Mortgage Cramdowns Are No Panacea

Kevin Drum joins Atrios in saying that whatever legislative barriers the administration faced on more stimulus, they really whiffed by not throwing their political muscle behind bills that would have let bankruptcy judges write down mortgages in bankruptcy to the face value of the principal.  Drum quotes the New York Times as saying that "the president's senior aides had concluded that a searing fight with the industry was simply not worth the cost."

However, the Times also noted that Geithner wasn't wild about the plan, and frankly, I doubt any of Obama's senior economic team was particularly excited about it. 

The basic idea of a cramdown is that the judge "strips" the loan into two parts:  a secured loan, with a principal equal to the current value of the asset; and an unsecured loan, with a principal equal to the rest of the original mortgage.  The payments on the secured loan are then determined with the new principal plus an interest rate that offers a "reasonable" compensation for risk--as I understand it, usually Prime + 1-3%, but I could be wrong about this.  Meanwhile, the "unsecured" portion is moved down in the payment queue with the other unsecured debt; very little of this is ever paid off.

I don't have any a-priori beliefs about whether mortgages should be crammed down in bankruptcy (though I do think that it is a mistake to change the rules on existing loans--just as I thought it was a bad idea to make bankruptcy tougher for people who had taken out debt under the old bankruptcy rules.  The ability to predict your legal environment matters a lot in making good markets.)  However, allowing mortgage cramdowns in bankruptcy is not going to magically repair matters for either underwater homeowners, or the economy.  Here are some things to think about when deciding whether or not to support the rule change:

  • Cramdowns are for people in Chapter 13.  There are two types of bankruptcy broadly available to consumers:  Chapter 7, and Chapter 13.  Chapter 7 lets you protect your income by liquidating your assets--other than the standard exemptions (which are set by state), you lose everything to your creditors.  Chapter 13 allows you to protect your assets by going on a payment plan: you can keep your stuff, but you have to spend three to five years in a court-ordered payment plan.  So this is not some simple process where you walk into bankruptcy court and get a judge to write down your mortgage; the judge is going to take all your surplus income and hand it over to your creditors for the next 3-5 years.  As I understand it, the general rule is that your creditors need to get at least as much from the payment plan as they would from a liquidation.  This is why only about a quarter of bankrupts file Chapter 13.

    Think about what this means for someone who finds things maybe a little tight, and wants to breathe easier with a lower mortgage payment, but isn't in quite as dire straits as a normal bankrupt.  The judge strips down your loan, bundling the unsecured portion of your mortgage with your other unsecured debts.  Then the judge is going to put you on a payment plan and take all your discretionary income to pay down as much of that unsecured debt as possible--including the unsecured portion of your mortgage.  This normally doesn't matter, because people who file Chapter 13 tend to have very little discretionary income.  But for the people who aren't bankrupt now, but want some help with their homes, this could mean actually paying more on the house for the next five years.

  • Most Chapter 13 filings fail  Data is surprisingly hard to come by, but this is the latest paper I'm aware of, and it confirms the bankruptcy attorney folk wisdom that at least two thirds of these cases never complete.  Some of them are dismissed, and some of them convert to Chapter 7s, but even of the filings that make it to a hearing with creditors and get the payment plans confirmed, less than 45% make it all the way to a discharge. 

    This is a serious problem, because if you do a Chapter 13 plan, and it fails, you're worse off then you were before.  That's because you've probably only been making payments on the secured portion of your stripped down loans; now that the payment plan has failed, you owe all that money again, and you're even further behind. 

  • Chapter 13 has high administrative costs  According to the paper I cited, about 15-18% of the payments from debtors went to cover the costs of the Chapter 13--attorney fees, court costs, etc.  This is a loss to the economy, particularly when the plans fail.

  • If you file bankruptcy to get a mortgage write-down, you're barred from filing again for years.  This increases the vulnerability of those who file just to save the house.

It's not that it mightn't help people who were already going to file Chapter 13, but I'm not sure it's a great idea for homeowners to use Chapter 13 as a broad remedy for underwater mortgages.  Moreover, the economic effects would be problematic.

  • Mortgages which can be "crammed down" cost more  It's only mortgages on primary residences that are immune from cram down.  This is often cast as a giveaway to the mortgage industry, but the people who designed the exception (implemented in the 1977 bankruptcy reform) viewed it as a way to make mortgages on primary residences cheaper.  Their belief is validated by the fact that mortgages on vacation homes or investment properties cost more and are harder to get than mortgages for primary residences.  (There are other reasons for this too, but the cramdown shield seems to play some role.)

    Now, you may think that that's a good thing--that mortgages should be more expensive and harder to get.  Perhaps so.  But what that would do to the housing market right now is tighten up already tighter credit conditions, softening demand, and depressing prices still further. This would, of course, push even more homeowners underwater on their mortgages, forcing more of them to avail themselves of the risky and expensive Chapter 13 process if they ran into an income shock.

  • Cramming down mortgages will impair bank balance sheets  Again, you may argue that they're already impaired, and that we're just forcing them to recognize that fact.  But this is not quite true.  Markets undershoot on the downside as well as overshooting on the upside, and Treasury policy right now is to minimize that undershoot.  Impaired bank balance sheets mean less lending, which means even less liquid housing markets, which means even larger price declines.  This will be especially problematic if the cramdown provision entices homeowners who are still making their payments into Chapter 13, forcing banks to write down loans that otherwise would have been paid . . . and double-especially problematic if those Chapter 13 plans fail at anything like the rate for current Chapter 13s.  That would dump more houses onto the market through bargain-basement foreclosure sales.

  • Premature bankruptcy would impair other lender assets  Chapter 13s include all your loans, not just the house.  American households do need to deleverage, but no one's enthusiastic about using contracting bank credit to speed the process up.

In short, while mortgage cramdowns might help the people who need to file bankruptcy for other reasons, there are reasons to worry about trying to use it as a tool to help those whose main problem is an underwater home.  Obama's advisors probably aren't keen to mess with any "solutions" that involve touching off further tightening of bank credit, or price declines in the housing market--much less encouraging large numbers of Americans to start bankruptcy filings.

Moreover, as a tool to help those who do use Chapter 13, it's probably not worth expending much legislative energy on.  Ultimately, you're talking about less than a hundred thousand people a year who will successfully complete a Chapter 13, not all of whom own homes.  Unless it came in the context of some broader bankruptcy reform, I'm not sure this would be worth spending staff time on even if the banking lobby didn't exist.