Here's one question that I haven't seen adequately addressed in the debate over cramdowns: what happens when the Chapter 13 plan gets dismissed without a discharge? Because 2/3 of Chapter 13 plans don't work.
To review: what proponents of cramdowns are proposing, as nearly as I can currently make out, is to treat mortgages the way we currently treat loans on most cars in Chapter 13. In Chapter 13, rather than simply discharging all your debts, you work out a payment plan that is supposed to keep your debts at a level you can afford. Secured claims are "stripped down" or "bifurcated" into two loans, one secured, one unsecured. The secured loan is written down to the value of the collateral, while the rest of the loan is transformed into an unsecured debt, the unpaid portion of which will be discharged at the end of your payment plan (generally, 5 years).
Mortgages are not treated this way in bankruptcy, though they were prior to the 1978 reform. The more conspiracy-minded readers and commentators have interpreted this as a bank-driven attempt to squeeze even more money out of the debtors they were sucking dry. In fact, prior to 1978, inflation-driven house price appreciation had made this clause moot for decades, before which time it hadn't really been relevant because the long-term self-amortizing mortgage didn't really come into widespread use until the 1950s.
No, the reason no one has been motivated to cram down mortgages like car loans is that doing so would have made loans more expensive (to compensate for risk), driven lenders to require higher downpayments, and shut many people out of the mortgage market entirely. Perhaps that would have been a good thing (though I think by the height of the bubble, lenders just weren't paying attention to depreciation risk at all). But politicians wisely knew what voters would think about suddenly finding it a lot harder to get a home loan.
At any rate, suddenly we do have a lot of house price depreciation, and a lot of people would like to see mortgages stripped down. Here's the question: what happens when the plan doesn't work? Even if we assume that cramdowns will attract a better class of debtor into Chapter 13, a near-majority of these plans are probably still going to fail.
What happens when a Chapter 13 plan gets dismissed is not pretty: the cramdown slips softly and silently away.
When a Chapter 13 case is dismissed prior to discharge, the protection
of the automatic stay disappears and your creditors can pursue all
available state remedies available to them. In a Chapter 13, the plan
often changes the monthly payment to secured creditors like a car
lender. So, for example, if your car payment was $450 per month
pre-bankruptcy, and your Chapter 13 trustee paid the lender $300 per
month, there is a $150 per month delinquency that is building. If your
case goes through to discharge, no problem. But when your case is
dismissed the lender will recalculate what you owe based on the
contract rate. This may put you hundreds or thousands of dollars
behind.
Now our homeowner has accumulated a bigger debt, and is going to be foreclosed upon anyway. Of course, they got to stay in their house an extra year or so. But the price was an extra 200 points off their credit score.
Meanwhile, what happens to the bank? A lot of people have been touting the notion that this is good, because it will stop the vicious cycle of foreclosure. But if 2/3 of these plans fail, all it does is delay it a while. Meanwhile, the bank has had the administrative expense of a bankruptcy proceeding and a foreclosure. Oh, and years of sharply reduced payments while the bad loan hangs out on their books. Double the number of months of nonpayment. And so on.
And the neighborhoods this was going to save? Again, all we've done is prolonged the crisis. Most of the houses that were going to end up in default will end up in default. It won't even take that long. Chapter 13 plans tend to fail pretty quickly.
Now, one could argue that even if most of the plans fail, we still have to consider the benefits of those that succeed. Indeed we do. But the costs of the failed plan are considerable. Especially if we contemplate the not-unlikely notion that the value of the cram down will encourage people who would not otherwise have gone through either bankruptcy or foreclosure to avail themselves of Chapter 13.
To review: what proponents of cramdowns are proposing, as nearly as I can currently make out, is to treat mortgages the way we currently treat loans on most cars in Chapter 13. In Chapter 13, rather than simply discharging all your debts, you work out a payment plan that is supposed to keep your debts at a level you can afford. Secured claims are "stripped down" or "bifurcated" into two loans, one secured, one unsecured. The secured loan is written down to the value of the collateral, while the rest of the loan is transformed into an unsecured debt, the unpaid portion of which will be discharged at the end of your payment plan (generally, 5 years).
