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The New Cramdown

posted by Adam Levitin

For the past couple of years, I've been thinking that cramdown is dead as a policy solution. But I was thinking about cramdown as requiring legislation. It doesn't. We could start doing it tomorrow. Under current bankruptcy law, a Chapter 13 plan may be confirmed only if secured creditors receive their collateral, receive the value of their collateral, or consent to the plan. The legislative proposals for cramdown all sought to enable involuntary modification of mortgages; cramdown was to be the stick that would encourage voluntary modifications. 

But we could have voluntary cramdown under existing law and this could be done on a large scale staring immediately. Specifically, FHFA could require the GSEs to adopt a policy of consenting to Chapter 13 plans that have cramdown. (FHA/VA/Ginnie Mae could adopt a parallel policy for government insured loans.) Such a policy would address the two major objections that have been raised to principal reduction by the GSEs:  the much dreaded (and overstated, imho) moral hazard problem and the second lien free-rider problem.

Moral hazard. Chapter 13 bankruptcy presents a significant cost to the borrower--it means living on a court-supervised budget for 3-5 years and a 10-year escutcheon on the credit report plus the stigma of bankruptcy. One could debate whether these are sufficient costs to avoid all moral hazard, but they are real costs, and there are additional features like shared appreciation and eligibility cutoffs that could also limit moral hazard. The GSEs could make plan consent conditional on cramdown being done based on their valuation, rather than a judicial valuation, and on shared appreciation for the duration of the plan (or perhaps longer). 

Free-Riding Second Liens

Underwater second mortgages can already be crammed down in bankruptcy, but if you can't deal with the first, there's not much point dealing with the second. But if the GSEs would consent to cramdown in bankruptcy, the concern about a GSE-to-bank transfer would go away.

It would be easy enough to adopt this policy for the GSEs and FHA/VA/Ginnie Mae. I think it could also be extended to portfolio and private-label loans if the GSEs and FHA wanted to exercise their monopsony power and make adoption of such policies by banks and servicers a condition of doing business with the GSEs. But even if they thought this was improper and didn't (this isn't making them buy broccoli!), there is no obstacle to the GSEs and FHA/VA/Ginnie Mae adopting such a policy.

To be sure, such a policy would likely result in an upswing in bankruptcy filings and that would result in more losses for unsecured creditors (credit card lenders, especially). Call it the flip side of BAPCPA. And maybe there's a question about whether such a plan can be confirmed under 1325(a)(1), which requires compliance with provisions of Chapter 13, but I would think that one could see consent as akin to a settlement under Rule 9019.

Again, I can't emphasize enough, all of this could be done tomorrow.  So what's Ed DeMarco's excuse now?  Shaun Donovan's?  

 Update: 

When I first wrote the post, I figured that the risk of a 1325(a) challenge to plan confirmation would be from the US Trustee or the Chapter 13 trustee or maybe a court sua sponte.  But in thinking about it more, I think the real risk of a 1325(a) challenge would be from an unsecured creditor, such as a credit card lender. If an unsecured creditor were successful, it would prevent an upsurge in bankruptcy filings in order to deal with mortgage problems, as consensual cramdown plans would not be confirmable.

I don't know if such a 1325(a) challenge would be successful, but regardless it points to something that I've missed about 1322(b)(2) despite having dealt with it for some years now:  the provision benefits not only mortgage lenders, but also unsecured creditors, as it discourages Chapter 13 filings by reducing the value of Chapter 13 relief.  Congress wasn't looking to protect credit card issuers when it enacted 1322(b)(2), but they've arguably benefitted even more than mortgage lenders. Mortgage lenders face the alternative outcome of foreclosure. Credit card lenders' alternative to bankruptcy is continued out-of-court collection, and that's a trade-off they like if their support for BAPCPA and Ronald Mann's sweatbox theory is any indication. So the real winners in the 2008 cramdown debate were...the credit card issuers. Turns out the politics of 2005 continue to hold sway.

Comments

In a recourse state, I don't think the unsecureds would have a basis for this argument. The bank can foreclose and then pursue the deficiency, so there is an unsecured amount that can rightly be placed in the unsecured pool. In a no-recourse state, though, there is no such deficiency option. The foreclosure eliminates any unsecured balance, so there is nothing to put in the unsecured pool. Bifurcating the debt in such a jurisdiction would mean the bank would have its collateral cake while eating the unsecureds' too, a result that 1) means that members of the unsecured class are not treated equally, and 2) the plan does not satisfy the liquidation analysis.

I don't think that an unsecured creditor should have standing to object to a plan because a secured creditor is getting less under the plan than it normally would.

Anyway, "consent" is specifically listed as one way to deal with a secured claim. One of three listed options in section 1325(a)(5) is "(A) the holder of such claim has accepted the plan." So even if the unsecured creditor somehow has standing, the objection that the plan doesn't comply with 1325(a) because it modifies the secured creditor's rights doesn't make sense when the secured creditor has consented.

The unsecured creditor can object if the plan doesn't pay all disposable income into the plan. If the modification of the mortgage results in freeing up income that would otherwise go towards servicing the mortgage that is being consensually crammed down, that benefits the class of unsecured creditors. If there are junior liens that are completely underwater, they will be paid as unsecured, which could dilute what gets paid to credit cards, but so what?

What about loan servicing on behalf of the GSE's/FHA/VA/Ginnie Mae being stripped from the banks? Would that provide an additional stick?

