Bankruptcy

Mortgage Modification in Bankruptcy: Redux

By Adam Levitin

The Dodd and Frank bailout proposals have both put the possibility of modifying mortgages in bankruptcy back on the table. To some Credit Slips readers, this is old hat (see below for links to our past posts). But I want to provide a quick primer for those who are not well-versed in the issue.

This is a pretty simple story. For over a century has been the primary mechanism for resolving consumer financial distress. The bankruptcy system, however, is incapable of handling the current home mortgage crisis because of the special treatment it gives certain residential mortgages. Unlike virtually every other type of debt, mortgages on single-family primary residences may not be modified in bankruptcy. This means that a family can write down credit card debt, car loans, medical bills, payday loans, loans on yachts, jewelry, furniture, and household appliances, and even mortgages on vacation homes, multifamily residences, or rental properties, but if they cannot make their original single-family home mortgage payments, right down to the last penny, they will lose their home.

Why do we no permit debtors to modify mortgages on their principal residences? The answer, it seems, is that Congress thought that by protecting mortgage lenders for this particular type of residence, it would lead to greater credit availability and lower credit costs. If that were true, that would be a reasonable enough policy choice.

But it isn't. To date, my paper on the topic (available here) is the only study of the impact of mortgage modification on mortgage costs/availability. To summarize the study succinctly, all available evidence indicates that there is little or no impact on mortgage credit from permitting bankruptcy modification. This evidence comes from a variety of current and historical sources, and from origination, secondary, and insurance market data. For example, private mortgage insurers do not charge a higher premium for insuring a two-family house than a single-family house even though the mortgage on the two-family house can be modified in bankruptcy.

As Alan White's research has shown, mortgage servicers, who decide whether to foreclosure or modify a defaulted mortgage, have engaged in very few modifications, and most of those modifications are not meaningful ones. Sometimes this is because servicers are outright forbidden by contract from modifying loans. Sometimes it is because of incentive problems. My own research with Tara Twomey (not currently available) shows that servicers often have strong financial incentives to foreclose rather than modify defaulted loans, even when the losses to the MBS investors would be much smaller if there were a modification instead of a foreclosure.

Permitting modification of mortgages in Chapter 13 bankruptcy does not require the consent of lenders or servicers; bankruptcy provides a solution when lenders or servicers are unwilling or incapable to make a deal with homeowners, just as it does in Chapter 11 to get around Trust Indenture Act restrictions on bond modification. Bankruptcy relief would help homeowners keep their homes with no cost to taxpayers, would not be available for speculators, would spread losses between lenders and homeowners, and would be immediately available, unlike government assistance programs that can take months to set up.

The financial services industry has argued that permitting bankruptcy modification of mortgages would result in a constriction of mortgage credit, higher prices for consumers, and instability in the marketplace. These are serious concerns, but entirely unsupported by the evidence (see Appendix C to my paper, here, for a discussion of the Mortgage Bankers Association's false statements). Moreover, in the current environment, the financial services? industry?s arguments border on the preposterous?due to a glut of easy credit, millions of borrowers are already trapped in loans that are too expensive, which has created the massive instability that already exists in the marketplace.

There's a new reason, however, for pushing for bankruptcy modification as part of a bailout package: it protects taxpayer dollars by putting pressure on lenders to sell to Treasury at lower prices. If a lender tries to drive a hard bargain with Treasury and bankruptcy modification is possible, the lender will be facing write-downs because of the bankruptcy filings. These write-downs will undermine the lender's inflated valuation of the MBS about which is negotiating Treasury. Allowing BK filing thus helps protect taxpayer dollars, independent of its direct relief to distressed homeowners.

If you want to read more, we've had a bunch of posts on this topic. You can read them here, here, here, and here. We've also done some posts about the complete bunk that the mortgage industry has been arguing--entirely confabulated numbers about the impact on the industry of allowing bankruptcy modification. You can read them here. And you can also read all of these pieces put together in my forthcoming Wisconsin Law Review article, here. (Of particular note is the appendix about the Mortgage Bankers Association's made-up claims.)

Correction: an updated version of my article with an appendix about the MBA's spurious claims will be available later this evening.

Full post as published by Credit Slips on September 23, 2008 (boomark / email).