Why not make the cheeky bastards who run banks pay for their mistakes?
Axiom: There Ain't No Such Thing As A Free Lunch. If you make the bankers pay, they will make you pay.
There is a school of thought that says that it is wise to do the cramdowns pour encourager les autres: if bankers fear having their loans written down to the market price of the house, they will be more careful about lending. It's best exemplified by the sadly late Tanta at Calculated Risk:
In fact, 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. If you are aware that your mortgage loan can be crammed down, I'm here to tell you that you will certainly not "forget" to model negative HPA in your ratings models, and will probably pay more than a few seconds' attention to your appraisals. You might even decide that, if a loan does get into trouble, you're better off working it out yourself, via forbearance or modification or short sale, rather than hanging tough and letting the BK judge tell you what you'll accept. That would be a major bummer, right?
There is something to this line of thought. But only a little something. Her proposal has a lot of problems.
For one thing, some of the premises on which it seems to be based--like that bankruptcy generally results in the loss of the house--are, as far as I know, simply incorrect. Bankruptcy is usually undertaken to make it easier to keep the house by shedding unsecured debt: distressed homeowners are often choosing between bankruptcy and foreclosure. A study from Delaware, the most notoriously creditor-friendly state in the nation (unsurprising, given how much of its political economy has been driven by credit-card companies), shows that most homeowners still owned their homes years after filing. Since most bankruptcy filings are Chapter 7, her premise that it's generally not possible to keep the house in liquidation is false. Of course, that may be different now, but I suspect that the choice between foreclosure and bankrupty remains; it's just that more people are probably choosing foreclosure these days.
Second, the idea that this will benefit bankers by stopping foreclosures can be, at best, only weakly true. To the extent that there really is a massive downward spiral in a neighborhood driven by foreclosure sales, yes, this might help by stopping the flood of sales. But that's only part of the problem banks face. There's a broad market depression driven by changing expectations, risk appetite, and credit availability.
Against the benefits of being stuck with homes in neighborhoods blighted by foreclosures, you have to set the costs the banks will bear. If you allow bankruptcy judges to hand people loan modifications of 10% or more of face, you will get all the people who would have been foreclosed upon declaring bankruptcy, plus a lot more. So instead of writing down the value of, say, a million homes in foreclosure, you suddenly write down the value of three million in bankruptcy. This will further impair bank balance sheets, contracting the credit market still further. Among other things, what that means is fewer mortgages extended, and thus, another fall in home demand.
Moreover, he administrative costs of workouts are very high. It is commonly noted that foreclosures can cost a bank 50% of the value of the property. Well, once you've added the cramdown to the administrative overhead of dealing with the bankruptcy court, cramdowns don't look so hot either. And as we noted above, you're going to get a lot of extra people applying for that cramdown bonus, meaning that the cramdown might cost the banks substantially more in overhead and loss of loan book value.