Principal Pay Down in Chapter 13 as a Means of Foreclosure Prevention

As we have discussed recently, here and here, the Federal Housing Finance Agency has asked for ideas about how to dispose of foreclosed properties in bulk.  But there is no reason we shouldn’t take this request as also encompassing reducing foreclosed inventory by preventing foreclosures to begin with.  FHFA has the power to implement either type of program for loans or properties controlled by Fannie or Freddie, the government-sponsored entities under FHFA conservatorship.

So let’s talk about the idea of Principal Pay Down (PPD) in chapter 13 bankruptcy as a foreclosure prevention strategy.  FHFA could direct the GSEs to go along with chapter 13 plans that propose to pay down principal over five years, thus affecting a broad swath of home mortgages.

Here are the elements of PPD

(with thanks to Norma Hammes for the particulars):

• This plan restructures certain undersecured (underwater) mortgages in chapter 13 bankruptcy cases so the homeowner can pay down the loan principal and reduce negative equity and acquire equity faster than with the existing loan.

 

• This is accomplished by reducing the interest rate to 0% for five years, letting the borrower’s entire monthly loan payment go directly to the principal.

 

• During the five-year period, the borrower’s minimum monthly housing payment is calculated similar to a HAMP modification payment, at 31% of gross income.

 

• At the end of the initial five-year period, the remaining principal balance is amortized over 25 years at the Freddie Mac survey rate.

 

• The bankruptcy judge, with the assistance of the Chapter 13 Trustee, reviews the borrower’s budget to confirm the eligibility of the borrower and feasibility of the payments; and they oversee the implementation of the plan.

 

• There is no cramdown – the benefit to the borrower is achieved by actually paying down the loan.

 

• In exchange for this benefit, the borrower agrees to a general settlement of all claims against the lender and servicer and avoiding future title and loan litigation.

 

• The federal government and US taxpayers’ substantial liability on Fannie Mae and Freddie Mac (all GSE) owned and insured loans would be reduced by this plan.

 

• Private mortgage investors will benefit similarly.

 

• Everyone wins with this plan – even the borrower’s community and local government benefit from improved neighborhood stability.

 

Here is an example.  Say the borrower has a $120,000 mortgage loan on a home worth $90,000.  This borrower is $30,000 (25 percent) underwater and thus can’t refinance or sell and pay off the loan.  Over five years in chapter 13, however, principal pay down could allow the debtor to pay down $1,000 a month or a total of $60,000 over 60 months, and end up with $30,000 in equity (rather than $30,000 underwater), assuming the home neither depreciated further nor appreciated in the meantime.  PPD thus here gives a cushion for further depreciation, which is still occurring in the hardest hit parts of the country.  In this example, the mortgage interest would have gotten paid $60,000 over five years, and the borrower would get credit for all of that toward the principal balance.

PPD is different from either principal write-down or shared-equity refinancing, discussed recently by Adam Levitin.  With PPD, there is no write-down but rather a pay down, and all equity thus acquired would go to the borrower.  This program would give many homeowners a stake in their properties by getting the mortgage balance below the value of the home, while also making their loans sustainable and helping to stabilize the housing market.

The compromise involved in PPD is that there is no write-down and that pay down occurs in chapter 13 bankruptcy, something borrowers are not going to do just to get a break on their mortgages if they can afford to pay them.  Chapter 13 involves court supervision for the length of the plan and is an arduous road for debtors.  PPD in chapter 13 thus addresses the moral hazard argument, that giving breaks on mortgages will draw those who don’t need them. If anything, PPD may be too tough a program.  Both PPD in chapter 13 and equity-sharing refinancing outside bankruptcy could both be implemented by FHFA at the same time to increase foreclosure prevention to a meaningful level and experiment with alternatives to see which ones prove most attractive and effective.

Full disclosure:  As noted in my bio, I am a member of the board of the National Association of Consumer Bankruptcy Attorneys, which supports PPD.

Comments

[AMC]

For "PPD" to happen, the lenders would have to consent, or the Bankruptcy Code would have to be amended.

If there were an objection, the plan could not be confirmed because this concept clearly violates Section 1322(b)(2).

But, even if it was just loans held by Fannie and Freddie, at least it would be something where the path to relief for homeowners was clear. And I have yet to see the documents filed on the Bankruptcy Court's electronic docket get lost repeatedly. So that would be an improvement over HAMP.

Politically, it might have a chance. If the implementation of PPD was going to be consent, there wouldn't need to be any change in the law. Just a change in the response of the mortgage holder to Chapter 13 plans with an equity repayment provision.

