Why the Bankruptcy Change is Important
Thanks to Masaccio for explaining what Dick Durbin is trying to do with the bankruptcy provisions on the bailout bill. It sure sounds like it would be a pretty darned sensible way to keep people in their houses. -ew
The Bankruptcy Answer
Why are Democrats pushing to include the bankruptcy revisions in the bailout bill? Let’s see what happens to a troubled mortgage in a Chapter 13. Suppose we have a subprime mortgage. The note has an interest rate of 9%, principle of $200,000, and a 30 year term. The house cost $210,000, so there was a 5% down payment.
The family made the income level by aggregating the income of husband and wife. One loses a job, they get behind, and then they get a new job paying a lot less. They file Chapter 13. The point of the Plan is to offer a proposal to repay their creditors, including taxes, secured debt, and unsecured debt. The Bankruptcy Code dictates how much they have to contribute from their paychecks. The amount is basically the difference between their income and their allowed expenses. Both of these terms are defined in the Bankruptcy Code, and are sort of like your natural understanding, but not quite. The money goes to the Chapter 13 Trustee, who distributes it in accordance with the Plan.
The Plan will deal with the mortgage note by cutting it back. First, we get a fair appraisal of the value of the house in its real estate market today. Let’s say it comes in at $180,000. The current rate for good mortgage loans is 6.0% for 30 years. The family agrees to pay $1,079.19 at that rate and for that term, plus an additional amount for taxes and insurance. If their statutory current income is enough to cover this payment, the expenses defined in the Code, and pay something towards the rest of their debt, the Bankruptcy Court can approve the Plan. If their actual income minus the Plan payments is enough to cover their actual living expenses, they should be able to live reasonably well. So they propose a Plan with those term, including the changes to the mortgage.
When the case is filed, the loan service company gets notice. The notice includes the Plan (or the Plan is sent along later), and the servicing company will have plenty of time to consider it. The servicer sends the notice to the holder of the mortgage. This might be a CDO Trustee with a name like Deutsche Bank as Trustee for MSAMPS Trust Series 103-A, or it may be the actual lender. Either the servicing company or the holder of the note is responsible for dealing with the Plan. They can either accept the proposal, or negotiate an acceptable arrangement with the family, or object and have a hearing and a court ruling. If the note holder doesn’t participate, the Plan goes forward, and the note holder is bound. When that is done, the family can go forward with the revised Plan, or convert to Chapter 7 and give up the house. Actually, I suppose they might negotiate an arrangement to keep the house in a Chapter 7, but they have no leverage.
When the Bankruptcy Judge approves the Plan, the terms of the note and mortgage are changed. The family pays the statutory amount for 5 years, and then just pays the mortgage with the changed terms. The servicer collects the payments, and distributes them as instructed by the note holder. The holder of the CDO gets whatever the Plan says. This eliminates the requirement that the holders of the CDO have to approve by a majority or supermajority. This has proved to be one of the major impediments to voluntary work-outs.
Now the family has a reason to keep the house: they are paying what it is worth at a fair rate, and have the real possibility of owning the house some day.
From the note holder’s point of view, the new price should be workable for the family, so they have accomplished a sale at roughly the current value. This avoids the costs and delays of foreclosure. And, more important, the price at a foreclosure is almost always worse than the current market price. Why is that? Only very rarely is the purchaser at a foreclosure the actual user. Third party buyers want to buy below market and make a profit on resale. So, by selling to the family, the noteholder gets the best possible price.
From the point of view of society, this is a good outcome. It gives stability to the market, by not dumping more houses on the market. It is good for families, by relieving them of financial stress. And, if the government has bought the toxic waste, it gives us all confidence that we got a good deal.
This alternative won’t be available to speculators. They can do exactly the same thing in Chapter 11, or they can just fail. Most of the other complaints are coming from the lenders, whose interests we should ignore. My alternative for them is to wallow in the failure pit where they belong.
The one problem with the collateral being securities…not the mortgages and the tax payer being on the hook with the securities. It may create a problem with pricing the securities to get the taxpayer out of this transaction.
