The longer this foreclosure crisis drags on, the clearer it is that voluntary loan modification programs are inadequate to meet the needs of millions of borrowers with homes worth less than the mortgages. A recent commentary published by the Federal Reserve Bank of Cleveland shows how an old tool could be used in this new context to help underwater borrowers.
The fact that the current modification programs, such as the Home Affordable Modification Program, are voluntary means that homeowners have little power to force reluctant mortgage loan servicers to the bargaining table. While several “judicial foreclosure” jurisdictions (where foreclosures must be approved by a judge) are implementing mandatory or voluntary court-supervised mediation programs that bring homeowners and servicers to the table, such programs are too few to address the nationwide problem of ongoing foreclosures.
Continuing to rely exclusively on voluntary modifications and expect a different result would be irrational and irresponsible. There are other options proven to be more effective at keeping people in their homes, such as allowing judges to modify mortgage loans on primary residences through the bankruptcy process. Under this option, bankruptcy judges would reduce the balance of the mortgage loan to the current market value of the home and turn the remaining balance into an unsecured claim that would be treated the same as other unsecured debts in the Chapter 13 bankruptcy petition. Almost any kind of secured loan, including mortgages on rental properties and vacation homes, can be modified through bankruptcy under current law–except loans for primary residences. When this exclusion was established, housing represented a borrower’s most stable investment. With home values on the decline, a home mortgage now represents many borrowers’ most volatile investment.
When Illinois Senator Dick Durbin proposed the idea of judicial modification for primary residences (S. 61) in 2009, it was shot down by the financial industry as a bankruptcy “cramdown.” Opponents argued that allowing judicial modification would create a “moral hazard” by allowing debtors to get out their debts and discouraging other borrowers who could afford to pay from keeping current on their payments, lead to higher mortgage interest rates/reduce the availability of credit, prompt an avalanche of bankruptcy petitions, and/or give judges too much power.
The Cleveland Fed piece is fascinating because it documents how the same objections were raised in opposition to judicial modification of family farm loans (the process was then called “stripdown”) during the agricultural lending crisis of the 1980’s, and how none of the feared results came to pass after Congress allowed farm mortgage stripdowns by creating a new Chapter 12 of the Bankruptcy Code. According to the authors, “the actual negative impact of the farm stripdown legislation was minor.” Furthermore, “what was most interesting about Chapter 12 is that it worked without working….[I]nstead of flooding bankruptcy courts, Chapter 12 drove the parties to make private loan modifications. In fact, although the General Accounting Office reports that more than 30,000 bankruptcies were expected the year Chapter 12 went into effect, only 8,500 were filed in the first two years” (emphasis mine).
The Chapter 12 reforms have been on the books for more than two decades now. While the authors note that there are some important differences between the agricultural foreclosure crisis of the 1980’s and the current home foreclosure crisis, we can learn some lessons from the earlier crisis. The authors concluded that “the effects of the stripdown provision … on the availability and terms of agricultural credit suggest that there has been little if any economically significant impact on the cost and availability of that credit.”
Now that we understand how allowing judicial modification of mortgages on primary residences through bankruptcy would likely result in most parties negotiating private modifications without causing other significant adverse consequences, it’s time for our policymakers to allow use of this proven tool to help stop the current tsunami of foreclosures.