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Cramdown and Future Mortgage Credit Costs: Evidence and Theory

posted by Adam Levitin

I've written extensively (see here, here, e.g.) on why permitting modification of mortgages in bankruptcy would generally not result in higher credit costs or less credit availability. As the debate over bankruptcy reform legislation to help struggling homeowners and stabilize our financial system moves to the fore, it's worth repeating some of the key points and making some new ones.

(1) The key comparison is bankruptcy modification versus foreclosure. Opponents of bankruptcy modification often misframe the issue, whether deliberately or ignorantly. It is not a question of bankruptcy losses versus no losses, but bankruptcy losses versus foreclosure losses. If bankruptcy losses are less than foreclosure losses, the market will not price against bankruptcy modification. This is an empirical question, and to date, my work with Joshua Goodman is the only evidence on it. Opponents of bankruptcy modification have only been able to respond with plain-out concocted numbers (e.g., the Mortgage Bankers Association) or insistence on applying economic theory that looks at the wrong question.

(2) Economic theory tells us that cramdown is unlikely to have much impact on mortgage credit costs going forward. The ability to cramdown a mortgage (reduce the secured debt to the value of the property) is essentially an option borrowers hold to protect themselves from negative equity. It is a costly option to exercise--it requires filing for bankruptcy, and that has serious costs and consequences. More importantly, though, cramdown is typically an out-of-the-money option. It is only in-the-money when (1) property values are falling enough that there's negative equity and (2) likely to remain depressed in the long-term. Long-term declining residential property values have been the historical exception. What this means is going forward there really isn't much for creditors to worry about with cramdown--homeowners can't exercise an out-of-the-money option.

Moreover, because the likelihood of the cramdown option being in the money is Instead, it is an option that is more likely to be valuable when default is imminent, at which point the loan is in the secondary market. So to the extent that the cramdown option does cost creditors, it is the secondary market, and the effects on credit availability and cost to homeowners would be diffused.

(3) Arguments about bankruptcy court capacity and bankruptcy transaction costs are made by people who have no experience with the actual bankruptcy system. A serious misconception about bankruptcy modification is the belief that the bankruptcy judge would decide how to rewrite the mortgage. That's not how bankruptcy works.  The debtor (and debtor's counsel) would propose a repayment plan that includes a mortgage modification. The judge either confirms or denies the plan, depending on whether it meets the necessary statutory requirements. This means that bankruptcy judges can actually handle significant consumer bankruptcy case volume. If you want proof that the bankruptcy courts can handle a huge surge in filings, look at what happened in the fall of 2005, before BAPCPA went effective. The courts survived that flood of filings. Today the bankruptcy courts are better prepared; there are more bankruptcy judges (thank you BAPCPA) than in fall 2005. Nor would there be tremendous time and money lost in valuation disputes. After there are a handful of cases decided in a district, all the attorneys know what the likely outcomes would be in future cases and settle on valuations consensually. Court capacity and excessive transaction cost arguments are made by people who have never stepped foot into bankruptcy court.

(4) There's no other serious option on the table. Permitting bankruptcy modification of mortgages will not by itself solve the finance crisis. It will not stop all foreclosures. But it will help stop some uneconomic foreclosures, which benefits homeowners, investors, communities, and the financial system. And, more importantly, whatever imperfections bankruptcy modification has as a solution, it's the only real option on the table.

There is no other detailed legislative proposal. There are various economist pipedream proposals around, but even the best of them fail, either because they are politically unrealistic or because they are too rooted to a belief that the private market can solve problems with a tweak here and there. I believe that people and institutions respond to incentives, but market-based solutions haven't worked to date. How many times do we have to be burned by "market-based" solutions before we try something else? The unfortunate truth is that no one understands enough about various mortgage market players' incentives to properly align them. We can't follow all the trails of servicing contracts, insurance, reinsurance, credit derivatives, overhead, and litigation risk and know what incentives look like. Even if we did, it would take serious time for the market to correct itself and start doing large-scale loan modification. That's time that families don't have, and I don't think that anyone who is advocating a market-based solution is also pushing a foreclosure moratorium to allow the market to get its act together. Bankruptcy modification is the only game in town, and to pretend otherwise is disingenuous cover for opposing it in the name of "studying all the options."

