Bankruptcy reform will fix the subprime lending crisis and save the economy

Cavalier lenders have damaged the housing market and the economy overall, even encouraging artificially inflated home appraisals to boost a record number of loans and refinances over the last few years. Stories of borrowers being wrongfully steered into subprime loans abound, and the result has been nothing short of catastrophic. Foreclosures are higher than at any time in American history. The carnage has not been contained to the housing sector, as an overall credit crunch has hampered economic recovery. It is time to force some medicine upon this subprime virus.

As I suggested in my previous article, there is a realistic bankruptcy solution to the subprime mortgage crisis, requiring only slight amendments in the current Bankruptcy Code. The idea is not at all radical, and, as a matter of fact, it is a common bankruptcy tool that has been utilized for decades.

Currently, debtors have the power to restructure secured debt in Chapter 13.  In many instances, a debtor can reduce the balance owed on an automobile, for example, down to its fair market value.  The debtor can then pay back that lowered balance over five years at a lower interest rate.  The same thing can be done for computers, furniture, and even real estate investments.  As a matter of fact, 11 USC § 1322(b)(2) allows a bankruptcy judge to make such modifications to any secured debt except a debtor’s primary residence. So, this begs the question, “Why not allow borrowers to ‘rewrite’ their home loans in bankruptcy?”

On May 1, 2007, National Association of Consumer Bankruptcy Attorneys President Henry Sommer met with the House Judiciary Subcommittee on Commercial and Administrative Law to discuss the bankruptcy system. He submitted to the subcommittee a proposal recommending that the Bankruptcy Code be expanded to allow Chapter 13 debtors the ability to repay lenders only the current fair market value of their primary residence and to allow the debtor to repay the loan at a fixed rate of interest. Other authors of the proposal includes John Rao of the National Consumer Law Center, Travis Plunkett of the Consumer Federation of America, Ira Reingold of the National Association of Consumer Advocates, as well as Ellen Harnick and Eric Stein of the Center for Responsible Lending.

This proposal is necessary because, even though foreclosures are at an all-time high, Chapter 13 bankruptcy filings are not keeping pace. Prior to this current crisis, a typical foreclosure was usually the result of a homeowner hitting a rough patch, whether it was a loss of income, divorce or illness. The problem was usually temporary, and Chapter 13 would afford a debtor the time to get back on his feet. Now, more often than not, foreclosures are a result of an ARM interest reset. The borrower was promised the opportunity to refinance before the rate hike, but lenders are reducing or eliminating loan products, making refinance impossible. The new mortgage payment is beyond the borrower’s financial ability. Simply put, a record number of Americans have given up their dream of homeownership.

The proposal also includes a Chapter 7 option, allowing the homeowner to “redeem” his primary residence for the fair market value. As BLN attorney Cathy Moran explains, “Redemption means that you pay the secured creditor the present value of the asset that is the collateral for the debt in a single cash payment. Upon payment, the asset is yours, free of the secured debt. The balance of the debt is treated as an unsecured debt in the bankruptcy and discharged with your other debts.”

Like the Chapter 13 proposal, the Chapter 7 proposal is really nothing more than an extension of existing law to primary residences. Given that many homeowners tied into 125% mortgages, based upon an inflated appraisal, redemption would allow a debtor a much better chance of refinancing the value of the home to avoid a foreclosure.

The proposed expansion of current bankruptcy law would achieve stability in the markets for two reasons.  First of all, it would stem the tide of foreclosures, thereby reducing the pace at which houses for sale are entering an already overcrowded market.  Secondly, it would provide desperately needed income to mortgage companies reeling from record losses.  These defaulted mortgages are already being sold for pennies on the dollar by collapsing mortgage companies, and one would think that the value of these mortgages would increase if they were still generating revenue, even at a discount.  

Lenders oppose the expansion of bankruptcy law in this manner because these subprime loans have been “pooled” together into trusts and sold on Wall Street as securities. BLN attorney Andy Miofsky explains that these trust agreements require the lender to buy back non-performing loans from the investor. American Home Mortgage Investment Corp. and New Century Financial Corp recently filed for bankruptcy protection because they lack funds to buy back these bad loans. The situation is magnified when these subprime loans are resold by the investor to other investors to offset risk. As Mr. Miofsky puts it, “An investor here is a seller there.”

Opposition to this bankruptcy reform should fall on deaf ears because, unlike America’s working poor, subprime investors are not in danger of losing their homes, but the oppressive loans they helped to create are doing real damage to everyone.