I believe it will reduce the price of the securities. If this is included the US should pay less for the securities because we have created a possible reduction on the income stream.
The problem of pricing is complicated. In general, the Treasury ought to figure out not the income stream predicted by the interest rate on the securities, but the actual rates indicated by the performance of the underlying notes. I won’t go into the complexities of that, but my example shows that the income will be greater than it would be if the house is foreclosed.
Thank you, masaccio.
Thanks for the explanation. I’d like to see the bailout include a massive government sponsored refinancing program. The government would get an accurate appraisal of the home and, if the current occupant could qualify at a reasonable fixed rate, force the lender to eat the difference. People with a decent chance of staying in their home would be helped and a whole lot of those securitized products would have a market value. It’s not fair, but hey, handing those idiots on Wall Street a trillion or so dollars ain’t fair either.
Why should this fictional couple have to have the stigma of bankruptcy which will pound them into the ground for five to seven years when the only real thing they need to do is retool their mortgage? Doesn’t this create a whole lot of administrative costs with both debtor and creditor likely paying attorneys to navigate the process? What about the congestion to the BK court dockets and the trustee calendars? Do we need more BK judges? How are they going to get appointed in time? Speaking of time, won’t this process take a godawful amount of it?
There must be a better way than funneling all these people through BK court…..
I have never seen a case where the couple could handle everything except an excessive amount due on a mortgage. Generally people pay mortgage debt and let other things slide: credit cards, medical bills, and so on, because they need a place to live. So, the bankruptcy cleans up their debt situation in full. I didn’t mention it, but the note holder gets a claim for the difference between the amount due on the note and the amount of the new note, so they get a bit more.
If our couple loses the house in foreclosure, they will presumably have to file bankruptcy anyway because of that debt together with the deficiency on the mortgage foreclosure.
We don’t have hearings in bankruptcy court very often, because bankruptcy lawyers realize that the cost of evidentiary hearings is too great considering the actual amount in controversy. (Actually, most of us aren’t really litigators, and we over-prepare to make up for it.)
Take my example. I put the house at $180,000, down $30K. Suppose the lawyer for the Debtor got an appraisal at $150K and the mortgage servicer got one at $180K. The hearing would cost at least $7.5K, including experts, and the court is likely to come in the range. Experienced lawyers will figure out the right price.
I know that sounds unlikely, and it is unlikely in areas where the bankruptcy lawyers are unreasonable, like NYC and Delaware, but across most of the country, it will get worked out. It won’t take long for the Bankruptcy Judges in the contentious states to beat reality into their bar.
Finally, I suppose this seems like moralizing, but one of the main goals of most Chapter 13 Trustees is to teach people to live without consumer debt. I know we need debt to handle a house, and maybe a car, but we need to learn not to borrow for other stuff. If our couple has an emergency fund, they can pay cash for the refrigerator if theirs goes out. Or, they can go to Goodwill and buy a used one cheap, and give it back when they can afford a new one. The loss of credit is not always a bad thing.
Yes, but would that be as true if there were a way to refinance a bad mortgage ahead of time, before payments jump $1500/month?
I wholeheartedly agree. For many debtors caught up in bad mortgages, ruthlessly sold, it’s the mortgage that sends them to bankruptcy, which itself creates enormous hurdles in achieving financial and personal recovery from economic peril.
A better solution would be a WPA-like agency, nationally headquartered, but with small offices in the most badly hit towns, where the houses and families are. It would be staffed by specialists and be focused solely on working out “qualifying mortgages”. (How about access to GI Bill like benefits for the thousands of people needed to staff these for several years?)
The agency would have the legal power to enforce its decisions and to penalize creditors and debtors who abuse it. But it would not involve the procedures, the costs and delays, and the stigma, inevitable in bankruptcy court. Those courts, after all, will still be working overtime to deal with the myriad of other problems, medical debts, job losses, divorce, that lead to financial ruin. Importantly, this agency’s rules would prohibit the refinancing of a mortgage through this process from being used by credit rating agencies to downgrade a debtor’s credit. There would be teeth with which to chew creditors and rating agencies who do it anyway.
