Mortgage bankers oppose workouts for bankrupt homeowners

Bill would allow bankruptcy courts to modify loan terms

Legislation that would allow judges to modify the mortgage loans of troubled borrowers who file for Chapter 13 bankruptcy protection would increase the interest rate on loans with small down payments by up to 2 percent.

That’s according to testimony by the Mortgage Bankers Association at a hearing on HR 3609, the Emergency Home Ownership and Mortgage Equity Protection Act of 2007.

HR 3609 has been referred to the House Judiciary Committee, where opponents of the bill hope it will stay, rather than being sent on for a full House vote

Mark Zandi, chief economist for Moody’s Economy.com, testified in support of the bill, saying lenders have been slow to modify the loan terms of troubled borrowers. Giving bankruptcy judges such powers would “significantly reduce the number of foreclosures” and reduce the likelihood of a recession, Zandi said.

Introduced Sept. 20 by Rep. Brad Miller, D-N.C., HR 3609 would remove current prohibitions that prevent bankruptcy courts from modifying the terms of a loan on a troubled borrower’s principal residence.

Judges, for instance, could require lenders to switch borrowers from adjustable-rate to fixed-rate mortgages, and reamortize their debt to reflect the current value of the home with the goal of preventing foreclosure and increasing the odds the loan will be repaid in the long run. The bill would allow modified home loans to be repaid beyond the term of a Chapter 13 bankruptcy plan, which currently cannot exceed five years.

Bankruptcy courts already have the ability to restructure the payment of other debts, such as credit cards, but the Mortgage Bankers Association says extending that capability to home loans would drive up borrowers’ costs.

The policy against modifying home loans has been in place for more than 100 years, and is “a cornerstone to an efficient U.S. residential mortgage market,” said David G. Kittle, MBA chairman-elect in his prepared testimony before the House Subcommittee on Commercial and Administrative Law.

“The protection provided to home mortgages was not a loophole or oversight,” Kittle said. “It was a deliberate act of Congress to ensure the continued low cost and free flow of home mortgage credit.”

Allowing bankruptcy courts to modify the terms of home loans would create incentives for borrowers not to repay their home loans and “dramatically change the residential mortgage market,” Kittle said.

If a loan’s terms were to be modified using appraisals conducted years after a loan is originated, courts might “strip down the lien to the current fair market value,” Kittle said. Bankruptcy filings would skyrocket, he said, because bankruptcy lawyers would “aggressively advertise” to borrowers “that bankruptcy provides an inexpensive method to refinance” — even if they are not in default.

To cover their potential liability, lenders would be forced to require 20 percent down payments on home loans, or require an extra point or more in fees for loans with 10 percent down payments, Kittle said.

“To explain this in terms of pure interest rate … we estimate that borrowers would see a (2 percent) jump in interest rates with a 5 to 10 percent down payment … with no points or fees at closing,” Kittle said.

Others, including Economy.com’s Zandi, dismiss such claims. Bankruptcy courts should have the ability to modify the terms of mortgage loans because lenders have been too slow to take such actions, the bill’s supporters say.

Last month, Moody’s Investors Service reported that a survey of subprime mortgage servicers found most had modified only 1 percent of loans that experienced a reset in January, April and July.

Such efforts “are unlikely to prove effective in forestalling the increase in foreclosures,” Zandi said, warning of a “substantial risk” that the housing downturn and surging foreclosures will lead to a national recession.

“The housing market downturn is intensifying and mortgage foreclosures are surging,” Zandi said in his written testimony to the subcommittee. “Odds are quickly rising that a self-reinforcing negative dynamic of foreclosures begetting house-price declines begetting more foreclosures will develop in many neighborhoods across the country. There is no more efficacious way to short-circuit this cycle than adopting legislation to allow bankruptcy judges the authority to modify mortgages by treating them as secured only up to the market value of the property.”

Zandi said that, if enacted, HR 3609 “will not significantly raise the cost of mortgage credit, disrupt secondary markets or lead to substantial abuses.” The incentive for abuse is low, he said, because it would be costly for borrowers to seek workouts through the Chapter 13 process.

“Given that the total cost of foreclosure is much greater than that associated with a Chapter 13 bankruptcy, there is no reason to believe that the cost of mortgage credit across all mortgage loan products should rise,” Zandi said.

Zandi predicted that while the cost of second mortgages like piggy-back seconds might rise, prime borrowers could actually see their costs go down.

Investors who buy mortgage loans in the secondary market would “easily adjust to the new rules,” Zandi predicted, noting that securities backed by consumer loans subject to modification through Chapter 13 proceedings are routinely sold in secondary markets.

Concerns about any unintended consequences of the bill could be addressed by allowing its provisions to “sunset,” or expire, after several years.

Bankruptcy attorney Richard Levin called fears that HR 3609 would disrupt secondary mortgage markets or the availability of mortgage credit “completely unwarranted and unsubstantiated.”

Levin, the vice chairman of the National Bankruptcy Conference — a group of lawyers and academics whose members have participated in past reviews and amendments of bankruptcy laws — said the bill would not be a major departure from past practice.

It was not until 1978 that Congress placed limitations on modifications of loans on a debtor’s principal residence in the Chapter 13 process, Levin said in his prepared testimony. No similar limitations were imposed on mortgages on vacation or second homes, he noted, or investment, rental or business properties.

From 1979 until 1993, Levin said, four federal courts of appeals ruled mortgage write-downs were allowed in Chapter 13 filings, “yet there is no evidence that mortgage credit was less available or more expensive” in the jurisdictions covered by those rulings.”

A 1993 Supreme Court ruling ended the practice.

“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,” Justice John Paul Stevens wrote in a concurring opinion. “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.”

But Levin argued that “whatever justification there might have been in 1978 for granting special protections to mortgages on a debtor’s principal residence has evaporated.” Current conditions, he said, “demand that the Bankruptcy Code be amended to reflect the extraordinary changes in mortgage finance that have occurred in the past 30 years.”


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