Mortgages are not treated this way in bankruptcy, though they were prior to the 1978 reform. The more conspiracy-minded readers and commentators have interpreted this as a bank-driven attempt to squeeze even more money out of the debtors they were sucking dry. In fact, prior to 1978, inflation-driven house price appreciation had made this clause moot for decades, before which time it hadn't really been relevant because the long-term self-amortizing mortgage didn't really come into widespread use until the 1950s.
No, the reason no one has been motivated to cram down mortgages like car loans is that doing so would have made loans more expensive (to compensate for risk), driven lenders to require higher downpayments, and shut many people out of the mortgage market entirely. Perhaps that would have been a good thing (though I think by the height of the bubble, lenders just weren't paying attention to depreciation risk at all). But politicians wisely knew what voters would think about suddenly finding it a lot harder to get a home loan.
At any rate, suddenly we do have a lot of house price depreciation, and a lot of people would like to see mortgages stripped down. Here's the question: what happens when the plan doesn't work? Even if we assume that cramdowns will attract a better class of debtor into Chapter 13, a near-majority of these plans are probably still going to fail.
What happens when a Chapter 13 plan gets dismissed is not pretty: the cramdown slips softly and silently away.
When a Chapter 13 case is dismissed prior to discharge, the protection of the automatic stay disappears and your creditors can pursue all available state remedies available to them. In a Chapter 13, the plan often changes the monthly payment to secured creditors like a car lender. So, for example, if your car payment was $450 per month pre-bankruptcy, and your Chapter 13 trustee paid the lender $300 per month, there is a $150 per month delinquency that is building. If your case goes through to discharge, no problem. But when your case is dismissed the lender will recalculate what you owe based on the contract rate. This may put you hundreds or thousands of dollars behind.
Now our homeowner has accumulated a bigger debt, and is going to be foreclosed upon anyway. Of course, they got to stay in their house an extra year or so. But the price was an extra 200 points off their credit score.
Meanwhile, what happens to the bank? A lot of people have been touting the notion that this is good, because it will stop the vicious cycle of foreclosure. But if 2/3 of these plans fail, all it does is delay it a while. Meanwhile, the bank has had the administrative expense of a bankruptcy proceeding and a foreclosure. Oh, and years of sharply reduced payments while the bad loan hangs out on their books. Double the number of months of nonpayment. And so on.
And the neighborhoods this was going to save? Again, all we've done is prolonged the crisis. Most of the houses that were going to end up in default will end up in default. It won't even take that long. Chapter 13 plans tend to fail pretty quickly.
Now, one could argue that even if most of the plans fail, we still have to consider the benefits of those that succeed. Indeed we do. But the costs of the failed plan are considerable. Especially if we contemplate the not-unlikely notion that the value of the cram down will encourage people who would not otherwise have gone through either bankruptcy or foreclosure to avail themselves of Chapter 13. Because if they go through Chapter 13, and they can't keep up the payments for any reason, they are now guaranteed to lose the house because of the arrearages they will have accumulated while making payments only on the secured portion of the suddenly-no-longer-bifurcated-loan.
Copyright © 2009 by The Atlantic Monthly Group. All rights reserved.
Fuck credit scores.
People idolize that stupid number as if it were an indication of personal virtue.
Go bankrupt, have a foreclosure. As long as you have a good job and no debt, you're credit score will recover quite nicely. Lenders are worried about whether THEY are going to get their money, not that someone else got stiffed in the past.
But yeah, 2/3 might be optimistic really. But a lot of people do 13s in the hope of saving the house but can never get a viable plan together, or they get their plan confirmed and then don't send any payments in.
The validity of the 2/3 number depends on the new crop of chapter 13s being the same as the old crop of 13s. I'd be willing to bet that the new crop is somewhat more financially viable than the old crop.
