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February 16, 2009

Mortgage Cramdown Key to Banking Crisis Unwinding

Democrats want Federal bankruptcy judges to have the authority to reduce the balances outstanding and/or rates on residential first mortgages in the same way that these judges can already reduce outstanding payments and balances on almost all other forms of debt; Republicans are opposing the legislation required to make this change. In my humble (and usually Republican) opinion, the Democrats are right and actually aren't going far enough. This strange treatment of these mortgages, first legislated in 1979 as one of many often misguided attempts to making housing more affordable even for those who couldn't afford a house, is a key cause of the logjam which is preventing the home mortgage toxic security mess from working itself out.

Banks already can negotiate reduction in principal with home owners and sometime do. Chances of repayment go up when the equity isn't underwater. An owner can make a rational decision to sell if he or she doesn't owe more on the mortgage than the house'll bring on the market. But financial experts say that many current mortgages can't be renegotiated because the creditors are split into mind-bewildering tranches of differently securitized investors who have no way or desire to reach agreement. Bankruptcy can cut this Gordian knot and let the mortgages be "marked to market" not only on the books of the banks but also on the books of the homeowners.

It may be that some banks are reluctant to mark mortgages to market because they haven't yet reflected the full loss of value of the underlying assets on their books. If this is the case, the sooner the true value is known, the sooner we know, for better or worse, which banks need to be liquidated.

As with other debts, the debtors and creditors are more likely to reach agreement if they know that a judge will eventually resolve any disagreements in a way neither of them may like. Many more voluntary agreements between mortgagors and mortgagees will be reached if the bankruptcy court is a known option – this is how almost all other situations where a debtor can't pay are resolved. With bankruptcy as a possibility, I'll bet the same Wall Street rocket scientists who figured out the maze of securitizations will get to work and figure a path out of the maze for many of their clients.

The Wall Street Journal, which was very right about the dangerous doings of Fannie Mae and Freddie Mac, is adamantly AGAINST the proposed amendment to the bankruptcy law. Below from an op-ed by George Mason University law professor Todd J. Zywicki:

"Mortgage modification would indeed provide a windfall for some troubled homeowners -- but its costs will be borne by aspiring future homeowners…

"In the first place, mortgage costs will rise. If bankruptcy judges can rewrite mortgage loans after they are made, it will increase the risk of mortgage lending at the time they are made. Increased risk increases the overall cost of lending, which in turn will require future borrowers to pay higher interest rates and upfront costs, such as higher down payments and point…"

Let's dispense with the rhetoric first. Bankruptcy always results in a "windfall" to a distressed debtor. When credit card and car loans are written down in bankruptcy, when the principal of a second home loan is written down, all of these writedowns result in "windfalls". More accurately, the pain is distributed between the creditor and the debtors. The idea is that this court-enforced sharing of pain results in better recovery for everyone overall than simple collapse. One reason the court has to get involved is to enforce requirements for future payments, make the appropriate garnishments, etc. Another reason is that it's often impossible to get 100% agreement from creditors so the final Solomonic decision on pain-sharing needs to be made by a judge.

We have commercial bankruptcies all the time (which the WSJ doesn't rail against) . Here's a description from the NY Times of the bankruptcy of Charter Communications: "Charter, one of the nation's largest cable television operations, said on Thursday that it would file for bankruptcy by April 1 as part of an effort to handle $21 billion in debt. Under the plan it has worked out with some of its creditors, Charter will be able to shave about $8 billion from that amount." $8 billion is quite a "windfall"; note that only "some" of the creditors agree. The purpose of bankruptcy in this case is to reach a settlement which determines the status of all debt and all creditors.

The second assertion in Zywicki's op-ed is that the cost of mortgage credit will go up in the future if banks have to take the risk that a bankruptcy judge will reduce the mortgage at some time in the future. Even if that's true, all that it means is that mortgages rates will fairly price in the ability of the debtor to repay just as other loans do already. That's good and not bad. If it forces the banks to think more about the credit-worthiness of the applicant and not just rely on the value of real estate (which we now know can down as well as up), that's a good thing. This mess was partly caused by giving loans to people who shouldn't have gotten them, remember.

Many of the proposals for making first mortgages on residences subject to bankruptcy deliberately only do this for EXISTING mortgages. This is a misguided attempt to make future mortgages cheaper by eliminating the threat of bankruptcy. We got into the mortgage part of the current mess by deliberately mispricing mortgages compared to other debt. It would be really dumb to sow the same seeds and not expect the same disastrous crop. There shouldn't be an exemption for mortgages or any other kind of private debt in the bankruptcy law.

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