 30 and lower the payment by about 300 to 400 a month. They just simply are not doing that. So we are stuck in a mortgage the is nonproductive and waiting to be foreclosed on because of a stubborn bank. In reality if they would make that simple modification they would make 100k more from our loan than to do nothing at all with it or to let it go to bankruptcy. We are waiting for the changes to be made because our bank doesnt want to see the big picture and has left us no choice. Its sad to see that the banks can be so stubborn and wont make the simplest of changes to keep people in their houses. I know we are not the only ones that are having the same issues with the banks. If the bankruptcy law cant be put into affect then they should make it manditory that the banks change the terms of the loans from 30 year loans to 4o years. Not only that whos to say that these judges wont use good judgement and do that to the loans anyway instead of cramming down the amount that is owed.

The modification of principal balances will cause AAA securities to be downgraded. Because bankruptcy losses are shared pro rata above a small threshold 100k, AAA securities will be downgraded to at least BBB. Firms that are required to hold a certain % of AAA securties (Insurance companies and Banks) will be put into a "forced sale" - at market values. OTTI analysis will also require a write down to market values if there is $1 loss.

What were once hold to maturity securities, with HTM values will quickly become massive losses once sold at current market prices. Essentially this legislation will cause a large forced sale of securities that really will only take a 10 basis point loss if held to maturity, this will drive prices further down as companies that are required to maintain a certain amount of AAA securities are forced to sell at huge losses.

Haybusha, you correctly note that once cramdown explicitly exposes the mortgages losses presently bundled in "AAA" MBS and CDOs, those securities will be downgraded to BBB. But you didn't address Adam's primary point: cramdown is merely loss recognition, not loss creation. The emperor here is the "hold to maturity" securities you describe, the underlying mortgages are his fancy clothes. The securities are naked because the clothes are not worth what "everybody" though they were worth.

Your objection appears to be that the emperor, now seen as naked, will be ridiculed and dethroned. I don't disagree. But I think there may be other, frankly positive, results. Who sold the emperor those clothes, who repeatedly assured him the clothes were beautiful and of great value, who charged commissions for making the clothes? Frankly, your emperor's owner, the hapless investors, should be suing the banks who created these products and the ratings agencies who valued them, rather than suggesting the sky will fall if the fraud is revealed.

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