Cram Downs!

Cram Downs!

From the WSJ:

“A measure to allow judges to reduce the principal amounts of mortgages for troubled borrowers in bankruptcy cleared a key hurdle Tuesday when it was approved by a U.S. House panel. (…)

Under the legislation, borrowers would be eligible to have a bankruptcy judge reduce the principal balance on their home loan — a move known as a “cram down.” Current law allows cram downs for mortgages on vacation properties, but not for those on primary residences. (…)

In key concessions to the banking industry, Mr. Conyers agreed to alter the legislation to allow court-ordered modifications only for existing mortgages and to require that borrowers contact their lender at least 15 days before filing bankruptcy. Citigroup Inc. had demanded the changes in exchange for throwing its weight behind the bill, a move that angered the rest of the industry.

In another change, the legislation will now require recipients of cram downs who resell their home within five years to share the proceeds with their lender.

The panel also added language dissuading bankruptcy judges from shrinking the principal amounts of mortgages guaranteed by the Federal Housing Administration, the Veterans Administration or the Department of Agriculture. Under current law, the government cannot guarantee or insure amounts that have been crammed down on such loans.”

This is good news. As I understand it (and my understanding owes a lot to Tanta at Calculated Risk; her classic cram down post is here), allowing cram downs just amounts to treating mortgage like any other form of secured debt in bankruptcy: if the amount you owe is greater than the value of the asset that secures the debt, your debt can be modified by a bankruptcy judge. So, in the case at hand, if your mortgage is underwater, it can be written down to the amount your house is now worth, and the remainder of your debt to the mortgage company is treated like other unsecured debt.

Every other form of secured debt is treated this way in bankruptcy. Mortgages were treated this way for most of our history. It is not clear why they should be treated differently. In the hearings that led to the exemption, mortgage lenders argued that they should get the exemption because they “performed a valuable social service.” Tanta:

“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.”

(I miss Tanta.)

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A whole lot of debt is going to have to be written down in the next few years. This is a way of writing down some of it in a way that’s basically fair, that shares the pain between the borrower, who has to go through bankruptcy, have his or her credit destroyed, etc., and the lender/servicer/whoever, who has to eat some of the value of the loan. It avoids the horrendous disruption of foreclosure, and it does so without either letting borrowers off the hook or paying lenders the full price of the mortgage, as though they had nothing whatsoever to do with the ludicrous loans that got made.

Sounds like a good step to me. At any rate, I think the burden ought to be on lenders to explain why mortgages ought to be treated differently than other secured debt. And somehow I don’t think that the claim that people who make mortgages can be presumed to be performing a socially valuable service, even when they run around trying to convince people to take out loans that only even seem to make sense if you assume that housing prices will rise in perpetuity, will cut it this time.