Levitin paper explains how change to bankruptcy law could provide the best solution to the nationwide foreclosure crisis

October 2nd, 2009 by Mike Hinshaw

If you’re trying to save your home, you should realize that you might qualify for bankruptcy protection. If this applies to you, you really, really need to read this–and I mean all the way through. We’ve covered several of these topics before, but spread over several posts. Today we’re going to gather in one post some very specific points from an April 2009 paper by Adam J. Levitin, titled “Resolving The Foreclosure Crisis: Modification of Mortgages in Bankruptcy.”

Basically, Levitin challenges “the economic assumption underlying the policy against bankruptcy modification of home-mortgage debt.” The law that keeps bankruptcy judges from being able to modify loans on primary residences is based on the idea “that protecting lenders from losses in bankruptcy encourages them to lend more and at lower rates, and thus encourages homeownership.”

Here’s the first thing wrong with that picture: the U.S. bankruptcy code is not supposed to be used to protect lenders. As Levitin says, “Traditionally, bankruptcy is one of the major mechanisms for resolving financing distress.” Now, don’t take that to mean that simply because you’ve got debt is an excuse to game the system, to abuse the bankruptcy laws. But U.S.-style bankruptcy is our society’s way to allow, as Levitin writes,  for working out “the problems created when parties end up with unmanageable debt burdens. Although the process can be a painful one for all parties involved, bankruptcy allows an orderly forum for creditors to sort out their share of losses and return the deleveraged debtor to productivity; a debtor hopelessly mired in debt has little incentive to be economically productive because all of the gain will go to creditors. Moreover, the existence of the bankruptcy system provides a baseline against which consensual debt restructurings can occur. Thus, for over a century bankruptcy has been the social safety net for the middle class, joined later by Social Security and unemployment benefits.”

In other words, in this country, we have recognized that sometimes people just simply need help, instead of being sent to debtor’s prison–where it’s impossible to be a functioning, tax-paying member of society. We recognize that debtor’s prison (and other Draconian methods of punishment, still embedded in other countries) is outmoded, impractical and inefficiently costly in the long run.

But here’s the problem: “The bankruptcy system, however, is incapable of handling the current home-foreclosure crisis because of the special protection it gives to most residential-mortgage claims. While debtors may generally modify all types of debts in bankruptcy—reducing interest rates, stretching out loan tenors, changing amortization schedules, and limiting secured claims to the value of collateral—the Bankruptcy Code forbids any modification of mortgage loans secured solely by the debtor’s principal residence. Defaults on such mortgage loans must be cured and the loans then paid off according to their original terms, including all fees that have been levied since default, or else the bankruptcy stay on collection actions will be lifted, permitting the mortgagee to foreclose on the property. As a result, if a debtor’s financial distress stems from a home mortgage, bankruptcy is unable to help the debtor retain her home, and foreclosure will occur. The absence of a bankruptcy-modification option also reduces the incentive for creditors to engage in consensual nonbankruptcy debt restructuring. Because of bankruptcy’s special treatment of principal residential mortgages, the legal mechanism on which the market depends for sorting through debt problems cannot function properly,and this is exacerbating the impact of the mortgage crisis.”

In other words, let’s say a person has become wealthy by devising a viable business plan and growing a successful company. Along the way, this business person has maintained a healthy FICO score and thereby has been able to amass quite an estate, plus the income that keeps all notes current on two vacation homes, one on the coast with a yacht moored nearby, and another in the mountains, complete with ski equipment and four snowmobiles.

But then some economic event occurs that requires both 1) the company and 2) the business owner to seek Chapter 11 protection (beyond a certain asset level, Chapter 13 is not an option). That way the company gets time to restructure, work with creditors in an orderly manner and to keep employees on the payroll, thereby limiting further damage to society and the economy.

Under bankruptcy protection, the stay order stops foreclosure on the main home is stopped, as well as all the harrasing phone calls and demands from credit card companies and other creditors. Additionally, the bankruptcy judge can modify terms of the loans on most of the “goodies,” including both vacation homes, the yacht, and all the snowmobiles.

Working from the data collected by the business owner’s bankruptcy attorney, the bankruptcy trustee, and the creditors, the judge can order “cram down” or “strip down” arrangements that modify the loans on all that stuff–what many of us would call luxury items–so that the business owner gets to keep everything as long as the monthly payments are made.

The creditors may not like it, but still they’re getting a better return than they would if all the stuff were disposed of in a
fire sale. Meanwhile, the company recovers, the employees don’t have to lose their jobs, and the yachts and snowmobiles and vacation homes are still in the family.

Now, our erstwhile business owner is no different than Joe Schmoe as far as the main house goes. That loan can’t be
modified. But our  business owner at least has a shot at keeping the luxury items, which are now being paid off at better terms than the original loans called for.

Contrast that scenario with all the Joe Schmoes, who have no vacation homes or yachts. They simply want to keep the one house, the family home–which is really all they’ve got, except for maybe a bass boat and *maybe* some kind of RV. But in the main, when wage-earner Schmoe winds up in tight straits, the chief concern is hanging on to the one home, the only home.