Comments

Adam,

You continue to advance the position that bankruptcy would not create larger losses for lenders than foreclosure, and the cost of mortgages will not increase as a result of cram down. You have also suggested in your testimony to coongress that any losses would be deserved since banks made irresponsible lending decisions and are responsible for the problem. But you have never discussed FHA and VA loan programs in this context. When it comes to these loans, you are wrong in all cases.

FHA and VA loans are underwritten with the most strict standards - fully documented income, FHA and VA approved appraisals, etc. FHA and VA lenders do not fit the mold that your positions are founded upon.

The FHA and VA programs were set up to provide home ownership opportunities to veterans and lower income Americans who would otherwise not have the option to own. These programs insure lenders against borrower default. In the event of foreclosure, FHA or VA steps in to make the lender whole for non-payment by the borrower. It is this insurance/guaranty that makes a low down payment viable for lenders. If these loans are subject to cram down losses, lenders will face enormous losses that they would have never been exposed to, and that will drive them away from low down payments loans (making mortgages more difficult/expensive to obtain for many, many people).

In today's real estate and lending market, FHA and VA now account for nearly 40% of all new mortgages. Subjecting these programs to cram down losses could further destabilize the market, decrease the pool of buyers, drive home prices down even further, increasing the strain on the economy.

Scott,

You're right that to date I've avoided commenting on FHA/VA loans. FHA/VA loans are different, not least because of the taxpayer guarantee. As you note, FHA/VA lost serious marketshare to subprime over the last decade, but now that subprime is gone, the FHA/VA market is booming (although unfortunately part of this boom is just subprime shops moving to FHA/VA work), and hopefully these are more sustainable loans. At the very least, FHA/VA require servicers to follow detailed loss mitigation procedures, which means that financially distressed FHA/VA borrowers are more likely to be able to get a workout without having to deal with bankruptcy (especially because the servicer isn't compensated in bankruptcy).

That said, to the extent that there is a problem for FHA/VA loans, it seems pretty easy to fix--just extend FHA/VA insurance to cover bankruptcy modification losses that occur in lieu of foreclosure. The bankruptcy exclusion in FHA/VA guarantee coverage only made sense when there wasn't a bankruptcy option. But if losses would be smaller in bankruptcy than foreclosure, FHA/VA should certainly want to cover the bankruptcy losses to avoid creating an incentive for foreclosure.

It might not be kosher to comment on a comment, but Scott's point seems to beg a crucial question: how have FHA and VA mortgages fared in the current downturn? While one suspects that there are some such mortgages that would be subject to strip-down, I would be surprised if, given the underwriting requirements for these loans, we would see a large number or percentage of underwater FHA and VA loans.

Can Scott or Adam (or anyone else) put some numbers on potential FHA or VA loans underwater? I was under the distinct impression that most underwater loans were those brokered by shady subprime operations and avaricious banks eager to lend despite negative information (or lack of such) on values, incomes, etc. Given the FHA and VA standards, I would think these loans would be sitting more or less pretty--which would underscore Adam's point about just deserts for the poorly underwritten loans that are underwater.

"The bankruptcy exclusion in FHA/VA guarantee coverage only made sense when there wasn't a bankruptcy option."

We agree about this. But you are advocating for a bankruptcy option that could have devastating effects on the housing market absent a change to this exclusion, and you have never mentioned it. I think the FHA/VA issue is something that has to be out front of any cram down discussion - by ignoring it in any of your posts or your testimonies before Congress, it certainly leaves the impression to others that this issue is either non-existent or unimportant.

Not only is it important to mention, it seems to me that your proposed fix for FHA and VA loans is critical in order for your arguments about the costs of future mortgages to hold water. Without the extension of the insurance to cover cram down as you suggest, the risk to lenders (and thus the cost of mortgages) would be drastically increased - arguably for the most responsible borrowers and lenders (not the 'bad actors' you refer to in your arguments).

