As pretty much everyone realizes by now, the Obama administration’s efforts to convince banks to modify troubled loans has been little more than window dressing. Despite the $75 billion promised to fund the program, only a fraction of the people it was intended to help have received any aid. The problem of homeowner defaults has only increased with rising unemployment, and with around one in four borrowers underwater, the current incentives for loan modifications are just too little, too late.
Earlier this year, the banking industry managed to avoid a change to the bankruptcy code that would have permitted bankruptcy judges to “cram down” the outstanding principal of a loan to the current market value. Predictably, the financial industry (as evidenced by this opinion piece in the Wall Street Journal) was aghast at such an idea, arguing that it would drive up the costs of borrowing and further inhibit lending. But, the cramdown concept has recently reemerged on Capitol Hill, championed by Barney Frank.
Although it seems strange to allow a bankruptcy judge to effectively renegotiate the terms of a loan after it has soured, judges already do this all the time. The only difference is that they do it on behalf of commercial real estate borrowers — just not homeowners, as a result of a quirk in the bankruptcy code. If the concept of cramdown were so fundamentally unfair to lenders, why would it exist in the commercial context?
The answer is that, strange as it may seem, cramdown is not at all unfair, and is actually a remarkably efficient tool for detoxifying troubled real estate loans. The real beauty of the cramdown lies in the fact that it provides leverage to the borrower to renegotiate the loan. Knowing that they might get crammed down, lenders usually prefer a negotiated solution with the borrower, which is quicker, cheaper, and more efficient than taking their chances with a bankruptcy judge. Without such leverage, the bank has little incentive to avoid simply going forward with foreclosure proceedings and taking back the property.
California has an anti-deficiency statute, meaning that banks who advanced purchase money on 1 to 4 unit properties can’t seek a deficiency judgment from defaulting homeowners for the amount they can’t recover from selling the property. (Of course, even without such protection, you usually can’t collect a deficiency judgment from a bankrupt debtor.) Thus, as a practical matter, banks already eat the entire loss after a foreclosure, leading me to seriously question the argument that permitting a cramdown in such a situation would really increase borrowing costs to any significant degree.
Now, in late 2009, it has become apparent that rising unemployment has (for now, at least) caused many homeowners to be forced to the brink of foreclosure without any obvious way out. Providing homeowners the protection that is already guaranteed to commercial borrowers would simply even the playing field. Congress should reconsider the wisdom of prohibiting cramdown for home loans. To reduce losses to lenders, the code could include protections, such as profit participation for lenders if the residence were profitably sold within a certain period of time. This would provide a benefit that lenders don’t currently enjoy in the foreclosure context – since they typically try to unload foreclosed properties quickly. Finally, cramdown should only be permitted where the borrower can show that they are in a position to be able to make the (reduced) payment after the principal amount has been reduced to the market price.