Bankruptcy and Primary Residences

The housing bubble was blown up to its absurd proportion by the joint willingness of people to purchase homes that, in many cases, they could not reasonably afford, coupled with a mortgage industry that knew as much but was happy to lend them money anyway. I'm not personally happy that either side in that type of transaction is getting bailed out but, like it or not, they affected (and continue to affect) their neighbors. In a faltering economy, even some responsible borrowers are struggling with mortgage payments inflated by the housing bubble, while housing values may be further depressed by abandoned homes (perhaps half-built), empty lots from abandoned or unsuccessful development, and foreclosures in their neighborhoods.

With hundreds of billions, really trillions of dollars of taxpayer funds being used to prop up the lenders in that scenario, while speculators walk away from bankrupt corporations or get relief through bankruptcy court, it should be no surprise that people like Todd Zwicki are shocked that any relief might be directed at... ordinary homeowners. I'm not sure where I can find Zywicki's outrage at hundreds of billions of dollars being directed at financial institutions, and I don't see in his editorial any lament that debtors can "cram down" the value of their investment properties and vacation homes in bankruptcy. But how horrible, that bankruptcy judges may be able to "rewrite" mortgages for people who own only one home.

In the first place, mortgage costs will rise. If bankruptcy judges can rewrite mortgage loans after they are made, it will increase the risk of mortgage lending at the time they are made. Increased risk increases the overall cost of lending, which in turn will require future borrowers to pay higher interest rates and upfront costs, such as higher down payments and points.

There are three obvious responses to that.

• Why should mortgage lenders sit in a privileged position as compared to other lenders? I recognize that this is the "American way" - you hire lobbyists to get legislation to favor your industry over others - but what is it that makes home lenders so special? In bankruptcy, where some bills will go unpaid, at least in relation to the unsecured portion of their loans why should financial institutions be privileged over doctors and hospitals?

• Is there any reason to believe that the increased costs will be substantial, particularly in relation to borrowers who aren't marginal? Are second mortgages or mortgages for vacation properties significantly more expensive than primary home mortgages?

• So what? If the net effect of bankruptcy law is that lenders think twice about housing prices "always going up", or require a sufficient down payment and proof of income to be reasonably certain that the loan will be repaid even if the market is flat or values decline, isn't that a good thing?

Further, Zywicki ignores the fact that this legislation limits itself to mortgages in existence at the time it passes. That should ameliorate its assumed effect on future lending decisions. In terms of that change, Zywicki writes,

This is illustrated by a recent example: In 2005, Congress eliminated the power of bankruptcy judges to modify auto loans. A recent staff report by the Federal Reserve Bank of New York estimated a 265 basis-point reduction on average in auto loan terms as a result of the reform.

The car loan example is an interesting one, as it highlights how lobbyists for an industry can shift costs to other lenders. Bankruptcy reforms restrict judges from reducing car payments in a Chapter 13 plan so, instead, payments to other creditors go down. Zywicki doesn't explain why that's a superior outcome.

But more to the point, as you may have guessed from the fact that car loan rates haven't dropped by 2.65%, he seems to have his numbers wrong. The Federal Reserve Bank of New York observed that "auto loan interest rates were higher for households in states with high home equity exemptions" and performed an analysis to "see whether BAR [the 2005 Bankruptcy Reform Act] undoes that link":

Overall, auto loan delinquency rates tended downward after BAR in higher or unlimited exemption states, significantly so for direct loans. Consistent with that result, auto loan interest spreads also declined after BAR in states with high or unlimited exemptions. The link between spreads and exemptions was more significant using unscaled exemptions, but the magnitudes were comparable regardless. The decline in the average auto loan spread was 15 basis points lower after BAR for unlimited exemption states, a 5.7 percent decline relative to the mean over all states (265 basis points). The regression results show clearly in Chart 5.

Looking at chart five, you find that the chart tracks the "interest rate on new automobile loan (5 year) minus rate on government bond (5 year)." The mean over all states is 265 basis points. Prior to BAR the interest rates for auto loans in states with "unlimited home equity bankruptcy exemptions" tended to be higher than those in other states. Subsequent to BAR, on average, the difference diminished by 15 basis points, 0.15%. That's a significant number for lenders, and appears attributable to BAR, but it's hardly the massive reduction Zywicki claims.

