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Bankruptcy: The Subprime Borrowers' New Best Friend
by Robert Franco
 | 2007/11/15 |
In response to evidence that as many as 2.2 million homeowners will lose their homes due to unsustainable subprime mortgages, Rep. Brad Miller (NC) and Rep. Linda Sánchez (CA) have introduced legislation that will provide some relief with a relatively simple change to the bankruptcy code. (H.R. 3609: Emergency Home Ownership and Mortgage Equity Protection Act of 2007) Currently, in a chapter 13 bankruptcy, the bankruptcy judge may approve a plan to "modify the rights of holders of secured claims, other than a claim secured by an interest in real property that is the debtor's principal residence." The proposed legislation, along a with a few other provisions, would strike the principal residence exception. What this means is that the judge would be able to reduce the principal of the mortgage, the interest rate, or the length of the loan. This would allow homeowners to keep their homes and make lower, affordable mortgage payments.
To understand why this type of legislation makes good economic sense, one only needs to look at the numbers. In an article on The News & Observer, A Coming Foreclosure Flood, Jerry Hartzell, a Raleigh attorney explains:
The numbers are so large as to be almost incomprehensible. In 2003, $332 billion in subprime mortgages were outstanding. Today subprime mortgage loans total $1.3 trillion. A recent congressional report says studies "show that cumulative default rates are very high. Estimates range from almost 18 percent to more than 20 percent."
Hartzell goes on to explain why those numbers are conservative figures. First, roughly 90 percent of subprime mortgages originated in 2004 through 2006 and were adjustable rate mortgages (ARMs) - the peak of the adjustments will occur during January through June of next year. Second, home prices are falling which will make it more difficult for many borrowers to refinance out their predicament. And, third, lenders are exiting the subprime market leaving virtually no opportunities for troubled borrowers to refinance. Most of these borrowers will not qualify for prime loans.
Allowing the terms of a loan to be modified in bankruptcy is nothing new. It can already be done on claims secured by other types of collateral, including yachts and vacation homes, only the primary residence is off-limits currently. This hasn't always been the case, however. From 1976 to 1993, bankruptcy courts could "cramdown" debt secured by a primary residence - this legislation will restore that provision.
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"Responsible lenders who made loans on reasonable terms have nothing to worry about in bankruptcy court, but predatory lenders will end up with the loans they should have made in the first place," Miller said.
Not everyone is in favor of such changes to the bankruptcy laws, of course. David G. Kittle, CMB, Chairman-elect of the Mortgage Bankers Association testified before the House Judiciary Committee's Subcommittee on Commercial and Administrative Law. In his testimony, Kittle told the committee that proposed legislation to reform the bankruptcy code and allow judges to "cramdown" debt on primary residential mortgages will impose significant costs on consumers by restricting the flow of capital into the mortgage market and increasing the price tag on all mortgages.
But, if you really think about it - what harm would this cause a mortgage holder who finds the terms of their loan modified by a bankruptcy court? For example, let's assume that a homeowner has a home worth $100,000 and is struggling with a mortgage for $120,000 that just adjusted up two points to 10 percent. Facing foreclosure, he files for chapter 13 bankruptcy protection. The court orders the principal balance reduced to the actual value of the collateral, $100,000, and reduces the rate back down to 8 percent. His payment just went from around $1,050, which he could not afford, to about $730.
The mortgage holder still comes out well ahead of where it would have been in foreclosure. At the foreclosure sale, the property would have had to sell for only two-thirds of the appraised value, $66,000. Alternatively, the mortgage holder could take the property back and add it to its already gluttonous supply of real estate owned (REO) properties hoping to sell it in a private sale, incurring more expenses. Either way, allowing the borrower to keep the home with the modified terms is worth more than the lender would have realized in foreclosure. Seems like a win/win situation to me.
Ultimately, the effects of massive number of foreclosures will be devastating to the housing market. A huge supply of cheap homes, that people still can't afford to buy, will continue to drag down home prices for a long time to come. Keeping homes out of foreclosure is paramount to saving the market. And, keeping payments flowing in on mortgages is a benefit to lenders and investors, who are already writing down the value of the loans, even if the amount is reduced.
This is good, common sense legislation! The mortgages that would be affected by the change in the bankruptcy law already aren't worth the amount of debt they secure, so why not revalue them in bankruptcy and allow the homeowner to keep their home?
Robert A. Franco
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rfranco@sourceoftitle.com
Categories: Legislation, Subprime Lending
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