Bankruptcy reform itself, which should be high on the Democrats’ agenda, we’ll save for another time.
I’ve been wondering about capacity myself. But a couple points.
1) Much of the process that masaccio describes sounds like underwriting, which should have been done in the first place but under Alt-A lending and the frantic pace of automated “underwriting” in 2004 to 2006 or 7, wasn’t. Therefore there are people who know how to set up a system that BK judges could use.
2) A lot of mortgage industry firms don’t exist anymore. Some of them let go of workers who are competent enough to do the underwriting. (Not all, according to numerous horror stories, however.)
On the other hand, I’ll bet that without some bulk remedy the worst bottleneck would be dealing with the CDO trustees. That’s where the mass purchase ideas look better than perhaps they should. Of course, as there really aren’t all that many CDO trustees, it’s easy to imagine some strategic behavior going on there.
Dean Baker’s own-to-rent proposal would start out similarly, but as a foreclosure workout instead of a bankruptcy so in principle there would be less exposure for the troubled borrower and the process would work through a somewhat larger bureaucratic channel. Also this proposal could make it possible for more lower income people to stay in their homes sustainably, since as Dean points out the banks might be willing to take a bigger discount to avoid managing a landlord business.
One thing about this era though, I don’t think bankruptcy is in practice going to be quite as great or enduring a stigma as it has been.
You highlight an essential feature of a workable plan that most commentators ignore or can’t explain.
For this to work, the plan has to cram down, that is, force the new mortgage terms onto the CDO holders. Otherwise, representatives of the CDO holders dither, not wanting to be responsible for the costs of their decisions. They force a court hearing, prolonging events and escalating costs, in order to show the CDO holders that they moved heaven and earth to protect their interests, but were forced by evil bankruptcy court judges to accept revised mortgage terms. The cost of that CYA is enormous.
The cram down makes a lot of economic and moral sense. It requires a practical, timely mechanism to establish revised market values — typically, the new principal amount of the bankrupt debtor’s mortgage. It requires statutorily mandating a clean mortgage — but not a Paulson, “don’t ask me what I’m gonna do, but authorize it anyway” kinda clean. By clean, I mean short, sensible and comprehensible. When you know what you’re getting into, it’s easier to meet your obligations; Bush’s administration demonstrates the dangers of reversing that logic.
In the mortgage arena, clean means editing out in bankruptcy the most egregious mortgage terms, according to a uniform pattern: exorbitant fees, egregious cross-default obligations, penalty rates, pre-payment penalties and the like.
Having accepted reasonable mortgage terms and a lower market value to the home, it ups the odds enormously that many people can stay in their homes, ending the nightmare of having sometimes hundreds of houses simultaneously in foreclosure in a single neighborhood. Kids stay in school; stability and lower family tension increases their odds of learning. Greater stability at home increases the odds a wage earner will be more productive at work. Communities have more reliable tax revenues, making it easier to manage schools and libraries, repair streets, keep them passable in bad weather, ad infinitum.
CDO holders take a hit, as may those who sold them the CDO’s, which is where much of the pain should fall. But the process is predictable, with an economic floor that corresponds to the real world decline in the value of the assets supporting the paper they bought, which makes the pain manageable, not worth that second bottle of XO brandy or jumping out the window onto the rocks of the North Shore.
For those worried about their vacation homes in the Hamptons and their multi-million dollar bonuses, none of this matters. They are financially and socially removed from public funded communities. But to 95% of Americans, this kind of practical stability is vital.
American taxpayers, as the lenders of last resort for bankrupt financial institutions, should still get an equity stake, limit executive compensation (those managers, after all, managed their firms into the ground), and demand translucent, timely, documented oversight over how Congress and Wall Street spend their money. Imagine what that oversight would look like if it were Citibank’s money at risk, then double it, because Citi wouldn’t touch these loans with a Cuban cigar.
is any of this retroactive, cuz I got two empty houses on my block
one was a speculative-investment home, the other was a primary residence
any hope for these people ???
I’m afraid not. But it sounds like a buying opportunity: offer the banks $10,000 and see what happens.
