Is There a Cramdown in Your Future?by Tim Manni
One of the priorities of the new Congress is to provide homeowners facing foreclosure with more leverage in dealing with lenders. President Obama today finally unveiled a two-part, $50 billion plan to help stem the rising tide of foreclosures; one of those parts involves a voluntary loan modification between borrower and lender. We’ll have plenty to say about that in the near future.
In addition, Congress is considering legislation which would permit bankruptcy judges to impose a ‘cramdown’ on a mortgage. Unlike a loan mod, which is voluntary, a cramdown happens when a bankruptcy judge reduces the principal amount of an outstanding mortgage. Under existing law, a mortgage is secured by a lien on property; if a borrower defaults, the lender’s recourse is to foreclose on the property.
What some in Congress propose is to make mortgage loans subject to the same provisions as apply to other loans when a person declares a Chapter 13 bankruptcy. If you declare bankruptcy, the judge can reduce the balance on car loans and other debts, which reduces the monthly payment to something that you can afford. It’s known as the wage earner’s plan, because “it enables individuals with regular income to develop a plan to repay all or part of their debts.”
If recent legislation proposed in Congress passes, bankruptcy judges could likewise modify a loan’s terms to reduce a homeowner’s payments. By making the loan more affordable, the homeowner could — other things being equal — stay in the home. (The judge could reduce the outstanding loan amount, drop the interest rate, or extend the loan term, or some combination.)
The proposed legislation is highly controversial. Proponents, which include many Congressional Democrats and community groups, argue that cramdowns will reduce foreclosures and, eventually, discourage bankruptcy filings on the theory that lenders will be more inclined to work with borrowers who are in trouble.
The proposal has been as steadfastly opposed by mortgage lenders and others. One research firm argues that
Mortgage cramdown legislation, if passed, would likely lead to rising losses for home equity and credit card lenders, while also reducing housing affordability, Friedman, Billings, Ramsey & Co. analyst Paul Miller wrote …
In bankruptcy proceedings, Miller said judges are likely to wipe out home equity loans or lines of credit and credit card debt from customers, leaving those lenders with losses as the primary mortgage is modified. Financial firms with large portfolios of those types of loans are likely to see even greater losses than they’ve already been facing amid the downturn in the housing market and ongoing recession. [...]
Similarly, the Mortgage Bankers Association claims that
[I]f this proposal were to become law, mortgage rates would increase in cost by 150 basis points. In addition, lenders will be forced to require higher down payments and charge higher costs at closing. All these increased costs would be necessary to account for the new risks that lenders will face when judges decide to change how much borrowers owe on their mortgages.
So who’s right? There’s some truth to both viewpoints. Lenders, facing borrowers who threaten to declare bankruptcy in order to force a cramdown, might well be willing to negotiate a loan modification in order to avert what could be greater losses. In fact, there are some reports that more lenders are taking this route. Wells Fargo (which purchased Wachovia Bank) is one such, and other lenders have announced such programs.
A voluntary loan modification negotiated between borrower and lender should, in theory, bring something to the table for both parties. “There isn’t a lender in this country that wants to foreclose on a borrower,” said Keith T. Gumbinger, a VP at HSH Associates. “That’s a complete money-loser for both sides.”
But as much as a loan mod might be desired, it can become complicated. First, in cases where the homeowner has a home equity loan, both lenders would have to sign off on any loan-mod deal. The lender holding the home equity loan might, or might not, ultimately receive anything from the loan mod.
On the other hand, those home equity lenders would have a greater incentive to work with the first-mortgage lender on a loan mod, because the alternative — a cramdown — might well be that they receive nothing at all.
Second, most mortgages are securitized, meaning that the lender doesn’t own the entire loan; he might not even own most of it. In short, the lender might not have the legal authority to negotiate a loan mod.
As best as analysts can tell, making home mortgages subject to Chapter 13 cramdowns would reduce bankruptcy filings — at least until it becomes clear, one way or another, that this is a solution that will work. Until then, predictions of higher rates (and/or fees) as a cushion against the risk of a cramdown will likely prove true — again, at least for a while.
Forcing cramdowns upon lenders will also result in even tighter and more rigorous qualification procedures, which would result in fewer mortgages being written. That won’t please anyone, least of all those banks which are being told by Congress to “make more loans!” while simultaneously being lectured by their regulators to “make safer loans!”
A key mortgage-lender trade group, the Mortgage Bankers Association, is adamant against allowing cramdowns:
By allowing judges to rewrite loan contracts and provide whatever relief they individually deem appropriate, [cramdowns] would cast doubt on the value of the asset against which the mortgage loan is secured. As a result, lenders and investors would likely demand a higher premium for offering these loans. This premium could come in the form of higher fees, a higher interest rate or the requirement for a larger downpayment, all of which would serve to make the American dream of homeownership less attainable for many Americans.
But in response, some market observers take a more punitive view of why cramdowns should be allowed:
I have some sympathy with the view that mortgage lenders “perform a valuable social service through their loans.” That’s why, when they stop doing that and become predators, equity strippers, and bubble-blowers instead of valuable social service providers, I like seeing BK judges slap them around. Everybody talks a lot about moral hazard, and the reality is that you’re a lot less likely to put a borrower with a weak credit history, whose income you did not verify and whose debt ratios are absurd, into a 100% financed home purchase loan on terms that are “affordable” only for a year or two, if you face having that loan restructured in Chapter 13. …
But I think my favorite part of the MBA lament is this: [cramdowns] “would cast doubt on the value of the asset against which the mortgage loan is secured.” Translation: lenders mark to model, but if you let them, BK judges will mark to market.
This debate has just begun, and both sides have valid arguments. It’ll take time to see whether Obama’s new mortgage-relief program works as advertised, but keep in mind that cramdown legislation — in some form — is still pretty much a sure thing at this stage.