Cramdown Gets the Clampdown

There was almost breaking news yesterday.

The senate voted yesterday on a measure proposed by Dick Durban that would have allowed bankruptcy judges to renegotiate the terms of mortgages on a debtor's primary residence.

The mortgage provision garnered only 45 votes in the Senate, falling well short of the 60 votes necessary to break a threatened filibuster to a measure sponsored by Senator Richard Durbin, Democrat of Illinois, that would give bankruptcy judges greater flexibility to modify mortgages. (source: New York Times)*

As the law stands now, an individual can file for bankruptcy under Chapter 13. This, like Chapter 11 for businesses, allows the overly indebted individual to go before a bankruptcy judge who will then determine if a) the individual is capable of paying off all of his or her debts, and if not then b) which creditors should be given priority, which interest rates are or are not viable given the income stream of the debtor, which principal amounts may be too high and what, if anything, the debtor needs to either sell or fork-over to the creditor. This applies to any and all debts--from mortgages on vacation homes to car loans to student loans--except to loans taken out on the primary residence of a debtor.

So, as an example, if Sol makes only minimum wage but also happens to owe $100,000 plus 6% annual interest on his yacht, while I make minimum wage but also happen to owe $100,000 plus 6% annual interest on my apartment, Sol can go before a bankruptcy judge and have those number tinkered down to accommodate his financial position, while I am totally screwed.

So, why the provision? The blanket statement issued by the banks, the various lobbyists of the banks, and the various senators of the banks is that maintaining the rates and premiums established in the terms of the mortgage contract helps to "encourage the flow of capital into the home and lending market."(source: opencrs)

Which is to say that if I'm a bank (or more importantly, an investor who might want to buy a mortgage from the bank in the so-called secondary mortgage market), I'm going to be much more likely to throw money in that particular direction if I know for sure that the rate that I sign off on is going to be the rate of return I receive. If there is a chance that the loan I make or the bond I buy is going to return substantially less than the contract-determined value because the debtor goes bankrupt, I'm either going to go elsewhere with my money or demand a higher interest rate. So, in simple terms,

the main legitimate argument against bankruptcy cramdowns: it increases the riskiness of mortgages, and therefore mortgage rates would have to go up a little for everyone. (source: baselinescenario)

Now, given the fact that mortgage rates were probably too low for too many people for way too long, that in itself might not be such a bad thing in the long-run, but even if we ignore that for a second, one could say that this is the price of any kind of bankruptcy provision. If businesses are allowed to declare bankruptcy, maybe banks and investors won't lend as much to businesses than they otherwise would. So are these same people arguing against Chapter 11 bankruptcy law? And for those who argue that enacting this law in the middle of the crisis is a bit like changing the rules in the middle of the game, this could be said of the enactment of any bankruptcy provision. It isn't as if the entire business cycle freezes to allow Congress to enact a new law.

While I think it's generally ill-advised to turn to any blog comment thread for enlightened commentary, one of the most satisfying counter-critiques that I've read comes from a comment left at the New York Times Freakonomics blog:

The idea behind keeping home mortgages intact through Chapter 13 (where just about every other creditor can be “crammed down to value”) is that the due diligence was done up front, and to allow the loan to move through the secondary market easily, a future holder of the mortgage wouldn’t have to do new due diligence on every mortgage when the secondary market buys bought hundreds or thousands of loans at a time. And all of this would minimize the cost of the lenders, and keep home mortgage interest rates lower than other consumer debts, etc.

This idea fell apart when loans were made that should have never been made, and the people working in the secondary market became complicit in allowing cruddy mortgage assets to become common. (Source: NYT, F. DiCesare)

In other words, back in the golden days when lending standards were tighter and home-loan securitization less common, it made sense to stream-line the processes of the mortgage market by keeping all the rates, prices and premiums fixed and visible for all to see. In theory, back in the late 1970s when the law was enacted, the banker who made the home-loan had properly evaluated the relative riskiness of the borrower and priced the mortgage accordingly. But with the advent of subprime lending and the kind of assembly line home-loan securitization that one found at such esteemed institutions as Countrywide until only two or three years ago, the assumption of the responsible banker who had an interest in the financial health of the borrower was tossed enthusiastically out the window.

So while I understand the complaints of those who argue that primary residence mortgage restructuring increases uncertainty and information asymmetry in the mortgage market, I also wonder where they've been the past two decades. The entire subprime lending market was built upon asymmetric information and uncertainty. Allowing a lower-middle-class borrower to restructure the loan on his or her first residence after it, in accordance with the fine print, adjusts upward from 3 to 12% may very well make lenders and bondholders feel uneasy about their subsequent lending activity, but given the complete lack of oversight and complete and voluntary blindness towards risk adopted by both the private and public sector in the lead up to this crisis, maybe that uneasiness isn't such a bad thing. And maybe, if it allows a significant portion of America's working and middle class to stay in their homes, to avoid foreclosure and to keep home prices from plummeting further, it's worth it regardless.

But nevertheless, over at Zero Hedge, Tyler Durden is indignant:

Apparently in addition to TurboTax, the current administration needs a refresher course on contract law
...
But than again what is wrong in having the entire nation pay for the ridiculous greed of a few million fiscally irresponsible potential voters, living way beyond their means, buying vacation homes in Florida and Lake Tahoe, and maxing out their credit cards to buy that 3rd 50 inch plasma TV screen for the second bathroom. (source: ZeroHedge)

To which I respond: go fuck yourself. First, the criticism that this bill was proposed to save a bunch of speculating flappers is beyond ridiculous--it's lazy. The entire purpose of the bill is to allow those who have mortgages on their first home--not their fifth McMansion, not their vacation villa in the Pocannos--to renegotiate terms. This bill would have simply extended the same legal rights currently enjoyed by those who owe money on second and third homes and plasma screen TVs and whatever the hell else the lower-middle class are apparently enjoying at the taxpayers' expense, to those who own a single home which they can no longer pay for.

But on a larger scale, what about contract law, this uncorruptable virgin that's always dragged out of the basement to shame us all whenever someone contemplates reform the sake of equity? What people forget is that once upon a time, the concept of bankruptcy was proposed. That certainly violated the existing notion of contract law, just like the Treasury Department's various permutations of the TARP program may violate contract law, but you see very few bankers complaining about either of those. Law is adaptive when improvement is possible. That's the magic of democracy.

But then again, with 12 Democrats helping to kick the bill to the gutter, so apparently is lobbying.

*By the way, does anyone remember when that majority party called Republican tried to do away entirely with the filibuster? I know the Democrats are supposed to be the better party in all of this, but if Republicans want to threaten a filibuster on a bill that helps more people stay in their homes and helps to dampen both the increase in national foreclosure rates and across-the-board adjustable rate mortgage rates, why can't Harry Reid and the rest of the Senate majority leadership hand them that rope? Since when is 60 votes the new 51?