Dollars and Jens
Wednesday, February 25, 2009
mortgage cramdowns
This article about "cramdowns" of mortgages doesn't go into a lot of depth about them, but I want to use it as an excuse to explain why I support them, and to clarify some issues around them.

The main reason I support allowing cramdowns of mortgages is that they're allowed for other kinds of secured debt, and in a way that makes sense. Corporate bankruptcy is simpler — perhaps because not quite as emotionally fraught as personal bankruptcy — and while I believe and hope most of what I'm about to say (except where noted) is true of personal bankruptcy, it's more reliably true of corporate bankruptcy, but hopefully at least provides some guidance.

If a creditor has a security interest in an asset, the creditor has first dibs on seizing and selling that asset to get its money back. If the asset sells for less than the creditor was owed, the creditor is still owed the difference, but now on the same basis as (other) unsecured creditors. Bankruptcy to a large extent looks to nonbankruptcy debtor-creditor law — that's how a lot of the state exempt property statutes come into the process, for example — and it generally preserves this feature in bankruptcy, where the secured creditor isn't allowed to seize the asset, but will retain the security interest. If, however, the value of the asset is less than the size of the debt, the portion of the loan that exceeds the value of the asset on which the security is held is effectively an unsecured debt, and it gets separated off and treated as such. Thus if I lend you $100,000 in exchange for a security interest in a can of tuna, that is effectively an unsecured loan, and remains such in bankruptcy, where I can retain the $1 secured loan and the security interest in the can of tuna, but face the same prospects for collecting the rest as any other creditor who lent you $99,999 unsecured.

Chapter 13, though, makes exceptions to this rule, limiting the alteration of secured debt incurred less than a year before bankruptcy, with a longer period for car loans, but a complete ban on forced alteration of mortgage terms. It might make some sense to treat loans incurred shortly before bankruptcy differently from those incurred earlier — indeed, there are a number of ways in which bankruptcy can reach back and change things after-the-fact to, among other things, dissuade bankruptcy fraud. It makes less sense to me that some of these secured interests are treated so differently from others based on uninteresting characteristics of the property securing them.

(Under current law, if your home loan is forcing you to bankruptcy, be sure to walk away from the house before filing. Even if you're in a state where the lender can get a deficiency judgment for the portion of the debt that the sale of the house doesn't cover, that's unsecured debt. Forcing you to do this, rather than allowing a cramdown, doesn't benefit the bank in any way, though, of course, the fact that many people might not do it probably does.)

There is some concern that this will cause mortgage rates to go up. It should, indeed, do that, to some extent, particularly on high loan-to-value loans, particularly to poor credits. At the moment, I have trouble seeing that as a persuasive argument against it, though I don't expect it to be a large effect anyway. In an attempt to avoid this, though, there is some indication that the bill will only allow cram-downs of mortgages made before a certain date, which is one of those things I try to store up for comparison in case I come across something else I think is the stupidest idea I've ever heard. Henderson is right about the time-consistency problem, and insofar as what this does is create uncertainty about future law, you're likely to reap something of the worst of both possible sets of law. I would oppose this as worse than nothing.

The other point I want to make — which, granted, is more true in Chapter 11 than 13, but is also to large extent true in Chapter 13 — is that the primary beneficiary of a law that harms a creditor in bankruptcy is not the debtor, but the other creditors. In Chapter 11 the shareholders and likely junior debtholders are wiped out regardless, and what you have is a contest for a pie that is, in some sense, fixed, or at least constrained; in Chapter 13, when the court determines how much money you can afford to put to paying off your old debts, if some of that money is then dedicated to the mortgage-holder, that much less is available for other creditors. Insofar as this is true, interest rates on other kinds of consumer debt would be expected to drop as a result of this provision. To the extent that people are unable to meet their mortgage payments when all other debt is eliminated, the provision might make Chapter 13 workable for some people for whom it would otherwise not be, but to a large extent this is less a bailout of irresponsible homeowners at the expense of irresponsible mortgage lenders and more a bailout of unsecured lenders to irresponsible homeowners at the expense of irresponsible mortgage lenders. Which may or may not make you feel better.


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