Lastly, FHA/VA borrowers are the most likely candidates to have an 'in the money' option (even at origination) because of their low down payments (0% to 3.5%). This makes the FHA/VA loan uniquely vulnerable.

One of the key components to an economic recovery is for the credit markets to open up again. At the moment, FHA/VA loans are an important part of that recovery. A short-sighted, broad-based cram down proposal which damages the FHA and VA loan programs would be disastrous.

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I think Jason raises some important questions. Here is what I know:
HUD and VA would have the data to support this (and there is an article in today's Washington Post). HUD and VA foreclosure rates have remained relatively stable over the past couple years, while subprime foreclosures skyrocketed. We are starting to see some increase in FHA/VA delinquency, but nothing lilke the subprime levels.

While some of the recent FHA production likely came from the subprime market, the FHA underwriting standards haven't changed. So increases in defaults could probably be attributed to an overall worsening of the economy (more unemployment or other life events that lead to defaults - not bad underwriting).

Also, the strip-down option is not linked to underwriting, but rather 'current market value.' We were all affected by the inflation of housing prices that came as a result of loose underwriting standards in some programs. It stands to reason that homes with FHA and VA loans will have experienced deflation and lost value as the real estate market has declined.

Jason: I can't put numbers on the table but just speak from a little experience in the Consumer Bankruptcy Biz. As far as foreclosures and FHA and VA mortgages, I see very little if any that are truly underwater (as you have pointed out, they will be sitting prettier). The instances of a "cramdown" on those mortgages I believe will be little to none. Face it, you just don't see 80/20 ARMS guaranteed by the Government. If you do, I would love to see it. When we do see debtors behind on those type mortgage it is because they are paying things like credit cards or finance companies loans instead of the mortgage. In those cases we would most likely see the re-capitalization of arrearage debt and not necessarily a cramdown. Getting rid of the "dead weight" all the while in Bankruptcy. If there is a realized profit over an above the re-capitalization, I support a "form" of clawback for the government. The longer the debtor is in that note the more likely there is to be a higher profit margin later (much later on). That same home if foreclosed on sits there (and they are) acts as a sea anchor, dragging liquidity and profits down an abyss with it.

The real help in not only in liquidity but profit (on the loan it self) will be by the debtors being able to perform better without fluctuations of those “creative” mortgage loans they got into. I don’t think rates are going to go much lower. With people already defaulting in record numbers the readjustment upwards on interest is only going to exasperate the situation. If there is no "hope" people will let those houses go and we will continue to have a glut.

We need a mass of people to feel and think that there is hope for that "American dream". With that "hope" people will perform. Most people file chapter 13 bankruptcies for that "hope", the mere possibility of saving that home.

Ok... Someone correct me here but, at least as far as any kind of loan that has been **securitized** is concerned, from my understanding the trust has insurance policies in place to cover any losses that may incur from defaulted loans. That being the case, the note holder has already received the value of the note from insurance claims made against said policy. Anything above and beyond is simply double dipping or unjust enrichment or whatever term applies in legalese.

I have no problem with a note holder/lending entity recouping their initial investment but when they start putting up a fuss because they aren't being allowed to double, triple or quadruple it (title insurance claims, pmi claims, sale of property after foreclosure etc.) I start to get a little irritated...

Insurance policies don't cover cram down. That is not the "double-dipping" situation.

The double dip occurs when an irresponsible borrower gets the home by paying less than they signed up for, and also gets to realize the gain when property values rebound. The holder takes 100% of the loss and becomes a defacto guarantor of property values instead of a financing mechanism. If you think that was part of the investment decision, you are very wrong.

The bank didn't set the price on the home. The bank didn't lie about the borrower's income, or whether it was an investment property or primary residence. The bank isn't defaulting on their end of the agreement. The reality is that the borrower got all the money they asked for from the bank/lending entity. The bank didnt change the rules for their benefit when my house became worth more than I paid for it, and I shouldnt be able to do it either.

The best foreclosure prevention mechanism is to pay your mortgage.