Zywicki's next argument is a red herring:

But by recent count, some five million homeowners are currently delinquent on their mortgages and some 12 million to 15 million homeowners owe more on their mortgages than the home is worth. If even a fraction of those homeowners file for bankruptcy to reduce their interest rates or strip down their principle amounts to the value of their homes, we could see an unprecedented surge in filings, overwhelming the bankruptcy system.

We should not fashion bankruptcy laws to prevent bankrupt people from declaring bankruptcy, merely because of the potential that it might be difficult for bankruptcy courts to do their job. We should instead provide bankruptcy courts with the necessary manpower and resources to do their job.

Beyond that, Zywicki pretends that this legislation will help people who aren't bankrupt. Sure, millions of people "owe more than their house is worth" - and the vast majority of them aren't bankrupt and are making their house payments. The problem faced by the majority of people who aren't making their payments isn't the value of their home - it's the fact that they can't afford their payments. Given that bankruptcy is not cost-free, many of those people will struggle, try to work things out with their lenders, and find ways other than bankruptcy to work their way through their financial difficulties. Others will weigh their options and walk away from their homes - either by allowing foreclosure or by surrendering their homes in bankruptcy.

Continuing his supposition that this legislation will cause people who aren't bankrupt to declare bankruptcy, Zywicki writes,

Finally, a bankruptcy proceeding sweeps in all of the filer's other debts, including credit cards, car loans, unpaid medical bills, etc. This means that a surge in new bankruptcy filings, brought about by a judge's power to modify mortgages, could destabilize the market for all other types of consumer credit.

I guess Zywicki has forgotten his earlier comments on the non-modifiability of car loans. But even overlooking that, I'm not sure how this follows. If you force people in bankruptcy to either give up their homes or to pay the full amount of their mortgages, you already create a significant distortion. In the former case, the home lender gets a foreclosure, and it may be that the other creditors recover a bit more money by removing mortgage payments from a Chapter 13 repayment plan. In the latter case, a Chapter 13 plan incorporates the higher-than-market mortgage payment, and other creditors get less. I guess the "horrible" outcome for Zywicki is the homeowner who otherwise would have allowed foreclosure but who can now stay in their home, resulting in smaller payments to other creditors. I somehow suspect, though, that the nightmare prospect for lenders is instead that borrowers who would have stayed in their homes anyway will have their mortgages revised, resulting in greater payments to other creditors and lesser payments to housing lenders.

Zywicki makes a reasonable point in relation to the interest rate that should be paid post-modification.

Consider that the pending legislation requires the judge to set the interest rate at the prime rate plus "a reasonable premium for risk." Question: What is a reasonable risk premium for an already risky subprime borrower who has filed for bankruptcy and is getting the equivalent of a new loan with nothing down?

Of course, he then extrapolates to suggest that if a borrower is bankrupt, they should be paying double-digit interest, and that anything affordable would be a "submarket rate, apparently violating the premise of the statute and piling further harm on the lender". If this were a medical study, at this point I would be asking "which pharmaceutical company is bankrolling Zywicki's research"? It may well be that the legislation should provide additional guidance to judges when it comes to setting interest rates. But Zywicki's comments betray his contempt for the goals, and perhaps even the concept, of bankruptcy.

Zywicki offers a single example that he pretends illustrates how the proposed legislation could be abused:

Imagine the following situation: A few years ago a borrower took out a $300,000 loan with nothing down to buy a new house. The house rises in value to $400,000, at which time he refinances or takes out a home-equity loan to buy a big-screen TV and expensive vacations. He still has no equity in the house.

The house subsequently falls in value to $250,000, at which point the borrower files for bankruptcy, the mortgage principal is written down, and the homeowner keeps all the goodies purchased with the home-equity loan. Several years from now, however, the house appreciates in value back to $300,000 or more -- at which point the homeowner sells the house for a tidy profit.

I do find some humor in the way Zywicki depicts the borrower in his example as the modern equivalent of Ronald Reagan's Cadillac-driving welfare queen. Never mind what's typical - he's trying to evoke an emotional reaction.