Some of the largest servicers are also the largest unsecured credit card issuers (BofA, Chase, Citi, Wells Fargo).

What specifically would prevent the GSE's/FHA/VA/Ginnie Mae from yanking servicing rights?

I don't see objections by any party in interest being a problem if the GSEs/FHA/VA decided to consent to cram down based on some formula.

1. The U.S. Trustee is not heavily involved in Chapter 13 cases to begin with. And, they are a branch of the Justice Department. I doubt they would change policy and get more involved in objecting to Chapter 13 Plan in order to undermine a federal governmental decision that had as its purpose the amelioration of the foreclosure problem. Highly, highly unlikely.

2. Individual Chapter 13 trustees might object. But at worst if would be a case-by-case basis until they got feedback from their judges. It would be, at worst, a localized problem.

3. Unsecured creditors. Really? Unsecured creditors taking action in Chapter 13 cases? The unsecured creditors very rarely raise objections in cases where their interests are much more clearly effected - it just isn't cost effective for them to do so. Why would unsecured creditors suddenly become proactive in Chapter 13s? The unsecured creditors weren't in the lead - or even in the chorus - fighting the cram down legislation. I doubt there would be any concerted effort to object to confirmation of Chapter 13 Plans with voluntarily accepted cram down.

There could be issues with the junior mortgages. Debtors' counsel would have to be careful to reduce the mortgage to an amount that still slightly exceed the value of the first mortgage, or else the second mortgage won't be strippable.

The problem with "consent" is going to be that consent to the modification of the terms of a first mortgage is not presumed just because a creditor fails to object to confirmation the Plan. That seems to be the right approach under Espinosa - that is not a "scream or die" issue. There would have to be some mechanism for getting a filed/docketed consent by the GSEs/FHA/VA to the cram down treatment of the first mortgage. Nothing else is likely to pass muster with most courts.

Just a point of nomenclature - it's not cramdown if the mortgagee agrees to it.

The issue with this of course is that the GSE's still have to pay the difference between the old mortgage and the new one, so they have to get that funded by the USTreasury so it's just another way to say let's put debt on future taxpayers (or print money) to help debtors who own homes. And those who aren't debtors or homeowners might wonder, when do I get my subsidy?

You get your subsidy in the form of economic recovery once housing markets start to clear.

This replicates a comment I posted over at NakedCapitalism...

There's a big chunk of the 2M underwater-yet-current GSE mortgagors who have neither 2d liens nor other unsecured debt. They are the poor slobs who bought at the top of the bubble on the basis of GSE-abetted juiced appraisals and other subsequently discovered origination "irregularities."

And now we have a 2d call from the IMF to resolve - on the heels of GAO's call for DeMarco to get real about principal reduction.

Adam's road map provides an easily workable solution for that big chunk of hood-winked and long-suffering GSE debtors (although it could be argued that the last thing you want to do to these responsible people is to inflict absurdly insulting 'moral hazard' punishments upon them).

With no unsecured creditors, what possibe excuse do DeMarco or Obama's technocrats have for not providing relief to this group?

"You get your subsidy in the form of economic recovery once housing markets start to clear."

1) If the housing market started to clear in the near future, it will do so at lower prices, I really don't know whether that helps the economy recover in the short run, although it would in the long run, certainly. (If you think it would work in the short run, logically you should be opposed to minimum wage laws, btw, because they too stop the market from clearing at lower prices). But macroeconomics may not be that simple. New home construction has been growing at 10% y/y for the past year but the growth rate for the economy as a whole has stayed the same, if not actually slowed somewhat. Even at the height of the housing boom last decade, increases in residential construction contributed less than .004 to GDP.

2) Anyway, economic growth is not a subsidy, it is a general public benefit, But, if I use your nomenclature, we get to the same result - the nondebtors get one subsidy - economic recovery - and the debtors get 2 subsidies - economic recovery and the mortgage re-write. So the debtors are still one up on a net basis re subsidies.

mt--let me try this another way: how much are you willing to pay to move the deadbeat out of the McMansion that he never should have purchased? I'd guess the answer is zero. When he gets moved out via foreclosure, you pay a price in terms of the value of your real estate. If he gets a principal reduction, is there any skin off your nose? Maybe, you'll face higher mortgage prices going forward. Is that cost greater on a present value basis than the cost you'd incur in a foreclosure? I don't know, but given the enormous support and subsidization we have for mortgage finance already, I suspect the foreclosure cost to you will be greater.

Regarding market clearing, I'm surprised you didn't go with usury laws. Market clearing is a good thing. But it doesn't trump every interest.

I am firmly convinced that had Congress enacted a cramdown provision in chapter 13 cases in 2009, the pain would have been short term intense for some, but it would be over by now and the housing market would have recovered. The "unfairness" would be diminished if the cramdown had included a kind of 1111(b) election for the crammed mortgagee. But that ship has sailed. Adam makes an excellent argument that, if the GSE's accepted a cram down (which would include a restructuring of the loan), it would be a win for the borrower, a win for the servicer, a win for the investor (or at least a lesser loss) and a win for the economy. Bravo.

@Adam: Avoiding foreclosure also avoids the cost of fixing the trashing that frequently occurs prior to the borrower vacating the house.

@Henry: And while we're doing 11/13 cross-overs, perhaps we can fix Grassley's abomination of duct-taping 13 requirements onto personal 11s with no consideration of making it fit.

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