Any "Responsible" lenders out there, any more? Or were they exempt from being "Responsible"? Are lenders all responsible now? Or were they made so against their will.

100% of what loss? It will only be any kind of loss if they "cash in their chips" at the wrong time. The consumer is bound to a 30-year note but lenders are not. The notes are pieced off and sold for "liquidity" sake.

What about all of that interest Mr. "Responsible"? So the lender gets something less than 3-4 TIMES the amount loaned. In days of old "Key stoning" was enough profit. Either way you look at it the lender is STILL MAKING MONEY and a ton of it! Even with a potential Cramdown.

Due respect, "Responsible Borrower", more happens with a note than you are apparently aware of. "Paying your mortgage" simply is not enough to ensure that there are no problems with your loan. And the purchase price of a property has little to nothing to do with it either. I know - I'm proof of that as are hundreds of thousands of other victims of whom I am aware... But as long as you're paying YOUR mortgage I'm sure you'll be fine.

Yes, Patches: Finance 101 will explain the concept of interest and opportunity cost. If you want willing lenders, you have to provide incentive by allowing them to make money (as in ANY business). If anyone knows where I can get an interest free loan, point me in that direction - free money for all would be great... I, for one, knew that the bank was charging interest when I borrowed (it was part of the contract that I signed).

Mike - I will be the first to admit that I may be missing something. But I am pretty confident that if I hold up my end of the bargain by paying my mortgage, then I will be fine. I realize that I probably came off a little caustic, but I tend to get irritated when people don't look at the long term consequences of their decisions. It seems to me that a lot of people bit off more than they could chew, and enjoyed their dream homes as long as they could. I budgeted for my modest home and didnt get all the frills. Now it sounds like some people want to bail out the borrowers who over-reached, and I may suffer for it when I am ready to upgrade from my starter home because the bank will have to weigh in additional risk...
I dont know the answer. But I dont like this one.

I seem to have read that there are a few in the "Big Banks" out there with interest free TARP money given away as Bonuses. I understand the concept of risk vs reward just fine. What we are talking about here is: The rewards are long gone and the bad actors "have left the building" with the cash and its like they are getting corporate social security or something because they are still getting paid for their bad bets (TARP). All we have now are the pieces. If mortgage mods were a permanent thing despite stricter lending standards I probably lean towards your position. Right now though, I don't think we are mid-way thru the storm of "resets".

It would have been great for all of those irresponsible borrowers to have just been able to make those payments or not have received the “toxic” loans in the first place. No one wanted to put them in a FHA and most people I see with ARMS are dumbfounded to know there are those types of home loans. Truth is that there was a mechanism out there that desperately wanted those types of home loans for investments. When we are dealing with risk vs. reward you just can’t have “only” reward. And who gets spanked when "risk" comes calling? The chickens have come home to roost. To see the volume of foreclosures we are seeing now, there had to be something else not right. Its like the sea floor ruptured here in American and the ensuing tidal wave is claiming victims clear across the planet. How else can you fix this mess? I don't think we can lend our way out of this one. Seriously, I am all ears because there are a lot of people to help out there. It may or may not be your job, but it is mine. I have to look them in the eye and say "there is no hope" and lecturing them about their bad decisions is not fixing the problem. Letting a potential of 5 million homes sit may bring home prices down even more. Responsible borrowers will feel the consequences of all of that “risk”.

RB, I don't disagree that, at least from a layman's POV, I have to wonder about the potential ramifications of BK modifications. Without the requisite legal education to provide the necessary understanding, the effect on contract law, in general, concerns me.

That said, one thing that many responsible consumers/home owners seem to forget it that the would not have been able to purchase the property if they had not been approved for the loan. And with that statement made, I simply refuse to believe that there were SO many people gaming the mortgage system that they all successfully defrauded the various mortgage companies. Were there con artists out there trying to make a quick buck during the bubble? Absolutely. Did some of them submit fraudulent docs for the underwriting of their NINJA or Liar loans? Definitely. But if underwriting had done *proper* due diligence on the vast majority of applications and/or had stuck to realistic underwriting guidelines, instead of getting as greedy as we all know they got, this problem would not have happened. At least not to the scale that it has.