In those cases, when bankruptcy is the answer, then bankruptcy provides a great deal of protection. For instance, in certain cases, you can file Chapter 7 and still keep your home. Chapter 11 is a legal possibility for less well-heeled consumers, but the creditors have a bigger say than they would under Chapter 13, which will stop foreclosure.

And foreclosure is a huge problem. As Levitin says, “At no time since the Great Depression have so many
Americans lost their homes, and many millions more are in jeopardy of foreclosure. Nearly 1.7 million homes entered foreclosure in 2007, and another 2.2 million entered in the first three quarters of 2008. Over half a million homes were actually sold in foreclosure or otherwise surrendered to lenders in 2007, and over 900,000 were sold in foreclosure in 2008.  At the end of 2008, more than one in ten homeowners were either past due or in foreclosure, the highest levels on record. By 2012, Credit Suisse predicts around 8.1 million homes, or 16 percent of all residential borrowers, could go through foreclosure. Expressed differently, one in every nine homeowners—and one in six households that have a mortgage—will lose their home[s] to foreclosure.”

In fact, it could be worse: one of the sources for Levitin’s numbers is a study published by Credit Suisse, which Levitin
quoted only partially in his footnotes. The full quote from the December 2008 Credit Suisse report goes thus: “At the time, most viewed our [April 2008] forecast as being overly gloomy. However, based on the trends in delinquencies we were observing, the growing negative equity and our home price forecast, the forecast seemed reasonable. In this report, we update our forecast to 8.1M, or 1.5 million foreclosures greater than our earlier forecast. Further, this forecast doesn’t fully take into account the consensus increase in the unemployment rate to 8%. Adjusting our forecast for the rising unemployment rate, results in an increase to 9.0M.”

(It’s worth mentioning that Credit Suisse was also too optimistic in assuming that unemployment would top out at 8 per cent.)

Now it’s bad enough from the individual perspective that millions of individuals get forced into foreclosure, but perhaps even more dangerous is the toll on society. Levitin uses academic terms to talk about the ripple effects: “Both the increase in, and the sheer number of, foreclosures should be alarming, because foreclosures create significant deadweight loss and have major third-party externalities. Historically, lenders are estimated to lose from 40 to 50 percent of their investment in a foreclosure situation, and in the current market, even greater losses are expected. Borrowers lose their homes and are forced to relocate, often to new communities, a move that can place extreme stress on borrowers and their families. Foreclosure is an undesirable outcome for borrowers and lenders.”

But the damage is not limited to borrowers and lenders. “Foreclosures also impose costs on third parties. When families
have to move to new homes, community ties are rent asunder. Friendships, religious congregations, schooling, childcare, medical care, transportation, and even employment often depend on geography. Foreclosures also depress housing and commercial-real estate prices throughout entire neighborhoods. For example, a study on foreclosures in Chicago in the late 1990s concluded that a single foreclosure depressed neighboring properties’ values between $159,000 and $371,000, or between 0.9% and 1.136% of the property value of all the houses within an eighth of a mile. For Chicago, which has a housing density of 5,076 houses per square mile, or around 79 per square eighth of a mile, this translates into a single foreclosure costing each of 79 neighbors between $2,012 and $4,696.

“The property-value declines caused by foreclosure hurt local businesses and erode state and local government tax bases. Condominium and homeowner associations likewise find their assessment base reduced by foreclosures, leaving the remaining homeowners with higher assessments. Foreclosed properties also impose significant direct costs on local governments and foster crime. A single foreclosure can cost the city of Chicago over $30,000. Moreover, foreclosures have a racially disparate impact because African-Americans invest a higher share of their wealth in their homes and are also more likely than financially similar whites to have subprime loans. In short, foreclosure is an inefficient outcome that is bad not only for lenders and borrowers, but for society at large.”

So the question becomes: Given all the disadvantages of foreclosure, why in the world does the bankruptcy code provide special treatment for mortgage lenders? The question becomes even more pressing in light of today’s “securitized” loans, in which “mortgage servicers” either can not or will not renegotiate terms, and all too often the actual owner(s) of the note can not be determined.

“The Bankruptcy Code’s special protection for home-mortgage lenders reflects a hitherto unexamined economic assumption. The assumption is that preventing modification of home-mortgage loans in bankruptcy limits lenders’ losses and thereby encourages greater mortgage credit availability and lower mortgage credit costs, in turn encouraging the homeownership that has been a major goal of federal economic policy for the past half century. As Justice John Paul Stevens noted when the Supreme Court of the United States addressed the Bankruptcy Code’s antimodification provision in 1993: ‘At first blush it seems somewhat strange that the Bankruptcy Code should provide less protection to an individual’s interest in retaining possession of his or her home than of other assets. The anomaly is, however, explained by the legislative history indicating that favorable treatment of residential mortgagees was intended to encourage the flow of capital into the home lending market.’

