Wednesday, March 5, 2008

What's the Deal with Mortgage "Strip Down?"

In a comment yesterday to my post about Henry Paulson's speech, Josh raised some good points about current treatment under the Bankruptcy Code of home mortgage obligations.

Josh, I just report the news. Congress makes the Bankruptcy Code. The justification for shielding principal residence mortgage lenders from strip down in 11 U.S.C. 1322(b)(2)(chapter 13 debtors) and, 11 U.S.C. 1123(b)(5) (individuals in chapter 11 reorg.) is controversial. I've always understood it as a political response to the home mortgage lending industry. Lenders want payment stability to smooth risk and make home mortgage backed asset pools relatively more attractive than other asset backed securities. The asserted political payoff for this special treatment is a relatively lower cost of capital to home mortgage borrowers and ostensibly more Americans with access to home ownership.
Read the rest of this post . . . .

The right to strip down the principal balance on a home mortgage to its market value hasn't been terribly useful for debtors in rising real estate markets. Usually, a home mortgage borrower in bankruptcy wants to maintain his or her contract mortgage payments and cure any default in installments over the life of the plan (called "long term debt treatment" 11 U.S.C. 1322(b)(5)). To take advantage of a strip down, a debtor would have to pay off the stripped down principal balance in the three to five year term of a plan-- which, for 15 or 30 year mortgages would have the effect of jacking up monthly payments way above the cash capability of most debtors in bankruptcy. (I probably don't need to mention that it's only the rare debtor who uses a chapter 13 to strip down a mortgage on a vacation home. Typically, the vacation home is long gone before the debtor seeks relief.) The right to strip down or "modify" a home mortgage suddenly becomes important in times like these where home values are falling, in some places, dramatically.

As for the proposed amendment to the Bankruptcy Code to allow current borrowers to strip down their home mortgages in bankruptcy, I worry that retroactive application to loans already out there could increase instability in securities markets, making the capital crunch even worse. And that would be bad news for borrowers for sure.

Elizabeth Warren (Harvard) has posted a cogent criticism of the Bush Administration's response to the "mortgage crisis" on Credit Slips. And on the same blog, James White (Michigan) offers his view on proposed strip down legislation. Adam Levitin (Georgetown) and Joshua Goodman (Columbia, Econ.) have posted a working paper that purports to debunk the lending industry claim that permitting home mortgage strip down in bankruptcy would injure capital markets. For a detailed explanation of the ban on stripping home mortgages in bankruptcy, including commentary on the specific legislative proposals to reform it, read Mark Scarberry's (Pepperdine) testimony before the Senate last December.


Josh Fershee said...

Marie, great post, as always. I know you are just reporting the facts -- it was not my intent to imply that you were advocating a particular bankruptcy inclusion or exclusion. It was, instead, my intent to criticize Treasury Secretary Paulson's choice of the term "speculator" for those who choose to make business-like decisions for their families. I find it hard to believe he would not have advised clients to walk away from certain business deals that were guaranteed (or highly likely) to be losing investments.

You would know better than I would, but my sense is that most people, and most businesses, don't file bankruptcy or default on debts unless they simply don't have any other choice. Those who game the system deserve the criticism, but I think his comments were overly harsh as applied to most people.

Marie T. Reilly said...

The term "speculator" as applied to a person who buys a home in part for consumption value does seem harsh applied to a hapless homeowner who we assume was snookered into a home purchase she couldn't afford by a subprime huckster. On the other hand, it is also clear that buying a house is an investment in real property. The investment becomes a loser once equity growth stalls and the debt load is higher than rent for the same kind of property.

Paulson's comments make us think about who is entitled to forgiveness for a misjudgment of the market (not speculator) and who is not entitled to that forgiveness (speculator).

I haven't made a judgment about who's to blame for the "mortgage crisis" or how we can best respond to it because I don't have a handle on the whole thing (besides, nobody's pressing me for my opinion so far).

Alison M. Kilmartin said...

I agree that homebuyers who do not have the funds to purchase a home are speculators. They are taking a risk, and should have known going into it that they were doing so. The numbers are clear, even if the bank is telling you that you have been approved.

No doubt people need to be educated more, but just because the bank approves a loan does not mean that people should throw common sense out the window. A good dose of common sense on both sides of these mortgages would have prevented many from entering into this mess in the first place.