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.
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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.