June 2008

The Mortgage Bankers Association recently fought off federal legislation that would have allowed bankruptcy judges to modify residential mortgages. The MBA’s victory was a huge success for lenders, but an unfortunate loss for homeowners who have declared bankruptcy. 

Lenders disliked the proposal, since it would have shifted some of the power over mortgages from lenders’ loss-mitigation departments to bankruptcy judges, who might have imposed modifications that the lenders wouldn’t have liked.

The risk was deemed so serious that the MBA pulled out all the stops to pound the idea into dust. Lawmakers were lobbied, members were mobilized, press releases were issued, and the MBA’s Web site featured a “Stop The Bankruptcy Cram Down Resource Center”.

Consider “cram down,” a bit of MBA-speak that refers to a judicial cut in the interest rate on a borrower’s existing loan. The term may be new to some, but in fact dates back to the last real estate downturn. The phrase naturally evokes emotionally charged images of gagging, choking and force-feeding, none of which is relevant to a serious discussion of bankruptcy relief.

Consider also the MBA’s claims that mortgage interest rates would rise by as much as 2 percentage points and that lenders would be forced to require bigger down payments and charge higher closing costs if bankruptcy judges had a say. No factual evidence was offered to support these arguments.

In fact, a causal connection between the so-called “cram down” and significantly higher interest rates is a stretch at best, according to an academic paper by Adam J. Levitin, a law professor at Georgetown University. The paper stated that even unlimited loan modifications in bankruptcy courts would have only an insignificant, if any, impact on mortgage interest rates or mortgage markets.

Of course, the MBA also had a promised presidential veto in its pocket and the support of Alphonso Jackson, the now-former secretary of the U.S. Department of Housing and Urban Development. In a speech, Jackson called the proposal “an odd, time-consuming, distant way to help homeowners,” and said, seeming with no evidence other than the MBA’s say-so, that it would increase interest rates and — horror of horrors — benefit lawyers and law firms.

The MBA has supported other measures such as pre-foreclosure counseling, the use of mortgage revenue bonds to refinance subprime loans, and the strictly voluntary Hope Now loan workout program. These measures may be worthwhile, but the cost to lenders is minimal and so far, the results have been modest.

Not surprisingly, consumer groups support an expansion of bankruptcy judges’ jurisdiction to encompass residential mortgages. AARP, the AFL-CIO, ACORN and the Center for Responsible Lending are among the groups in favor of this proposal. These groups believe the federal government should put more pressure on lenders to help homeowners who are in danger of foreclosure, and a Congressional Budget Office report said lenders might have more incentive to modify loans if bankruptcy judges had the power to impose such concessions.

The MBA deserves plenty of credit and kudos for the success of its “Stop the Cram Down” effort. The group did exactly what such groups are supposed to do, which is to protect the interests of their own members — no matter how narrow or parochial those interests may be.

But at the end of the day, the win on this one should have gone to the homeowners. Bankruptcy isn’t pretty, and recent changes to the U.S. bankruptcy code have already made the process more onerous. Yet bankruptcy serves a legitimate and important public policy purpose, which is to give people in dire straits a fair and reasonable way out of their extremities. Bankruptcy shouldn’t be just another form of Dickensian debtors’ prison. It should offer real relief and an opportunity for folks who’ve experienced hard times to get a fresh start.

As the law stands today, home-loan lenders are a favored class of creditor in the bankruptcy system. In fact, residential owner-occupant mortgages are perhaps the only type of debt that bankruptcy judges aren’t allowed to modify. Judges can alter loans backed by cars, boats, farms, manufacturing plants, mobile homes, vacation homes and investment properties.

Of course, there should be limits to bankruptcy judges’ power, and the proposed legislation contained plenty of them, perhaps even too many. Relief would have been offered only to homeowners who faced imminent foreclosure, who had a subprime or nontraditional loan such as an interest-only or payment-option adjustable-rate mortgage, and whose income wasn’t sufficient for them to afford their mortgage payments. Bankruptcy judges would be required to set commercially reasonable interest rates on modified mortgages and wouldn’t have been allowed to reduce loan balances to less than the home’s market value.

Homeowners who’ve been forced into bankruptcy deserve a chance to keep their homes if they can afford to make reasonable mortgage payments, and bankruptcy judges are in a good position to make that call.

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