Bankruptcy 'tweak' could save 600,000 homes
Consumer group pushes for change to bankruptcy law; others worry about negative impact on mortgage-debt markets.
NEW YORK (CNNMoney.com) -- One consumer group estimates that 600,000 foreclosures could be avoided over the next two years by making a simple change to the bankruptcy code.
The Center for Responsible Lending (CRL) calls it a tweak, but it could be a significant change for homeowners and the market for mortgage-backed securities.
CRL's proposal - reflected in a House bill recently introduced - would make changes to the regulations for Chapter 13 bankruptcies, which don't wipe out debts, but rather establish a repayment plan.
Under current law, when a person files for Ch. 13 bankruptcy, judges cannot reduce mortgage debt owed on a person's primary residence, although they may modify mortgages on investment property or second homes.
Under the House bill, the bankruptcy judge would have the option of reducing what the homeowner owes the lender. Say a homeowner's property is worth less than what he owes. The judge could reduce the principal to match the home's current market value as well as reduce the loan's interest rate.
The rest of the original principal would then be treated as unsecured. That means it becomes a lower priority for repayment than the borrower's secured debt, such as the newly reduced principal on his home. Unsecured debts may be discharged.
Potential pros and cons
CRL contends that being able to modify loans on primary residences would allow lenders to get paid more than what they might in a foreclosure. In foreclosures, lenders incur expense to arrange for a sale, they often sell at below-market prices and they forego future interest.
"Loan modification ... just allows the process to reach a resolution without a homeless family and boarded-up home as the unnecessary by-products," said CRL's senior vice president Eric Stein in written testimony before a House Judiciary subcommittee last week.
And that can preserve the neighbors' home values, which can take a hit when there's a foreclosure on the block, he said.
CRL also contends that such a change to the bankruptcy code wouldn't necessarily increase bankruptcy filings. Here's the theory: if lenders and investors know such a provision exists, they might be more willing to modify borrowers' terms. Though given the current contractual constraints on modifications, that might be easier said than done.
For homeowners, greater protection under Chapter 13 is not entirely a get-out-of-jail-free card. Their credit will be damaged, and their finances will be closely monitored for years by a bankruptcy judge. But CRL says it may be the lesser of two evils when compared to foreclosure since homeowners would be able to keep their home.
Some note that the proposed amendment in its current form is much more than a tweak. "It would be a very significant change," said Samuel Gerdano, executive director of the American Bankruptcy Institute. While noting the potential benefits of such an amendment to ease the current subprime crisis, Gerdano said that it could also remove the risk of homeownership and affect the trade of mortgage debt.
If investors in mortgage debt knew that mortgages could be adjusted by the courts without the consent of the lender, that could increase their perceived risk and change their valuation.
Steve Bartlett, president and CEO of the Financial Services Roundtable, contends the ultimate price would be paid by consumers. "If enacted, [the House bill] could have a de-stabilizing effect on the mortgage markets, which are now begging to stabilize," Bartlett told a House Judiciary subcommittee.
Funding for the mortgage-debt market would dry up, and consumers would pay the ultimate price, he said. "This will force mortgage lenders to charge much higher interest rates for all types of mortgage loans. This will dry up credit for any American who cannot afford these higher interest rates."
But mortgages that go into foreclosure hurt the value of mortgage securities and the pricing of mortgages, too. And since investors and homeowners lose either way, said Henry Hildebrand III, a Chapter 13 bankruptcy trustee in Tennessee, at least being allowed to modify primary residence loans under Chapter 13 means everyone takes a lesser hit than they would in foreclosure.