Opinion: Keeping bankruptcy judges, and logic, at bay

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Free-marketeers and banking industry allies cheered yesterday when the Senate buried a proposal to let bankruptcy judges ‘cram down’ home mortgage debt. Under current law, when homeowners file for personal bankruptcy, the court cannot alter the terms of the loans they hold on the homes they live in. Loans for vacation homes, investment properties, farms, commercial bulidings are all fair game for bankruptcy judges, but principle-residence mortgages are not. As a result, mortgage holders who file for bankruptcy are pretty much compelled to sell their homes to pay off whatever they owe. On Thursday, Sen. Dick Durbin (D-Ill.) sponsored an amendment to S 895, a bill to avert some foreclosures that would have put home mortgages on the same bankruptcy footing as other types of loans, but the amendment was defeated, 51-45.

Score another one for bank-industry lobbyists, who persuasively argued that exposing home mortgages to cramdowns would raise future interest rates. Of course it would. But so what?

One of the Big Important Lessons of the most recent housing bubble is that the U.S. has gone too far in its efforts to encourage home ownership. Guarding against cramdowns is one of several ways the feds and states work to make home ownership more affordable; others include the tax deduction for mortgage interest, measures that cap property tax increases (such as California’s Proposition 13), and federal mortgage guarantee and insurance programs. These mechanisms have not just reduced the price of borrowing enough to allow some renters to buy houses; they’ve also encouraged speculators to try to create wealth out of thin air by betting the banks’ money on rising property values. Many banks were happy to go along for the ride even if it meant lending sums that couldn’t possibly be repaid. They just wanted the fees from the loan, not the long-term revenue stream, which they sold (along with the risk of default) to investors -- among them Fannie Mae and Freddie Mac, which Congress created and maintained ostensibly to protect would-be borrowers against a shortage of loans.

Traditionally, lenders assumed the repayment or credit risk, which was offset by their ability to repossess and resell the properties in question. Borrowers, meanwhile, assumed the investment risk -- that is, the risk that the property wouldn’t prove to be as valuable as they’d hoped. Allowing bankruptcy courts to cram down home mortgage debt would make lenders share some of the investment risk with borrower, and they would almost certainly respond by charging higher interest rates (although the experience with farm and commercial loans suggests the increase would be small). More important, though, they’d also pay a lot more attention to the borrower’s ability to repay. And after the debacle we’re still mired in, who doesn’t want that?

I understand the moral hazard argument. Responsible folks would suffer in the future if we intervened on behalf of the binge borrowers. Setting aside for a moment the number of borrowers who aren’t to blame for their current troubles (e.g., those who lost their jobs, or who were fraudulently steered into subprime loans), consider what the aid here would be. Judges would have the power to write down mortgage debt only to the point that it matches the current, presumably depressed value of the house. If borrowers couldn’t afford the payments at that level, there would be no cramdown. In other words, write-downs would happen only if they were better for the lenders in the long run than foreclosing and reselling the home.

Rational lenders would be doing those modifications anyway, regardless of the indignation felt by ‘responsible’ homeowners. But a large percentage of the loans in trouble are owned by investors (through complex securities) and managed by loan servicing companies, which have been deterred from writing down debt by opposition from investors. The mere prospect of cramdowns may help servicers overcome investors’ reluctance to making significant but economically rational modifications before borrowers go into bankruptcy. Of course, the banking industry might have prefered the alternative offered by S 895: it would provide servicers that modify loans immunity against investors’ lawsuits. But that’s more of an assault on the sanctity of contracts than allowing cramdowns would be -- the bankruptcy process, after all, is designed to tear up contracts in an effort to mitigate all parties’ losses.