Not sure how unsecured creditors would be affected under this scenario - I'm sure the credit card companies would not be on board with a program that asked them to forgo what they would normally be entitled to receive in order to allow the debtor to build equity in their real estate.

At one point, the cramdown legislation had a real chance - with larger banks starting to get on board with the concept. The supporters of cramdown were just too stupid - or greedy - to realize that they needed to cut out the community banks who still held the paper on their mortgage loans, and the credit unions. And those two very powerful constituencies rose up and buried the cramdown solution and danced on its grave.

Now we are looking at a lesser solution for a smaller number of mortgages. But the losses associated with foreclosure and the continuing slide in housing prices are becoming more obvious - as is the ineffectiveness of voluntary loan mods, no matter how much lipstick they try to slather on the lips of the HAMP pig.

[Alan White]

This is a very promising idea, but just to be devil's advocate, eligibility would be an important consideration. A PPD program would benefit lenders and investors only if you minimize the moral hazard, i.e. effectively exclude homeowners who would otherwise service their entire debt including interest in the absence of the program. The means test and disposable income test do this to some extent, but many homeowners are now underwater and paying more than 31% of their income on performing mortgage loans, and could easily pass the tests.

Reducing interest to zero also means there is no income from which to pay for servicing (usually 50 basis points, and lately more.)

The other difficult with bankruptcy as an anti-foreclosure tool is the combination of cost ($3,000 or more) and local culture that seems to limit the number of homeowners with access to Chapter 13 in good times and bad.

[Mark]

Wouldn't stop or reduce foreclosures in Southern California because our houses were / are much higher cost and thus the loans on them are enormous.

$60k wouldn't put a dent in the negative equity of the clients and prospective clients I see everyday. Typical loan is $650k first with a $150k second and current value of $400k. The gross income for the typical family living in this house is roughly $85k annually, so 31% over 60 months wouldn't accomplish much.

The trustees would also riot in opposition because this would almost surely soak up all of the PDI and thus give virtually nothing to the unsecureds, and they'd have to administer the plan without pay.

I think it's lack of feasibility in this market points out how truly messed up we are with housing values and how huge the bubble really was. No wonder Bank of America is trading at $6.75 -- they're the most exposed to the loans on these houses.

[Jean Braucher]

Thanks for these comments.

The idea is definitely voluntary sign-on by FHFA to chapter 13 plans proposing principal pay down, initially at least only reaching GSE mortgages. (Although if the principal paydown plan works, it might become a model for expansion to other sorts of mortgages.)

The alternative to paydown is not likely to be full performance outside bankruptcy or a chapter 13 with lots of payment to unsecured creditors, but rather surrender in chapter 7 of a seriously underwater home in a no-asset case or just out-of-bankruptcy default and foreclosure. So neither chapter 13 trustees nor unsecured creditors would necessarily be hurt. Chapter 13 trustees would benefit from having cases and distributions (especially if paydown payments were through the trustee as a conduit, allowing the trustee to get paid a percentage, which does in fact come out of unsecured debt repayment or just make the plan less affordable, but if the alternative is chapter 7, unsecured creditors are not really losing anything).

As for how to pay servicers in chapter 13 under a paydown plan, my example may need revising to reflect the mortgage interest paying $5 a month (50 basis points on $1,000) to the servicer and only keeping $995 rather than the full $1,000 payment. So instead of getting paid $60,000 over five years, the mortgage interest would get $59,700 and the servicer would get $300. Still better than surrender, ultimately to the GSEs' control for bulk transfer in whatever new program (if any) the FHFA comes up with and at some very depressed price.

As for moral hazard, it again depends on what you are thinking of as the alternative. The debtor may be paying a $120,000 debt on a home worth $90,000 and OK with that. If the payments are affordable and the debtor's income is stable, the debtor is probably not going to file bankruptcy. But if the mortgage payment starts to get really burdensome, due maybe to reduced income or rate reset or both, the hopelessness of ever having equity may put the debtor over the edge to surrender or some other form of default. Keep in mind, in the example, the payment of $1,000 would typically be a reduction of the monthly payment, down to 31 percent of gross income, making the payment more affordable, and then there would also be the hope of attaining equity provided by paydown as an incentive to make a really burdensome payment, along with the prospect of a reasonable fixed rate mortgage after paydown. A payment of 31 percent of gross income is often going to be 40 to 50 percent of takehome pay, which is a nasty way to live for a moderate or low income person. One person's moral hazard is another's highly moral effort.