"Mortgage fraud" goes both ways. Fraud committed against the lender and fraud committed against the borrower. "Mortgage fraud" is, for the most part, an *origination* issue. Mortgage *SERVICING* Fraud (thank you again Prof. Porter for "Misbehavior and Mistake") is a *securitization* issue and one that affects strictly the borrower for potentially the life of the loan.

No offense to you, RB, but these days I just shake my head when people say "I pay my mortgage on time. I'm OK." I know of many borrowers, some of them personally, who were current in their mortgage payments when they were foreclosed on. It happens. And it happens far more frequently than the vast majority of America seems to want to believe - although more and more people, consumers, regulators and adjudicators alike, appear to finally be catching on to the fact that something terribly wrong has been occurring for at least the last 15 and possibly 25-30 years.

Are some people trying to get away with something through the process? Sure. Unfortunately, there always will be those attempting to take advantage of any system. Do bad things happen to good people? Absolutely. In many of both of these scenarios, there is nothing that either can or should be done to assist these people. But it's the ones that were set up to fail, the ones that were taken advantage of because of pure and simple greed on the part of the industry that don't deserve to be punished for wanting there piece of "the American Dream". Had they been told that they could not afford to buy property during the application process they never would have ended up in the situation they find themselves in. Many simply are not financially savvy enough to know better believe it or not.

You want to own your own home. Your piece of "the Dream". You walk in to a lender and say, "This is what I make, this is what I want. Can I get a loan for it?" and the lender says "Sure you can!" and proceeds to lay out what seems to be a reasonable plan for you to purchase the property. People, ESPECIALLY first time home buyers, really aren't going to question the guy/girl behind the desk because a.) They want to purchase the property b.) They went to a "professional" and/or a "reputable" lender/broker who is looking out for the borrower's interests - as opposed to his/her OWN financial interests and c.) Because s/he is a "professional" working for a "reputable" lender/broker the borrower can absolutely trust the guy/girl behind the desk to deal with them fairly. This is where the trouble starts. For the longest time, borrowers thought that lenders/brokers had a duty to look out for them, the borrower. I'm not trying to demonize the entire industry here because there have always been good people right along side the bad ones in the mortgage/housing industry, but for the last few years we've been finding out the hard way that some of them simply have not been looking out for the borrowers. And what may be even more scary to some is that they weren't required to. And far too many people simply did not understand that.

RB, take a few minutes to search "Mortgage Servicing Fraud" because it absolutely can happen to you - despite the fact that you stay current in your payments every month. If nothing else, what you find may give you a little insight as to why I get so long winded on the topic.. ;) If you find that you have any questions, feel free to drop me a line directly. If I can answer them I'll be happy to. If not, I may be able to point you in a direction - possibly Prof. Porter's, or Max Gardner's, or Kurt Eggert's as they've got a far greater understanding of the subject matter. I've had to learn what I could on the fly...

Cram down is a key principle underling reorganization law. It has very little to do with irresponsible/responsible borrower and/or lenders.

The principle has an inherent beauty in its simplicity. The lender has a secured claim to the extent of the value of the collateral and an unsecured claim for the balance. This recognizes the lender’s remedy under state law to sell the property at auction and pursue the debtor for a deficiency. The debtor gets to keep property vital to its success, so long as the payment plan is “feasible” and interest is paid so that the total payments equal the amount of the secured claim as of the date of the plan.

These concepts are as applicable to a consumer trying to get back on his feet as opposed to liquidating. For decades, consumers were allowed to modify home mortgages, until the law was changed at the behest of mortgage lenders as special interest legislation that excluded the application of the cram down rule from collateral consisting of a home.

It makes little sense to exclude cram down for home mortgages when it is allowed for vacation homes and duplexes and is available to businesses. Why allow cram down at all?

Mortgage lenders say stricter underwriting standards will result if cram down is allowed. That would be a good thing as lax underwriting helped create the crisis. I have doubts rates would rise significantly. Plus, foreclosures hurt the whole neighborhood.

