A terrible housing idea

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Feb 18 2009, 10:07 am by Benjamin Lockwood

Today Obama is expected to announce his proposal to prop up the beleaguered housing market later today. An article in the Washington Post this morning discusses several potential components of the plan, some of which (interest rate reductions, workout incentives) are good ideas. One piece that should not be included, however, is a provision for bankruptcy cram downs.

Cram downs would allow bankruptcy judges to reduce the outstanding principal on mortgages for homeowners filing for bankruptcy. This is what judges already do for many types of debt (loans to buy cars, yachts, vacation ski lodges) during bankruptcy proceedings. But primary residence mortgages have historically been outside the purview of bankruptcy debt reductions in order to keep mortgage rates low. The reason for that is simple: if lenders knew bankruptcy judges might reduce the principal owed, they would charge higher mortgage spreads to compensate for that risk. But some Democrats like the idea of cram-down provisions and have been frustrated by Obama's reluctance to embrace them.

But the fundamental risk of cram down provisions -- that mortgage rates would rise as a result -- is still relevant, however, and the last thing we need in an ailing housing market is an increase in mortgage rates. Furthermore, cram-down provisions create moral hazard by making bankruptcy relatively more appealing (emphasis on "relatively," as the Dems are quick to point out that nobody likes declaring bankruptcy) and thereby might clog bankruptcy courts with underwater mortgages that could be better dealt with through a standardized loan modification process.

Comments (2)

InsultComicDog February 18, 2009 3:22 PM

Cram-down provision in Obama's plan only apply to existing mortgages.

They are needed as an incentive for banks to put forth their best efforts to renegotiate terms with lenders.

candideyam February 18, 2009 3:53 PM

I think you overstate the moral hazard involved with Chapter 13. Chapter 13 debt repayment plans leave debtors with little or no disposable income. Allowances are made for basic needs, but the balance of the debtor's income is assigned to the repayment of all debts.

If the property values and/or interest rates are crammed down, they would only be reduced to a level which results in a payment below the debtor's non-essential income. The net result is the same, however; the debtor keeps the house but has no disposable income for 5 years.

Chapter 7 has a greater moral hazard. While the debtor continues to pay under Chapter 13, Chapter 7 allows the debtor to abandon the property and fully discharge any remaining debt. Nonetheless, the damage to the debtor's credit is no less for Chapter 13 than Chapter 7. Even with a cramdown, the prospect of having no disposable income for 5 years is far less attractive than simply giving up the house and becoming debt-free.

And one other point; there are a great many non-securitized mortgages in the U.S., and a large percentage of those have been issued by predatory subprime lenders whose very business model depends on default and foreclosure. An example: Monument Street Funding, a subsidiary of TARP-recipient Wachovia, exclusively issues subprime mortgages and forecloses on over 70% of them. (A quick Google search will reveal hundreds of hits on foreclosure proceedings nationwide.) Even though this company is partially owned by a TARP recipient, the mortgages are wholly-owned and therefore not eligible for any of the Federal foreclosure prevention programs, including those announced by Obama today. There are many other companies with the same business model.

For the recipients of these predatory mortgages, Chapter 13 cramdowns hold the only possible hope to avoid foreclosure.