Back to the drawing board: another look at judicial modifications

As it becomes increasingly clear that voluntary loan modification programs like the Home Affordable Modification Program (HAMP) are woefully insufficient to prevent foreclosures on a meaningful scale, it’s time to consider broader-reaching approaches. The debate on allowing bankruptcy judges to modify the terms of mortgages on primary residences (often referred to as “judicial modification” or “cramdowns”) has quieted down since 2009, when Sen. Dick Durbin (D-IL) introduced a bill that would allow mortgage debt on primary residences to be restructured in Chapter 13 bankruptcy. The bill, called the Helping Families Save Their Homes in Bankruptcy Act (S. 61), didn’t pick up steam. As our president Dory Rand will argue later this week, new analysis has shown that concerns about the negative impacts of judicial modification are likely overblown. Before we take a new look at judicial modification, let’s review what it entails (special thanks to Credit Slips for providing a wealth of information about mortgages in bankruptcy).

In Chapter 13 bankruptcy, a person who is deeply in debt undergoes a financial reorganization by completing a three- to five-year repayment plan to his or her creditors. The debtor generally retains all of his or her property, but he must devote all of his disposable personal income to repaying his creditors over the course of the court-supervised repayment plan. Debt that is backed by collateral, such as a home, is called “secured” debt, while debt that is not backed by collateral, such as credit cards, is called “unsecured.”  Secured debt is composed of two portions: a secured claim up to the value of the collateral; and, an unsecured claim that is the remaining debt beyond the value of the collateral. For example, a debt of $200,000 on a home worth $150,000 would have a $150,000 secured claim and a $50,000 unsecured claim.

Chapter 13 reorganization treats the two kinds of debt differently. The debtor in bankruptcy must pay the full value of the secured claim, while he would pay only a portion of the unsecured debt over the course of the three- to five-year payment plan. For the most part, bankruptcy judges are able to separate the secured and unsecured portions of an outstanding debt and modify the unsecured portion so that the debtor pays only a portion or none of it. In our example, the bankruptcy judge could modify the $200,000 debt so that the debtor has to pay only the $150,000 the home is actually worth—functioning like the principal write-down loan modifications that advocates have been promoting, since it addresses the problem of negative equity, which is a key driver of foreclosure.

Unfortunately, there is an exception in the bankruptcy code that prevents judges from modifying mortgage debt on primary residences in this manner. This means that borrowers with vacation homes, rental properties, or investment properties can effectively have principal written down in bankruptcy, but that remedy is not available for the home they live in and rely on day to day.

The Helping Families Save their Homes in Bankruptcy Act proposed to end that special treatment that primary residence mortgage debt receives and allow judges to treat it the same as virtually all other kinds of debt. It would also have strengthened protections for borrowers in bankruptcy from deceptive and predatory lending practices. Ending the special treatment of primary residence mortgages would likely encourage lenders to seriously engage in offering widespread modifications, mitigate the risk to the economy posed by high foreclosure rates, and keep more families in their homes.

Check back tomorrow when Dory Rand will debunk the objections to judicial modifications of primary residence mortgages. For a detailed discussion of judicial modification in bankruptcy, please see this paper by Georgetown University’s Adam Levitin.