One would think lenders would make deals with consumers to avoid taking over a property in foreclosure. However, lenders and servicers are very understaffed. Staff is not able to do due diligence and does not want to take a risk. In addition, the documents creating the mortgage pools make it onerous/impossible for a servicer to do a workout with consumers on a case by case basis.

New story on MSNBC:

http://www.msnbc.msn.com/id/28846944


“10 groups representing the lending industry and other businesses are fighting back fiercely. Several have engaged portions of their lobbying machines to stop the legislation. The groups spent $83 million in lobbying on multiple issues in 2008, a figure that shows the power of the banking and investing industry and their business supporters”.


It looks like Mortgage Bankers Association is putting Millions into the fight. They have such a tight grip that they (legislators) have pulled it from the stimulus bill. Can’t say as I blame them. How many hundreds or thousands will lose their home in the meantime? Who is spending that kind of cash on them? They say “hope now” was for the consumer when actually it was for the banks.

It seems all I have are words…………… and a vote.

Mike - Thanks for the information/education. i admit i am in over my head on a bankruptcy forum - i got to Adam Levitin's post via a link from 'naked capitalism' and poked my two cents in where i have some opinion. I confess my ignorance and will look into this "mortgage servicing fraud." i am sure it exists, since there is someone around every corner waiting to defraud us. but i am a little confused as to how you can pay your mortgage on time and get foreclosed on - or if that is the case that it could be such a widespread problem that i havent heard of it. again, i am sure it has happened. but is it really that prevalent? and are there not laws having nothing to do with bankruptcy to protect a borrower if a fraud really has occurred?

one last thought - why not give the lender a chance to recoup some of the property devaluation by sharing in some of the appreciation when/if it happens? it seems like that way the borrower and lender get to share on the downside and the upside.

The discussion of cram down as a core principle of bankruptcy law that should apply to individual bankruptcy unfortunately confounds corporate and individual means of ownership.

In corporate law, cramdown means that tbe business owners get nothing unless they pay their creditors in full or get them to agree on something less.

It is inapplicable to individual bankruptcies because the modification proposals contemplate that the owner KEEPS the property without repaying creditors in full.

That can only be explained as a homeowner welfare program justified if at all by some macro good.

The cramdown analogy also overlooks the presence of 1111B which says that if a chapter 11 debtor seeks to bifurcate its mortgage debt into a secured and unsecured portion, and wipe out the latter, the holder of the mortgage has the option to keep the full debt claim secured by the mortgage and accept a lower payment stream. This was adopted to eliminate the strategy that was employed in the 1970s of filing bankruptcy when one's real estate was at a depressed value, writing the debt down to that value, blowing off the rest of one's debt, and then re-selling the property when things turned around, at a profit. Unfortunately, the current mortgage mod proposals seem to be indifferent to this precedent although the precedent is well known.

RB, grab a copy of Professor Porter's "Misbehavior and Mistake In Bankruptcy Mortgage Claims" when you have a few moments. And feel free to drop me a line directly or hit my website to get a better feel of where I'm coming from. I'll be happy to discuss off board so as not to take up bandwidth needlessly. That is a standing invitation for anyone that may be interested.

RB, take a look at this story as well:

"Banks ignore struggles of responsible borrowers"


http://realestate.msn.com/article.aspx?cp-documentid=16393981&page=2

Mark:
Thanks for reminding me about 1111(b); you raise a fair point. My understanding is that the provision works as follows. If the secured creditor had a claim of $100,000 secured by collateral worth $50,000, then it could elect to have a $100,000 lien on the collateral but give up its deficiency claim. The secured creditor is entitled to receive payments over time that have a present value of $50,000. Total payments (including interest payments) must be at least $100,000.
Those numbers might easily work for a consumer who stays in his home for a long time with payments based on a 30-year amortization schedule but prove problematic for a debtor who wants to sell quickly at the first uptick in the market, as perhaps it should.

I am curious whether the original chapter 13 enacted in 1978 had a provision similar to section 1111(b). Anyone know?

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