I'm sure some of those consider bankruptcy are people who, in an idea would, would have said, "Hum, the price/rent ratio on this house is far above its historical mean, I should rent until home prices fall." Instead they were told prices always go up, if they don't buy now they will have to rent forever. (oh, and only low class losers rent)
They are the victims of their own ignorance and greed, not victims of poor retail impulse control - as may have been the case with the old Chapter 13s.
Megan,
I don't believe that you've adequately addressed this topic. I think at least three more 1,500 word posts are needed to make your case.
Need a bit of a there, Megan - you repeated the entire top section of the post before you added the concluding sentence.
FYI, the section you quoted from thebkblog (paragraph immediately following the link) is missing the blockquote tags.
No, the reason no one has been motivated to cram down mortgages like car loans is that doing so would have made loans more expensive (to compensate for risk), driven lenders to require higher downpayments, and shut many people out of the mortgage market entirely.
This is where my socialist friends' eyes tend to glaze over and they get lost.
People want something for nothing, but TANSTAAFL in the free market. If you change the rules of housing debt, you change the price of housing debt.
Assuming the 1/3 success rate (focus on the positive) holds, though I think it would be higher for those who still have incomes in the current climate (need income for ch 13 in the first place), that prevents 1/3 from going into foreclosure. The other 2/3 of failures would have failed anyway. Odds are those are the people who weren't making payments before the filing.
When I first started thinking about cramdowns, i thought it would give the banks an incentive to start cleaning up their balance sheets by renegotiating mortgages. Yet, they haven't done so even in states with non-recourse mortgages (meaning bank can't sue you for the unsecured balance after foreclosure). http://www.wtop.com/?sid=1553699&nid=111
In non-recourse states, especially the major bubble areas in AZ, CA, and FL, an underwater home owner only has a lower FICO to fear by walking away, which isn't enough of a concern when you're underwater by over 100k. If more people were aware of how easy it is to just walk away in non-recourse states, you'd see foreclosures go up even higher. You get to live rent free for 6-12 months during the process, then move along.
Are banks waiting for a better deal from the feds or are their hands tied by complicated MBSs? I don't understand why they aren't more eager to renegotiate principal in non-recourse states.
Megan,
Interesting as the discussion has been, I think we've all lost sight of reality. People who entered in to long term fixed rate mortgages at rational rates might kick themselves over a bad bargain, but as long as they maintain their prior income they'll have no basis to apply for bankruptcy unless they have additional unsecured indebtedness. Despite all the "too left" talk about cramming down, since the huge percentage of mortgage holders would get no relief, and because most people accept the idea of fullfilling a contract even when it's a bad one, there would be NO public, ie. political, acceptance for reducing principal even on the nastiest teaser rate ARMs. If anything were to be crammed down it would be excessive interest rates, and since even lower interest on a mortgage that is 1.5 times the value of the home is still no value I don't think buyers would opt to take it.
I think a lot of the current public acceptance of the concept, undefined, is simply more of the "Do Something to save the country!" mood and would evaporate as the details evolved.
Interesting post.
The Chapter 13 cramdown is largely symbolic. I wouldn't expect a lot of people to choose to do a Chapter 13 bankruptcy in order to gain the benefit of the cramdown. The truth is that most people who can't pay their mortgage are going to lose the house.
Things are so bad already, the availability of a Chapter 13 cramdown for existing mortgages will have little effect on the value of mortgage backed securities and little effect on the price of new mortgages.
I'm going to have to go with toxic on this one. The whole cramdown thing is a diversion. What people can do who are underwater is just walk away from their home. They could probably even rent it back from whoever ends up buying it at a far lower cost than their mortgage payment. Prices are low enough that investors are buying foreclosed houses for rental income (according to the anecdotal evidence of a few houses on my street).
And leave us not forget that they aren't much more than a bunch of bailout bums or something.
Why would people who go through a Chap 13 perform any better than people who have had significant loan modification?
