Bankruptcy

Shared Appreciation Clawbacks

By Adam Levitin

As bankruptcy modification of mortgages (a/k/a Chapter 13 "cramdown") looks more and more likely to become law, it's worth considering what the final legislation might look like.  Already there have been some compromises in order to get Citibank's support. 

One issue that might be raised is a clawback of principal for creditors if there is future appreciation on a mortgage, the secured amount of which has been reduced in bankruptcy.  The question of shared appreciation emerged last year when bankruptcy modification failed to pass Congress and is one that has bedeviled many mortgage modification plans, including the Hope for Homeowners Act, not just bankruptcy modification.

Leaving aside the thorny question of how a clawback would work, I think it's important to consider whether there should be a clawback.  How one views this issue, I think, depends heavily on framing.  If the comparison is between a modification involving a principal write-down and a loan that performs at its original terms, then permitting an appreciation clawback as part of the modification seems quite fair.   In this framework, it makes sense to try to give the creditor as close to its original bargain as possible; otherwise would be a windfall for the debtor. 

But if the comparison is between a modification involving a principal write-down and foreclosure, then an appreciation clawback in the modification would result in a windfall for the creditor.   When a creditor forecloses on a house, the creditor doesn't benefit from any future appreciation in the property's value after the foreclosure sale.  The whole idea behind loan modifications, in bankruptcy or voluntary, is that they are value enhancing.  If a loan will perform at 75% of original value when modified, that's a lot better than a 50% recovery in foreclosure.  If a creditor is already benefitting from a loan modification relative to foreclosure, why should the creditor then also receive a share of the property's future appreciation?  Wouldn't that be a windfall to the creditor? 

Another way to see this is whether the modification is a temporary or contingent one or whether it is a life of the loan modification.  The danger with a temporary mod is that it just kicks the can down the road.  Requiring an appreciation clawback raises the question of modification sustainability.  Any which way, this is an issue that is likely to pop up again. 

Full post as published by Credit Slips on January 15, 2009 (boomark / email).