Percolating behind the scenes during the transition period for the new administration is President-elect Obama's support and Democratic Senators' support for a change in bankruptcy law that allows bankruptcy judges to modify the terms of mortgages on primary residences. Currently bankruptcy judges can modify various loans, including on secondary/vacation homes and investment property, but cannot modify loans on primary residences.
That may be coming to an end soon as the new Congress is considering a change in the bankruptcy laws to allow judges to modify loans, including principal reductions (sometimes known as "cramdowns"). The financial services industry has, of course, been very wary of allowing this to happen since it will potentially lead to many homeowners seeking the protection of bankruptcy to obtain home loan modification to a level they can afford. But today according to an article in the Wall Street Journal, in a major reversal, Citigroup expressed support for the Senators' plans to modify the laws to allow principal reduction by bankruptcy judges.
More after the jump...
As I have written before, I think principal reduction is the best way to slow foreclosures as it gives homeowners some hope that they won't be "underwater" on their loan for the next 10 to 15 years and encourages them to continue to make payments on their home. However, banks have been reluctant to undertake principal reductions for several reasons. First, it increases moral hazard among homeowners since they have been essentially bailed out from a contract they signed, and secondly, banks will tend to charge higher interest rates on future mortgages to cover for the risk that homeowners will simply use bankruptcy court to get their loans modified. Finally, some banks/loan servicers aren't able to write down principal because they do not own the loans - the investors in the mortgage-backed securities do.
Of course, using new bankruptcy laws creates several interesting incentives in the loan modification process. First, bankruptcy does carry a higher penalty on credit scores than foreclosures (typically staying on credit reports for 10 years versus 7 years for a foreclosure). So there is some penalty associated with the choice to enter bankruptcy and consumers will have to think hard before using bankruptcy. (However, in some states like Arizona, anti-deficiency statutes already protect many homeowners who would prefer just to walk away from their home and deal with 7 years of bad credit - perhaps still a better option if you don't need to stay in your home.) Secondly, changing the bankruptcy laws may create an incentive for banks to undertake principal reductions on their own prior to entering bankruptcy. They may do this to avoid legal costs associated with bankruptcy. This could lessen the burden on bankruptcy courts.
In trying to figure out why major players in the financial services industry would suddenly get on board with this plan, the only reason I can think of is that they may need backing under the law to convince the investors in mortgage-backed securities that it is in their best interest to permit principal reductions in the portfolio loans. Currently, some loan services/banks may want to reduce principal on the loans they service, but investors holding the RMBS often have to approve any principal reduction under terms of the master servicing agreements (which they are not currently doing). Being able to tell these investors that the alternative is allowing a homeowner to go into bankruptcy, have their principal reduced anyway, and the investors incur additional legal fees, may be the stick banks/loan servicers need to get the investors to agree to principal write-downs.
It also sounds like as part of the deal with Citigroup, Congress is wiiling to protect lenders from some of the repercussions of Truty in Lending Act (TILA) violations - fining banks instead of allowing recission of the loans. Perhaps Citigroup has a huge portfolio of loans that have TILA violations and is worried that class action law suits are soon to come.
Another point that should be raised is that judges in bankruptcy court wouldn't necessarily have to reduce principal all the way to current market value. In Chapter 13 proceedings, judges are generally interested in figuring out a way to get the bankrupt person in a position to be able to pay at least a portion of their current debt with their current income (fyi, I am not a bankruptcy lawyer or expert so this is simply my understanding). I have advocated reducing principal amounts only partially - perhaps 75% of the current underwater amount - so that both bank and homeowner bear some of the burden and the homeowner will have incentive to stay for a few more years until they are no longer underwater, or if they want to sell, to come up with the new, lower deficiency amount to pay to the bank upon sale.
If this new bill becomes law, I will write more about how it affects homeowners in Arizona in relation to Arizona's anti-deficiency statutes. It will add in at least one new option for homeowners in Arizona to consider.
Update: According to the WSJ Law Blog, the National Association of Home Builders has also reversed its opposition to cramdowns - although it doesn't say exactly why they made the change.
Update 2: It sounds like Citigroup acted alone in approving this deal with Congress, as the American Bankers Association indicates it still opposes any sort of bankruptcy law change to allow principal write-downs.
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