02 May Why Did Cramdown Fail? Insurance and Principal.
On April 30, the US Senate voted against S. 61, a bill that would let judges modify home mortgages in bankruptcy. Karen Oakes wrote an excellent article, “Congress Votes Against Consumers Modifying Home Mortgages In Bankruptcy” discussing the vote.
But some might wonder why the banking industry would fight so hard, and spend so much money, lobbying against a bill that would seem to save it money. After all, saving lenders the costs and expenses of foreclosure, maintenance of the property after foreclosure (including property taxes, maintenance, HOA and condo fees) and the lower price it will receive when the property is finally sold, and changing the loan into one that pays interest would seem to a good thing for them.
So, what’s the problem?The problem is insurance. Mortgage insurance, to be precise. It gives lenders a very strong incentive not to write down principal, and gives them more money if they foreclose, even where the property is sold at a significant loss, than to work to make the loan performing.
Many are familiar with PMI, or Private Mortgage Insurance, that is part of the mortgage payment. This insurance doesn’t protect you; it protects your lender from loss if the property goes into foreclosure and the lender loses money. But PMI isn’t the only source of insurance. The Federal Housing Agency (FHA) issues government-backed mortgage insurance to lenders as well.
So what typically happens in a foreclosure? The lender sells the property at auction, tallies up the costs of sale, credits the money received when the property is eventually sold, and submits a claim to the mortgage insurer for the difference. This may result in a loss for the lender, but the loss is far smaller than that which would exist without the insurance. And from the lender’s perspective it doesn’t matter how much the loss is, since that loss is paid by insurance.
Now look at what happens if the loan is crammed down in a Chapter 13. The PMI and FHA insurance typically exclude from coverage losses due to bankruptcy cramdowns…so the lender can’t make a claim and eats 100% of its losses. Is it any wonder why the lenders have been fighting so hard against S. 61?
There has been virtually no discussion of this vital issue, and no indication that the negotiations between the lenders and Congress have touched upon it. Interestingly enough, one would expect that the PMI insurers would support cramdown legislation, since it would seem to reduce the loss they would have to pay; a crammed down mortgage will still be higher than the eventual price that would be received in a post-foreclosure REO sale, thus lowering their payment. The problem is that the three major PMI insurers, MGIC, RMIC and Genworth, are in such financial straits that they currently have little leverage, particularly as compared with the banks.
One option to allow this necessary piece of legislation to pass would be to require the coverage of bankruptcy losses by PMI and FHA insurance, removing the fiscal incentive lenders have to foreclose, allowing them to reduce principal and letting bankruptcy fix things where the lenders won’t.
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