The downturn in the real estate market two years ago was a major factor in sending America into recession. The subprime mortgage crisis exposed a house of financial cards, and the first wave of mass foreclosures began.
Today, a “new normal” of high unemployment and diminished property values has taken hold. The struggling economy itself, not overly fancy financial instruments, is pushing more and more people into foreclosure. And, for the most part, most of these home foreclosures no longer involve dubious subprime mortgages. Many of the people affected now are those whose jobs were lost during the Great Recession. In the starkest terms, it takes a job (or two) to meet a mortgage payment – and jobs are harder and harder to come by.
Why, then, when the real estate market has become so saturated with foreclosed properties, do bankruptcy judges not have the power to modify mortgages on primary residences? After all, granting judges the power to do so would keep more people in their homes and stabilize neighborhoods.
Mortgage Modification Proposals, Then and Now
Two years ago, Congress considered a proposal to grant bankruptcy judges the power to modify the mortgage principal on primary residences, in a process known colloquially as a “cramdown.” The political dynamics did not come together for passage at that time. But the cramdown proposal is now being seriously discussed again.
One key reason for this is that the Home Affordable Modification Program – the main federal response to the problems of struggling homeowners – has been so utterly ineffective. HAMP was supposed to encourage banks to voluntarily modify mortgage payments. After a three-month trial at a reduced rate, the revised (and lowered) terms were supposed to become permanent.
Instead, the program has been a cross between a misfire and a charade. The problems started with lack of notice to eligible homeowners of HAMP’s existence. Many of those who did assemble all of the necessary paperwork to participate were kicked out after the three-month trial, even if they did make the revised payments. For them, HAMP has been merely an exercise in frustration.
The core problem, at bottom, is insufficient incentives for banks and other lenders to opt in to HAMP, which is a voluntary program. The carrots have not been enough. The result, for many people, has been a mortgage nightmare. Far too often, documentation supporting modification needs to be sent repeatedly, as if into a black hole.
Benefits of Cramdown
Incentives work best when there is also a punitive stick that carries real consequences. If the “carrot” of payments from the HAMP fund is not enough to promote participation by lenders, the next step is to present them with the prospect of a judge ordering a modification.
Granting bankruptcy judges this power would be consistent with the overall purpose of the bankruptcy code: to give (within reason) debtors a fresh start. Under current law, it is inconsistent for judges to be able to modify the terms of debt on investment property, but not on a primary residence.
Originally, this exception to the usual bankruptcy rules may have made sense, as an incentive to the mortgage underwriting industry. The point was to encourage the industry to lend, by allowing lenders to insist on the original terms, even when the homeowner files for bankruptcy.
A Fresh Start for Homeowners
In today’s difficult economic times, however, it doesn’t make sense to keep giving lenders this break. Houses aren’t going up and up in value anymore. In fact, it’s been quite the reverse in recent years. Combine that with the job-loss fallout from a tough economy, and many homeowners are in an unfortunate situation. Hundreds of thousands of them face the real possibility of being out on the street due to foreclosure.
This isn’t only emotionally painful for homeowners. It’s also deeply destabilizing to society, particularly the neighborhoods that have clusters of foreclosed homes. Property values decline for everyone when foreclosures reach a tipping point – and that point has already been passed. It’s time to start repairing the damage by finally giving bankruptcy judges the power to modify mortgages the way they do other types of debt.
To be sure, there are other measures that can also be taken to address the foreclosure crisis. These could include mandatory mediation between lenders and homeowners, or a right-to-rent program for homeowners who have lost their homes to foreclosure. The crisis had multiple causes and so must be addressed on many fronts.
A good place to begin, however, is by granting bankruptcy judges the power to modify mortgage principal on a primary residence. For many, the American dream of home ownership has become an albatross around their necks. When a bankruptcy judge is considering a fair way to lighten the load, mortgage modification should be in the judge’s tool kit.