Foreclosure Offense and Defense: Changing the Bankruptcy Laws

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WASHINGTON (MarketWatch) — For many people, filing for bankruptcy is seen as a scary, worst-case scenario, but consumer advocates say this last resort could be a real help for beleaguered homeowners.

There is no shortage of proposals in Congress to address the housing crisis: the Depression-era Federal Housing Administration is up for a makeover, and there are other plans to ease the stress of pricey mortgages. Under veto threat is a proposal that consumer advocates see as key to helping more people stay in their homes: allowing bankruptcy courts to modify troubled mortgages on primary residences.

Under current Chapter 13 bankruptcy law, courts cannot modify the mortgage on a principal residence, though they may for vacation or second homes. Consumer advocates and others see bankruptcy, which is meant to adjust debt and make it easier for people to repay creditors over time, as an efficient and established method for troubled homeowners to make good.

“The marketplace is designed so that it will protect owners of vacation homes and second homes, but yet a consumer who is struggling to make their mortgage payments cannot include their home,” said David Berenbaum, executive vice president with the National Community Reinvestment Coalition.

A major strength of court-supervised modifications, consumer advocates say, would be their ability to help people who have “piggyback” loans, which are second mortgages taken on homes at the same time as a first mortgage. Struggling homeowners are often urged to seek a loan modification from their lenders, but many second-lien holders won’t allow loans to be modified without being paid out, said Mark Zandi, chief economist of Moody’s Economy.com.

“Second-lien holders are mucking up the process, they don’t want to be subordinated,” Zandi said. “The other limitation is that some mortgage investors are not allowing these modifications to go through because they don’t think it’s in their best interests.”

Generally, a first mortgage gets paid in full, followed by the second, so the holder of the second mortgage has no incentive to support a modification that could cause it to face a 100% loss, said Eric Stein, senior vice president with the Center for Responsible Lending.

“The holder of the second is better off waiting to see if a borrower can make a few payments before foreclosure,” Stein said. And, he said, dealing with two servicers is a “negotiating challenge that most borrowers cannot surmount.”

About 40% of home-purchase mortgages in the first nine months of 2006 involved piggyback loans, according to a report last year from Credit Suisse. That figure jumps to more than 60% in some markets such as Los Angeles, Las Vegas, and Sacramento, according to the report.

Battle over bankruptcy law

 

• Changing bankruptcy law to enable loan modification faces strong opposition from President Bush and may have a tough time in Congress. ”Amending the bankruptcy code in this manner would undermine existing contracts, leading to contraction in mortgage credit availability and affordability,” according to an administration policy statement. “These and other bankruptcy-related provisions in the bill would rewrite long-standing tenets of bankruptcy law in ways that would fundamentally alter the expectations of parties to hundreds of thousands of home purchases after the fact.”

• The Mortgage Bankers Association said a bankruptcy proposal currently in the House of Representatives would give “judges free rein to rewrite these contracts without statutory or economic restraint.” The MBA also said the prospect of the bill’s enactment could prompt more foreclosures. “In the short term, lenders will likely move quickly to foreclosure to ensure that they are not covered by the onerous provisions of this bill,” according to MBA.

• However, CRL’s Stein said bankruptcy changes could act as an incentive for servicers and investors to refinance more loans because they may feel they can get a better deal.

• “It will induce some investors to go and accept a refinance program, and it will also get others to agree to modifications outside of bankruptcy,” Stein said.

• Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies, said bankruptcy reform should be considered, noting that the infrastructure already exists.

• “Particularly, if you look at alternatives like a large federal program,” Retsinas said. “For any new initiative, the government rulemaking will take months or longer.”

• The Congressional Budget Office estimated that the House proposal could encourage some to file for Chapter 13 bankruptcy, resulting in a 4% to 5% increase in annual filings. But there would not be a run to file for bankruptcy, said NCRC’s Berenbaum.

• “Most American homeowners understand the long-term impact of filing for bankruptcy. You have to wait before you can apply for a mortgage again. It impacts your credit,” Berenbaum said.

• Speaking Thursday, Sen. Barack Obama, D-Ill., offered his support for the modification of loans to avoid foreclosure or bankruptcy.
  • “It’s also time to amend our bankruptcy laws,” Obama said, “so families aren’t forced to stick to the terms of a home loan that was predatory or unfair.”

 

Ruth Mantell is a MarketWatch reporter based in Washington.