As foreclosure plan takes shape, millions more mull the choice: Bankruptcy or foreclosure?

February 24th, 2009 by Mike Hinshaw

While the country waits for specific information about the recently passed stimulus bill and attendant plan to slow down foreclosures, one component remains glaringly clear: Lenders are not going to be forced to do anything.

“Treasury’s new foreclosure plan is not perfect,” says a Feb. 23 editorial in the Cleveland Plain Dealer. “Its workability seems largely subject to the willingness of lenders and mortgage-servicing middlemen to participate, since there’s no absolute requirement that any mortgage holders work out any loans for struggling homeowners. Bailed-out banks are told to participate ‘consistent with’ Treasury loan modification guidelines, but that standard seems far short of saying they must reach out to all customers with an offer to modify loans. Final rules on the foreclosure plan are due early next month.”

In other words, unless President Obama is able to muster support for new legislation that allows bankruptcy judges to modify terms for primary residences, homeowners facing the bankruptcy versus foreclosure question may ultimately rely merely upon lenders’ desires to play ball with Treasury.

With that in mind, it might be useful to survey recent opinions of various pundits who address the question. In a Jan. 12 piece for cnbc.com, Diana Olick says in her cutsie-sounding “Realty Check” column that the issue for authorities seems to hinge, either-or fashion, on “bankruptcy and ‘walkaways.’ ”

Olick says, “Congressional Democrats are pushing for a plan to allow bankruptcy judges to modify home loans because current industry and government loan modification programs aren’t working.” Fair enough. Granted, the push is substantial, and Obama seems to wholeheartedly on board, having been quoted as saying he’ll sign such legislation the second it hits his desk. The problem, says Olick, is that “critics of that plan argue that as home prices fall further and higher income borrowers start to tally up losses, the number of borrowers who simply decide to walk away from their debt commitments will surpass those that actually want to keep their homes.”

All that heavy thinking led Olick “to ask the question, which is worse to your financial future: personal bankruptcy or foreclosure?”

So she called “the folks over at FICO,” describing them as “the guys who invented that score that all the lending types use to determine just how much of a credit risk you are. A very affable representative of the company, Craig Watts, told me that a bankruptcy is far worse than a foreclosure because it usually involves more than one account, like credit cards or auto loans. That said, a foreclosure is still going to bash your credit score, especially if you have pristine credit.”

What she finds particularly intriguing is the prospect that walkaways–even formerly prime borrowers who dump homes that have lost more value than the loan–will become a wave of such proportion that foreclosure will no longer be a hickey on a person’s FICO score.

“Some have even suggested that the large number of borrowers going into foreclosure will have some kind of mitigating effect on credit scores: that is, foreclosure will cease to be such a big credit risk because it’s so commonplace,” says Olick. But her new, affable contact at FICO blasts that idea: “That’s nonsense,” argues Watts. “Even if the number of foreclosures has doubled, you’re still talking about 90 percent of loan holders paying their loans on schedule.”

Now…this is interesting. Follow the reasoning here. Olick points out that the best-ranked credit risks are particularly hard hit by a record of foreclosure.

“If you have pristine credit,” she writes, “and you allow your home to go into foreclosure, your score will drop 200 points in a nanosecond. That means you will have a much harder time qualifying for a mortgage on another home, and if you do get one, you’ll have to pay more for it. It also means that you may have trouble renting an apartment, since landlords do check your credit score. It may even prevent you from getting certain jobs. Interestingly, if you had weaker credit before foreclosure, your score doesn’t drop as much because you were already a risk.”

Say, that is interesting, Ms. Olick–if the Wall Street-fueled meltdown has shredded your credit rating, well, you’re already labeled a risk. Makes sense, in a Draconian twist of financial Darwinism… But then she says this:

“Personal bankruptcy is really no better, which is why I have trouble understanding why lawmakers are pushing for bankruptcy judges to modify loans. That would just give borrowers more incentive to file for bankruptcy. I guess the argument is that they have no choice, and at least bankruptcy could keep them in their homes.”

Astounding. Simply astounding… Bankruptcy is no better, but at least it could keep people in their homes.

Here’s another writer’s take, in no less than The New York Times. In a Jan. 23 article called “Bankruptcy as a Step to Solvency,” M.P. Dunleavy summarizes the opinion of Katherine M. Porter, an associate professor at the University of Iowa law school and a researcher with the Consumer Bankruptcy Project: “One common misunderstanding is that declaring bankruptcy will ruin your credit. If you’re at the point of even considering bankruptcy, it’s likely that your credit is in tatters anyway, says Ms. Porter.

‘You may not end up that much worse off,’ she said. And Dunleavy adds, “In some cases, your credit could emerge in better shape once you’ve dealt with your debts.”

The Times article also addresses the stigma of bankrupcty. “The sting of failure and the dread of ruined credit are, understandably, deterrents to a bankruptcy filing. But those fears can prevent people from taking advantage of the financial protection offered by bankruptcy,” which can include erasing debt or lowering debt while preserving assets such as “retirement accounts and sometimes even your home and car. Instead, many people delay filling until they are truly desperate.”

‘When we surveyed people about how long they seriously struggled, over 40 percent said more than two years,’ said  Porter. ‘A lot of attorneys say they wish people would come earlier, before they emptied their retirement accounts or lost their car to repossession.’ ”

This Forbes article also debunks the idea that bankruptcy means no more credit: “The fact that you filed stays on your credit report for 10 years, but you can get credit again well within that time period. Your ability to do that depends on your pre-filing payment history, current income, debt-to-income ratio and how well you’ve paid your debts after the discharge.”

That Feb. 10 article also describes the basics of Chapters 7, 11 and 13 filings and offers three “case study” scenarios addressing who should and who should not file bankruptcy.

Of course, the decision really should be made in concert with a competent attorney, but as the Times’ piece notes, it’s better to act sooner than later, regardless of the decision.

“Another myth is that you must be at the frayed end of your financial rope before you file. You won’t lose everything in a bankruptcy because some assets are protected, and you will need those to move forward, says Elizabeth Warren, a professor at Harvard Law School and one of the lead researchers on the Consumer Bankruptcy Project. Waiting until your resources are entirely depleted defeats an important purpose of bankruptcy, ‘which is to help people rebuild their lives on a sounder footing,’ Ms. Warren said.”

So, yes, Ms. Olick–it’s true that some critics of the administration’s plan get the serious heebie jeebies because they’re afraid that “walkaways” won’t get punished and “house flippers” or those who bought “too much house” will get bailed out. But, really, the point is to keep in their homes those thousands of regular folks who simply got sick, laid off or are trudging along among the under-employed. As a nation, we’re overdue in extending a helping hand.