“According to Justice Stevens, Congress intended to promote mortgage lending by limiting lender losses in bankruptcy. Justice Stevens’s assertion has scant support in the legislative history, but has nonetheless become the dominant explanation for the Bankruptcy Code’s mortgage antimodification provision. Underlying the economic assumption embedded in the Bankruptcy Code’s antimodification provision is another assumption—that mortgage markets are sensitive to bankruptcy-modification risk. This Article empirically tests the policy assumption behind the Bankruptcy Code’s prohibition on the modification of single-family primary-residence mortgages. It marshals a variety of original empirical evidence from mortgage origination, insurance, and resale markets to show that mortgage markets are indifferent to bankruptcy-modification risk.”

In other words, the “official view” is, yes, it’s strange to not protect people’s homes, but that’s the way it has to be keep mortgage lenders happily making loans: Allowing bankruptcy judges to modify loans on primary residences would make mortgage rates go up to offset the risk of potential bankruptcy modifications.

But, wait, says Levitin. Proving once again the brilliance of simplicity, he realized that if the official view were true, then lending rates should be higher for properties with loans that can be modified. But in the main that’s simply not the case.

Levitin  constructed an elaborate test (he thoroughly explains his methodology) that involved comparing rates in a variety of states; using various credit scores from low to high; for single-family homes through four-family, owner-occupied units, vacation homes and investor-owned propoerties. The results? For conforming loans with 20 per cent down,  [i]nterest rates, points, and APRs were identical for these property types, despite the variation in bankruptcy-modification risk. Uniformly, however, investor properties had higher interest rates and points.”

The higher rates for investor property is not surprising, says Levitin, because they come with risks that single-family and vacation homes don’t have–but those risks have nothing to do with the potential for bankruptcy. He also made comparisons among the various scenarios but with only 10 per cent down. He also examined Private Mortgage Insurance rates for sensitivity to risk of bankruptcy. He noticed a slightly different pattern but still found that “[c]urrent mortgage-origination rates indicate that mortgage-lending markets are indifferent to bankruptcy-modification risk, a conclusion confirmed by PMI pricing.”

Levitin also looked at historical data (mostly pre-securitization), and there he found some differences, but concludes that even though are minor to the overall market, the higher rates suggested might also provide answers to the rampaging predatory lending that helped fuel the current crisis: “Taken together, the historical data and current market-pricing data indicate that mortgage markets are largely indifferent to bankruptcy modification outcomes. The current market data suggest almost complete indifference, whereas the historical data [from a time when far fewer mortgages were securitized] show some sensitivity, particularly for higher-price and higher-LTV (i.e., riskier) borrowers. These findings indicate that permitting strip-down or other forms of modification for all mortgages would be unlikely to have anything more than a small impact on interest rates or on mortgage-credit availability.

“The impact, if any, would be primarily on marginal borrowers, which might be a good thing because, prospectively, it would help discourage the aggressive lending (such as nodocumentation and low-documentation loans, and high LTV ratios) and irresponsible borrowing (such as borrowing based on an assumption of refinancing before teaser rates expired) that is at the root of the current mortgage crisis.”

The next section of the paper looks at the staggering costs of foreclosure and attendant damage to neighborhoods, not only physically but fiscally. He cites one case of a lender recovering only about $100 thousand on a home that sold for $300 thousand–and says that some data suggest there might be another $50 thousand tacked onto the average foreclosure in various fees. Levitin believes that consumer finance legislation in general has been outstripped by the evolving, ever-more-innovative products from the consumer finance industry: “. . .because of diversification among millions of borrowers, risk-spreading through securitization and insurance, and fee-based profit models, the scope of the bankruptcy discharge has very little impact on the price or availability of credit except at the margins. If this theory is correct, then we must both update our thinking about the effect of bankruptcy law on consumer finance and rethink consumer-bankruptcy policy from the ground up, with an eye to expanding the scope of the discharge. As consumer finance becomes more complex, it is time to update the model of the effect of bankruptcy law on consumer finance. The theory and modeling of consumer finance can serve as a meaningful policy guide, but to do so, it must account for the actual structure of the evolving consumer-finance industry.”

The bottom line is that bankruptcy modification is much better than foreclosure, not only for homeowners and lenders but also for society. In fact, says Levitin, “permitting modification of all home mortgages in bankruptcy stands out as the best of all possible solutions proposed to the mortgage crisis. Unlike any other proposed response, bankruptcy modification offers immediate relief, solves the market problems created by securitization, addresses both problems of payment-reset shock and negative equity, screens out speculators, spreads burdens between borrowers and lenders, and avoids both the costs and moral hazard of a government bailout. As the foreclosure crisis deepens, bankruptcy modification presents the best and least invasive method of stabilizing the housing market.”

Levitin does his homework, and this paper should be required reading for every U.S. Representative and Senator–and every member of Team Obama, too.

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Bankruptcy protection might your best route, not only to protect your home and assets needed to make a living (as well as many personal effects) but also for a legitimate chance at new beginning. Here’s a good place to start reading. If you’re ready to schedule a free consultation with a trained, experienced bankruptcy attorney, click here.