WORD ON THE STREET: Our country's well-established system for handling problems related to consumer debt is bankruptcy court. The availability of this remedy is so crucial for both creditors and debtors that the framers established it in the Constitution, and the first bankruptcy legislation passed in 1800. Today, bankruptcy judges restructure debt for corporations and individuals alike.
Shockingly, however, when it comes to the family home – the primary asset for most people in our country – these experienced judges are powerless: Current law makes a mortgage on a primary residence the only debt that bankruptcy courts are not permitted to modify in Chapter 13 payment plans. Owners of vacation homes, commercial real estate and yachts can have their mortgage modified in bankruptcy court (and the peddlers of predatory mortgages such as New Century or over-leveraged investment banks like Lehman Bros. can have all their debt restructured), but an individual homeowner is left without remedy.
Addressing this legal anomaly would solve, almost in one fell swoop, a range of problems that have beset efforts to combat foreclosures. First and foremost, bankruptcy does not leave foreclosure prevention to the voluntary efforts of servicers. Instead, a trusted third party can examine documents, review accounting records, and ensure that both the mortgagor and the mortgagee are putting all their cards on the table. Moreover, the homeowner is the one who controls when this remedy is sought, rather than the servicer.
Second, in bankruptcy, the judge can reduce the level of the mortgage to the current market value of the property. This stripdown – some call it cramdown – or principal reduction, can help put homeowners in a position to begin to accumulate equity on their home again, thereby shielding them against future income shocks and increasing their incentive to make regular mortgage payments.
Third, a bankruptcy judge has the power to deal with the full debt picture of the homeowner, including any junior liens on the family home and other consumer debt, such as medical bills, credit cards or student loans. Second liens have proven to be one of the most vexing problems facing many foreclosure-prevention efforts, and high consumer debt can threaten the sustainability of any mortgage modification made in a vacuum.
Fourth, bankruptcy addresses "moral hazard" objections, meaning the concern that people will want relief even when they don't need or deserve it. Filing a Chapter 13 claim is an onerous process that a person would rarely undertake lightly. Any relief from debt comes at a substantial cost to the homeowner – including marring the homeowner's credit report for years to come and subjecting the homeowner's personal finances to strict court scrutiny.
Fifth, the availability of this remedy would, in large part, be the very reason why it would not need to be used very often. Once mortgages were being restructured regularly in bankruptcy court, a ‘template’ would emerge, as it has with other debts, and servicers would know what they could expect in court, making it much more likely that servicers would modify the mortgages themselves to avoid being under the control of the court. Similarly, the fact that a homeowner had the power to seek bankruptcy would serve as the now-missing stick to the financial incentive carrots provided by other foreclosure prevention programs.
Permitting judges to modify mortgages on principal residences – which carries zero cost to the U.S. taxpayer – could potentially help more than 1 million families stuck in bad loans keep their homes. As foreclosures continue to worsen, more and more analysts and interested parties are realizing the many benefits this legislation could have. Recently, the Federal Reserve Bank of Cleveland published an analysis of using bankruptcy courts to address the farm foreclosure crisis of the 1980s, concluding that using bankruptcy to address that crisis did not have a negative impact on the availability or cost of credit.
Congress has the power to require that all servicers, industry-wide, engage in loss mitigation, and that the failure to do so is a defense to foreclosure. For many servicers, only a legal requirement will cause them to build the systemic safeguards necessary to ensure that such evaluations occur.
This article was adapted from Oct. 27 testimony delivered by Julia Gordon, senior policy counsel for the Center for Responsible Lending, before the Congressional Oversight Panel. The testimony can be found in its entirety here.