Okay... so I have a marginal borrower who comes into my bank and says, "Give me a $300,000 loan for my $300,000 house." I wouldn't ordinarily give him the loan, and would historically have required 10-20% down to protect my investment, but I've decided that housing prices will invariably go up at 10-20% per year so I authorize the loan.

Within three or four years I'm proved "right" - the home now appraises for $400,000. So I'm very secure in the event of default. Now the borrower comes back to me and says, "I want to take out every penny of equity." I again note that he was a marginal borrower at $300,000, and that's even more the case at $400,000. But I'm more convinced than every that housing hyperinflation appreciation at a rate of 10-20% per year is inevitable, and that housing values never go down, so again I authorize the loan.

Then the bubble bursts, and the economy crashes. The borrower loses his job and falls behind on his payments. His house appraises for only $250,000. Traditionally I would foreclose, try to sell the house as quickly as possible, and hope to recover about $220,000 to $230,000 after the costs of foreclosure and sale. If I were in a state that allows deficiency judgments, I might seek one from the borrower - although it would be dischargeable in bankruptcy. Not a good outcome for me....

Under the new law, the borrower declares bankruptcy. A court revises his mortgage to reflect the market value of his home, and sets an interest rate a few points above prime. He makes his payments. But sixty months later, at the end of his repayment plan, he is able to sell the house for $300,000. All I get back is the $250,000, plus of course the interest I've obtained over the course of the repayment plan (not a bad rate of return, but well below what I would have charged this borrower in the post-bubble market). (Sure, I gave this guy a 0% teaser rate to get him to sign up, but let's not change the subject.)

I'm well ahead of where I would have been had I foreclosed at the bottom of the bubble, but so is the borrower. I'm in the same position as any other creditor at the end of bankruptcy, seeing a debtor who has recovered from a crisis and is now able to pay off some of the debts that were discharged, but for reasons I can't fathom he's protected by the law. It's almost as if bankruptcy is supposed to help people get back on their feet and get a fresh start - how absurd is that!

Meanwhile, the only thing I could have done to protect myself would have been to apply reasonable lending standards, and not let a marginal borrower repeatedly max out the equity in his home. Or voluntarily worked with the borrower to restructure the loan or payments in a manner that would have kept him out of bankruptcy. How unfair is that!

What if I'm in state where first mortgages are non-recourse loans, and where I lent $400,000 for a first mortgage to a home buyer whose house is now worth $250,000? If the borrower allows foreclosure, I can't get a deficiency judgment. If the borrower goes into bankruptcy under the proposed law, I get a $150,000 unsecured claim that should be partially repaid over the course of the repayment plan. That would appear to improve my position at the expense of other unsecured creditors. If the debtor is ordered to repay 1/3 of his unsecured debt over the course of the repayment plan, my recovery is $250,000 + $50,000 = $300,000, the assumed market value of the house at the end of the plan.

Credit Suisse took a look at this proposed reform, weighing the good and bad. Its report reflects that the impact of this reform is likely to be substantially less than Zywicki suggests, for reasons that seem obvious:

The impact of the law reform at this stage is unclear as we’re not sure what percentage of borrowers can and will take advantage of this option. For borrowers who can’t even pay the secured amount of the mortgage, bankruptcy isn’t an option. For borrowers who have lots of excess income, bankruptcy will provide little benefit. So only borrowers who want to stay in their homes, can afford the secured amount but not the entire mortgage, and are willing and able to go through the invasive procedure of Chapter 13 bankruptcy seem likely to apply.

Bottom line is that the new plan adds an important new tool in the foreclosure avoidance arsenal and will likely result in a marginal reduction of foreclosures.

A benefit I see in resolving these issues in bankruptcy is that the burden is primarily borne by the two responsible parties - the borrower and lender. There's a further benefit, in that if foreclosures are prevented, housing values in the rest of the neighborhood are less likely to be negatively affected by foreclosure sales or abandoned properties. But the biggest benefit, as I see it, is that lenders might think twice before repeating the reckless lending policies that inflated the bubble and led to the current financial crisis.