BLOG VIEW: Are Bankruptcy Cramdowns For Real?

Two developments that the servicing community should find noteworthy have taken shape this week. One deals with the again-red-hot bankruptcy cramdown issue; the other pertains to modifying loans or, more accurately, taking loan modifications to a new – and possibly necessary – level.

The House Judiciary Committee on Tuesday approved the plainly titled Helping Families Save Their Homes in Bankruptcy Act of 2009 (H.R.200), which, as servicers are fully aware by now, seeks to allow bankruptcy judges to modify loans for borrowers who file Chapter 13. Yes, the dreaded cramdown talk has returned and in a very fervent fashion. Since Sen. Richard Durbin, D-Ill., introduced the bill weeks ago, industry groups have not held back on voicing their opinions (mostly in opposition). One huge player, Citigroup, has broken away from the pack and committed its support for the legislation.

Now the issue goes to vote in the House, where it will apparently garner enough support to pass, reports suggest.

The House committee decided against limiting the legislation to subprime mortgages – an amendment put forth by Republican representatives and identified by top Mortgage Bankers Association officials as a necessary step. The committee did, however, adopt a stipulation that requires borrowers to share any profits from a home sale with lenders.

It's ironic that the committee's chairman, Sen. John Conyers Jr., mentioned the FHA's Hope for Homeowners program in his statement about H.R.200. Conyers cited that program's underperformance as evidence that not enough is being done to assist troubled borrowers. The H4H name drop is ironic because one of the FHA program's components – profit-sharing – was singled out in a conversation I had with an FHA representative last week as being one of the chief reasons H4H hasn't been successful.

Granted, borrowers who are good candidates for receiving cramdowns are not necessarily the same borrowers who might be interested in H4H. Whereas H4H's profit-sharing element makes the program unattractive to some borrowers, borrowers who may qualify for a judge-modified loan likely won't be in much of a pick-and-choose position. During his testimony in front of the House committee, MBA Chairman David Kittle commented on how cramdowns might hurt the market.

"Cramdown legislation would make it harder for borrowers to get an FHA loan, because lenders would face the possibility that FHA insurance would not cover the loss from principal reduction," Kittle told the committee. "The same is true for VA lending. In effect, Congress would end the only meaningful lending option currently available to most low-income borrowers – almost overnight."

Passing Durbin's legislation during the current credit crunch, Kittle predicted, will further destabilize an already shaky mortgage market.

Chairman Conyers, probably more than a little familiar with a position such as Kittle's, noted in a statement that bankruptcy judges have been delegated this mod authority for a long time on a variety of secured debt – including real estate.

"[F]or over 20 years, this very same kind of modification has been available even for home mortgages – if the home was a family farm," Conyers said. "There is no indication that this has in any way increased the cost of credit for any of these kinds of loans."

The second newsworthy item that I alluded to earlier is the Federal Reserve's Foreclosure Prevention Program. Yes, the Fed appears to be joining the modification craze, and not a minute too soon. When historians write about Fed Chairman Ben Bernanke years down the road, the Foreclosure Prevention Program will probably not be high on the list of things to mention. That said, the program is significant if only because the Fed has expressed a willingness to reduce mortgage principal for loans it picked up in its rescue of Bear Stearns and AIG.

Federal Deposit Insurance Corp. (FDIC) Chairwoman Sheila Bair set off a litany of modification program imitators when she announced the FDIC's plan to systematically modify bad IndyMac loans. Will the Fed's decision to reduce loan principal simulate a similar wave of wannabes?

Consider this statement by Alan White, an assistant professor at Valparaiso University School of Law who has been one of the leading researchers on the topic of voluntary modification efforts by the industry: "The average foreclosure loss on a first mortgage in November 2008 was $145,000 or about 55% of the average amount due. Loss severities increased steadily throughout 2007 and 2008 and are expected to worsen in 2009. In these circumstances, rational investors should accept mortgage principal reductions corresponding to home value declines of 20% or so, were it not for the various obstacles to servicers' restructuring of mortgage loans."

Principal reductions are generally considered a last-resort option, but White's research indicates that – in some cases – they provide a better return to the investors than do foreclosures. Improving returns for investors and saving homes? That doesn't sound too bad.


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