More Cramdowns!

More Cramdowns!

The House seems to have postponed action on mortgage cramdowns until tomorrow, which gives all of us one more day to contact our Representatives and let them know our views. The best post I know of on this topic is from Tanta; this discussion in Business Week is also good. Here’s my take:

HR 1106 would allow judges to modify the terms of mortgages in bankruptcy. Presently, judges can do this to all other forms of secured debt, and to mortgages on houses that are not the debtor’s primary residence. They could do it to these mortgages as well until 1993 in many parts of the country. This bill would not put mortgages for primary residences on a par with other unsecured debt, though: for instance, it would require that the mortgage be in foreclosure. (I think this is a mistake.)

There are two main arguments against mortgage cramdowns. The first is that, according to banks, it would make future mortgages more expensive. Tanta disagrees, as do Jason Kilbourne at Credit Slips and others:

“Not everyone accepts the Mortgage Bankers Association’s math, however. ‘The M.B.A.’s number is kind of hokum,’ said Adam J. Levitin, who teaches bankruptcy law at Georgetown University. After recently analyzing loan data from 1978 to 1993, he found that interest rates did not rise in areas where cram-downs were common.”

The second argument is that it would reward lenders borrowers (oops!) who took out irresponsible loans, which would be bad in its own right, and because it would create moral hazard. It’s worth noting exactly what the bill does: it would allow mortgages to be written down if they are already in foreclosure, but only if there was no fraud involved, and if the resulting plan is one that the debtor could reasonably be expected to actually pay. According to this statement (pdf) from the Center for Responsible Lending, and my rather inadequate attempts to read the bankruptcy code, the mortgage could not be written down below the present value of the property, and the amount by which it was written down would be recaptured as unsecured debt. (I don’t know bankruptcy law well enough to check these claims; any illumination would be welcome.) Moreover, if the borrower sold the home for more than the new, written-down value during the next five years, s/he would have to share any proceeds with the lender. The combination of (a) a prohibition on writing the mortgage down below the value of the home and (b) the requirement that a plan be one the debtor could reasonably be expected to pay means that people who took out truly outrageous loans will probably not qualify.

Besides that, when someone takes out a mortgage that they should never have been able to take out, that person is not the only one to blame, and not the only party whose moral hazard should concern us. Lenders made loans they should never have made. People bought securities based on these mortgages that they should never have bought. Moreover, these people, unlike your average borrower, are professionals whose job it is to know how to make responsible decisions about things like this. It is true that people ought to pay their debts, but it is also true that when businesses make stupid decisions, they should live with the consequences.

Cramdowns inflict losses on the people who hold the mortgage. But bankruptcy inflicts losses on the person who took it out. Moral hazard is less of a concern when you have to suffer some ghastly fate in order to get the benefit that supposedly creates the hazard. This is why I wouldn’t really be worried that paying for chemotherapy would create moral hazard: you have to get cancer in order to get this payment, and both cancer and chemotherapy are sufficiently dreadful that it’s hard to imagine anyone thinking: hey, now that my chemo will be paid for, I don’t need to worry about getting cancer! Same here: you need to declare bankruptcy in order to get this benefit, and that mitigates my concerns about moral hazard — especially since, as noted above, there seem to be real limits on how much courts can write loans down.

On the other hand, I worry a lot about the moral hazard of letting people who are paid to understand mortgages and loans make irresponsible decisions. As things stand, if I buy a mortgage on a primary residence that I should have known the borrower would never be able to pay, I am still entitled to payment in full, even if the borrower declares bankruptcy. I therefore have less reason to scrutinize that loan than I would have if I were, say, buying corporate debt. Providing people who make, securitize, and buy mortgages with more incentive to scrutinize the credit-worthiness of borrowers seems to me like a good thing.

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There are two more general factors that make me think this is a really good idea. The first is that everyone in this country has too much debt. We need to find some way of reducing it that does not reward stupidity too much. Mortgage cramdowns, which borrowers can access only by going through bankruptcy, and only if they will be able, under bankruptcy, to afford their house at its present value, seem to me a good way to do that.

The second is more speculative. Consider this question: why, exactly, are banks so opposed to mortgage cramdowns? By all accounts, taking over properties in foreclosure is not good for them: the properties lose a lot of their value, and banks are not really set up to be in the real estate business. Cramdowns would remove the need for a considerable number of foreclosures while ensuring that banks still get the present value of the house, which is probably the most they could get if they took it over and sold it themselves. So what’s the problem?

I had my suspicions, but didn’t know enough about accounting procedures to know whether or not they were right. However, Business Week attributes my theory to people who do:

“A major reason financial institutions and investors are so determined to avoid modifying loan terms more aggressively has to do with accounting nuances, say industry lobbyists. If, for example, a bank lowered the balance of a certain mortgage, there would be a strong argument that it would have to reduce the value on its balance sheet of all similar mortgages in the same geographic area to reflect the danger that the region had hit an economic slump. Under this stringent approach, financial industry mortgage-related losses could far surpass even the grim $1.1 trillion estimated by Goldman Sachs (GS) in January. A desire to postpone this devastating situation helps explain lenders’ intransigence, says Rick Sharga, vice-president of marketing at RealtyTrac, an Irvine (Calif.) firm that analyzes foreclosure patterns.”

If this is right, then banks are afraid that allowing bankruptcy judges to reset mortgages to the present value of homes would force them to reduce the value of similar mortgages. That is: it might force them to admit losses they have been trying to paper over. And the word “admit” is crucial here: these would not be losses caused by cramdowns; they would be losses that banks have already incurred, and are trying to paper over.

This is a good reason for banks to resist cramdowns. But it’s a really good reason for the rest of us to support them. We need banks to admit the full extent of their losses. The banking system will not return to normal as long as people worry about the unexploded bombs that might be lurking on banks’ balance sheets. If a bank is basically sound, we can recapitalize it. If not, we should put it out of its misery. The sooner we figure out which is which, once and for all, the better. And if mortgage cramdowns will help, all the more reason to support them.