2009: The Coming Meltdown. Part Three–Mortgage/Real Estate

Since its beginning in January of 2007, we at the Bankruptcy Law Network have written hundreds of articles about the mortgage and real estate crisis. As of early 2009, foreclosures are at an all-time high. Housing prices have fallen off the cliff, along with housing sales. And even if you want to buy, no one is making mortgage loans. People who thought their future was secure with the large amount of equity in their biggest investment—their home—now find themselves “under water”: owing more on mortgages than their property is worth.

It’s bad, so bad that we haven’t seen a mortgage or real estate market like this since the Great Depression. And despite these horrors, not much has been done to fix it. The TARP program seems to have just paid Wall Street hundreds of billions of dollars without (thus far) getting much for the taxpayers’ investment. Credit markets are still tight, and nothing has happened to help ordinary folks deal with high mortgages, low prices and record foreclosures.

Some argue that people who took out bad mortgages or bought houses they couldn’t afford once interest rates reset shouldn’t be helped. “I acted responsibly,” they say. “Why should someone who acted less responsibly that I did be rewarded by a better deal than I got?” Others say that the collective impact of all these mortgages going into foreclosure has such a negative effect on the economy that something needs to be done to staunch the hemorrhaging.

The problem is that all of the “solutions” discussed thus far seem to carry a high price tag. Buying the bad mortgages would cost hundreds of billions, as would giving government benefits directly to people with bad mortgages.

But there is a solution, one that is simple, already largely in place, and best of all, doesn’t cost the taxpayers much of anything. What is it?

Allowing cramdowns and mortgage reformations on primary residences in Bankruptcy Court.

Currently, although commercial properties, vacation homes, and investment properties (as well as furniture, cars, computers and other assets) can have the principal amount of the loan reduced to the value of the property, the interest rate lowered to market rate and the loan reamortized—what we call a “cramdown”—there is an exception. You can’t do it for the mortgage on your home.

Why not? It’s a holdover from 30 years ago, when mortgages had large downpayments and fixed interest rates. Because the loans were simple and conservative, they were shielded from having to take a hit when homeowners filed for bankruptcy.

Well, the interest-only, adjustable rate, zero downpayment, NINJA (No Income No Job No Asset) mortgages of today (or at least last year) are anything but simple or conservative. There simply is no need for this exception in this market.

Apart from letting people keep their homes, allowing cramdowns has other significant benefits. First, it will restore cash flow to the mortgage-backed securitized trusts. This results in cash flow payments on the securities issued by those trusts, with the resulting payments to the insurance companies, money market plans, retirement plans and investments who bought them. The payments even go to the taxpayers—after all, the TARP funds bought an awful lot of these securities from companies like AIG and Fannie Mae.

Second, it will reduce the number of foreclosures. In recent months, many, many of my bankruptcy clients who would previously have filed a Chapter 13 or Chapter 11 to catch up on mortgage payments are letting their homes go in a Chapter 7. The payments are too high, or the property value has dropped so much that they are better off not pouring money into an “upside down” investment. By allowing cramdowns, many of these people will be willing to work to save their homes—the lowering of principal to market value and the interest rate to market rate gives them both the incentive and the ability to keep their home.

The reduction in foreclosures will help to alleviate the downward spiral of home prices. With fewer REO (Real Estate Owned, or foreclosed houses) for sale priced below market rates, housing prices won’t keep ratcheting down, with banks constantly lowering prices to get cash, and homeowners needing to sell having to keep reducing their listing to keep up.

Finally, there is a penalty to obtaining a cramdown: it can be done only by filing for bankruptcy. People who did not take an adjustable mortgage, or finance 100% of the value of the property, will not be penalized for their judgment, and people who want the benefit of a cramdown must also take a bankruptcy.

Allowing cramdowns on residential mortgages should be part of the economic stimulus program currently being debated by the new Congress. The bill should contain the following:

1.    A reduction of principal to the current market value of the house, as determined by the Bankruptcy Court;
2.    A reduction in the interest rate to the current market rate, given the risk of the loan, as determined by the Bankruptcy Court;
3.    Mortgage arrearages can be forgiven or rolled over into the restructured loan;
4.    Mortgage loans can be reamortized over 30 years; and
5.    Cramdowns should be allowed in Chapters 7, 11, 12 and 13.

With these changes, Congress can give real and lasting benefit to homeowners, stop the collapse of housing prices, and restore returns to mortgage-backed securities—all without costing the taxpayers a penny.