Megan makes a good point here (rather long though)
About 1/3rd to half of people who've had radical loan mods redefault (radical means the rate was sharply cut and amortization or repayment periods were rolled forward)
Why would a BK do any better? Granted people who bother to do a BK might be a better class of borrower, since the government has been forcing banks to modify anygoddamnborrower's loans, even obvious frauds'.
Still, the gist of what Megan is pointing out is there's no free lunch, and even if a mortgage is cramed down to it's "fair value" the borrowers may still not perform very well: then where are we? Loans still going bad; deferring the same inevitable problem; AND the cost of mortgage financing will go up for the rest of us.
even if a mortgage is cramed down to it's "fair value" the borrowers may still not perform very well: then where are we? Loans still going bad; deferring the same inevitable problem; AND the cost of mortgage financing will go up for the rest of us.
Most of the alleged "workouts" we've had as of late have simply lowered payments temporarily, employing negative amortization to avoid reductions of the principal balance. So we're simply burying people under more debt, while avoiding a full recognition of the problem on the banks' balance sheets. So no, you have no real-world proxy with which to support your point.
We have liar banks that understate the extent of their capital needs. We have a cynical stock market that is understandably punishing bank stocks by their obvious failure to account fully for the extent of the problem. Unfortunately, that punishment is extended to the rest of the market, which leaves us with torpedoed IRA's. The little guy is taking it in the shorts in order to perpetuate the cover up of the deficiencies of these institutions.
Assuming that it is structured properly, the "bad bank" proposal offers the most logical solution. The banks won't like it because the real-world market value that would be paid by a vulture is a fraction of the loan balances, so unfortunately, the government will invariably have to pay above market to prevent them from taking the full hit. The joys of yesterday's deregulation are going to force tomorrow's socialization of more losses.
Mortgage rates are bound to go up, because the banks will have to return to their old business model of making money from their spread, rather than origination and servicing fees earned from churning out loans and flipping them into securities. The securitization business made it possible to accept lower margins; with less securitization in the future, pricing is bound to go up a bit.
Bankruptcy is such a tiny piece of the market that it is effectively irrelevant. If anything, during times like these, the workouts that bankruptcy would encourage would often prove to be better than foreclosure, as the real-world resale value of a foreclosed property is likely to be less than the agreed upon balance in a bankruptcy plan. No need to hype up the downsides, when they aren't really there.
Wow, you address a question I have had for the longest time in such an easy to follow manner. Many of those 13's don't go through and I always wondered what happened to them. I now know thanks to you!
I agree with "toxic"...fuck credit scores. People have been brainwashed into bowing at the foot of FICO. As more and more Americans credit "score" is trashed by foreclosures, job losses, etc., people will come to realize that you can live without "great" credit. It is just a trap. I probably could not get credit for a used tire right now, and could care less. Welcome to the new age in America.
Cramdowns will do one IMPORTANT THING - get the taxpayer out of the cycle. Everyone screwed up and right now banks are playing it to try to get the taxpayer to cover their losses. Like others have pointed out, right now banks are NOT negotiating anything, they're simply piling on debt trying to keep their pinciple in tact. Face it folks, the value in those houses is gone. The cramdown gives banks a legal requirement to clear up their books and will show just how bad they really are.
As a tax payer, I don't want to own that "toxic" crap and I'm for cramdown with a vengence!
If that makes people have to put downpayments for homes... oh, wow, how horrible! If that makes banks have to evaluate borrowers again... gain... how horrible! They're being forced to act responsibly. Something they haven't done in nearly a decade.
So I say cram it down the bank's throat instead of the taxpayer!
Oh, and as for the "everyone will run out and get a bankruptcy" scare tactic... that doesn't hold water at all. You have to qualify for a bankruptcy. I hardly think someone making enough money to pay their bills is seriously going to go out and liquidate all their assets and take a lower paying job long enough to qualify just to knock a few thousand dollars off their mortgage.
Only banks would be that stupid.
CRAMDOWN YES! Let the banks and owners work it out and let the taxpayer out of it!