The cost of chapter 13 is a deterrent, which also cuts into the moral hazard argument. But keep in mind that $3,000 in attorney's fees would be paid over time in the plan and the lawyer only gets that much if the plan is confirmed and continues long enough to pay the full attorney fee, suggesting some hope of success in actually achieving pay down. Paying $3000 in fees to get $30,000 in equity after five years (after paying $60,000 in the plan), along with reduced monthly payments, isn't necessarily a terrible deal.

As for expensive SoCal real estate, indeed, this will not work for all. But even there it would work for some. On $85,000 a year in gross income, paying 31 percent per year, the debtor could pay down nearly $132,000 in five years. That would make the difference in some cases between inevitable default and hanging on to build equity. And once again, the right comparison may not be performing on the loan or paying the full loan in chapter 13. It is more likely instead default and the property ending up in the bulk GSE inventory.

As a whole, these comments go mostly to the modest nature of the principal paydown plan.

[Pat]

Hmmm,

* the homeowner gives an immediate benefit to the bank/servicer ("the borrower agrees to a general settlement of all claims against the lender and servicer and avoiding future title and loan litigation.")

* the homeowner gets the "promise" that the formerly bad actor ("the bank") giving the promise of a future benefit: Actually not f*cking over the homeowner like the bank was just doing.

Gee what could possibly go wrong here?

W.o.u.l.d. n.o.t. t.a.k.e. t.h.e. b.e.t.

[mt]

Just want to focus on one statement in this post:
"The federal government and US taxpayers’ substantial liability on Fannie Mae and Freddie Mac (all GSE) owned and insured loans would be reduced by this plan."

To the extent this proposal is legally possible without unanimous consent of the holders of the MBS (which isn't going to happen), it isn't really the case that the fisc's liability on the MBS is reduced. Rather, the guaranteed liability to holders of those loans remains the same in respect of the missing interest payments. The government does not get a pass through break on the interest holiday. The government still has to make up the lost interest to the holders. You'll slightly reduce the amount of future interest because the principal will be reduced. But that is relatively small.

You'll also face the political problem of discriminating against those who have been paying their mortgages, who although ovelooked because they aren't "a problem", are still >4x those who aren't. Remember this issue is what started the Tea Party back in 09.

Last, many of the defaulted homeowners can't make payment regardless of how it is credited.

The resulting economic boost would unfortunately be negligible, probably less than $50B a year which I calculate by (x) reported $1.2T in troubled mortgages times (y) the weighted average interest rate (which is sadly impossible to ascertain in any government data, but Fannie reports that they are earning 4.82% on their book, so use that as a proxy and (z) back out some guesstimate of those who can't pay anyway, which I think is at least 25% of the subject population). Just to put that in perspective, $50B is less than .004 of GDP.

I spend a lot of time trying to develop a proposal and researched the numbers around this problem as best I could. I am pessimistic that there is a more cost effective one beyond (a) give the home back to the apparent lender, (b) give the mortgagor $3000 to pay for moving expenses, a bankruptcy filing, and a security deposit on a new rental, and ( c ) tell them to move out and rent somewhere.

[Catherine Isobe]

This plan would not work for most of my clients here in New York City- like So. Cal., the mortgage balances are just too high relative to annual household income for the borrowers to make a dent by paying 31% of their income for 5 years.

As a judicial foreclosure state, we aren't seeing any judgments of foreclosure being signed where MERS is involved- nor indeed for most any securitized loan because the documentation to lawfully foreclose just isn't there. Cramdown would have been a much better way to go. The bankers got their wish and killed it- now they can reap the rewards here in NY- thousands of mortgages caught in legal limbo for the forseeable future.

[Knute Rife]

AMC is exactly right about the statutory hurdles, and another objecting party to worry about is the Chapter 13 Trustee. I've seen too many who are decidedly anti-consumer and who also can't understand the policy and the math behind this.

[Kay]

Who monitors the mortgage company if they are not applying the payments to the principal? I am in a principal pay down for 5 years in chapter 13 but the balance on my mortgage has not changed. It has remained the same in the last year and a half. Who do I notify about this lack of accounting in the mortgage company?

[Dana Oglesby]

This plan could benefit a great deal of my clients. I see many who are upside down on their first mortgage and paying down principal for 5 years would really make a difference. Something needs to be done for the people who want to keep their home, but financially it doesn't make sense. This plan will help increase equity and give homeowners an incentive to keep their home instead of letting it go to foreclosure or surrendering it in bankruptcy.