Thanks masaccio.
digg
You wholly misunderstand that whole “stigma of bankruptcy” thing.
Speaking to the ordinary folks, lLenders and the moneyed pitch the idea that a bankruptcy will ruin your credit – and treat the credit of bankrupts accordingly – not because it is true, but rather because it is false. They continue pitching this falsehoold and spend a lot of money on doing so because it is profitable to them.
Hhere’s how and why.
Let us assume our hypothetical couple goes into bankruptcy. It matters not which chapter we are discussing.
At the moment they file bankruptcy, they get several things. First, they get a court order, called the “automatic stay”, which freezes all collection efforts, lawsuits, foreclosures, bill collector calls, and prohibits creditors from taking the family’s money or stuff. It’s an injunction issued by the bankruptcy court, whose purpose is to stop the status quo until the bankruptcy court and the Trustee can get a handle on the case, process it, and go forward. If any creditor wants “relief from the automatic stay” (which means permission to proceed with whatever they were doing) they have to make a motion to the bankruptcy court and show a good reason (laid out in the Bankruptcy code; too complicated to go into detail here).
That motion and such will take the better part of a month at a bare minimum before anything can proceed. No foreclosure sale, etc.
When our couple files the bankruptcy, everything they own becomes part of what is called the “bankruptcy estate”. They own outright nothing anymore. They have an interest in the property, but it is all subject to the Bankruptcy and the Bankruptcy Court. There are exemptions from bankruptcy: clothing, professional tools, a car, certain household goods, a whole laundry list. Those will, up to a certain dollar value in each category, pass through the bankruptcy and back to the debtor. The remainder of their property will remain in the bankruptcy estate, to be divvied up among the creditors.
At the end, the debtor will get what is called a “discharge”. The discharge is a judgment which nullifies all debts remaining after the divvying up of the property in the Bankruptcy estate. In a Chapter 13, you get your discharge when you complete the payments under the plan. That takes 5 years, ordinarily. In a Chapter 7, you get your discharge a lot earlier, but you don’t get to keep your stuff like you do in a 13, and more debts are exempted from discharge.
And with your discharge, you get a fresh start. That means, for example, your credit is clean. There are no debts from before which would impair your ability (based on whatever your income is) to pay a debt.
There is a time frame within which you cannot file a new bankruptcy. For a Chapter 7, last time I looked, you had to wait 6 years from the most recent discharge to file a new one. So, all the debts you incur after your Chapter 7 discharge cannot be wiped out for at least 6 years. This is where the creditors make their money. They know there is no way you can screw them out of their payments for at least six years. So, when you file bankruptcy, they will bombard you with credit card offers. Because, not only can they not be screwed by a new bankruptcy, but they know (because you went bankrupt) that you have no idea how to handle credit. They troll bankruptcy filings (its all computerized now) to get the info.
It’s like you moved into a drug-dealer-infested neighborhood with a big sign that says “hopeless junkie” on your back.
In a 13, it’s a bit different, because you can file again before the six years, but with the credit counseling requirements, you can’t just wake up this morning and decide to go bankrupt. Your creditors will know, and have worked out ways to profit from that.
All the while, they’ve been propagandizing how going bankrupt means your credit is ruined, you’re a bad risk, etc. All of which allows them to play that they are really doing you a favor by condescending to give you new credit, but you’ll have to pay a higher rate for it. And because you believe the propaganda, you’ll thank them for it.
See?
As you implicitly note, the worst part of the whole thing is that you can’t file again for 8 years. Good bankruptcy lawyers don’t file unless they are pretty sure that the client can manage under that rule. That means checking to make sure the client has health care coverage, a decent job and enough to pay for the education of their kids in that community.
Debtors are required to go to a financial education class in connection with their case. Hopefully they learn enough to protect themselves from credit, to live within their means, and to save up for a rainy day.
Thanks so much masaccio.
I might add. The financial education classes should become required high school curriculum for high school graduation. Then in the future we might limit the number of cases before the court. Systemic, preventative medicine.
Thanks massaccio. No time to do your post justice right now, but really, really appreciate it.
Same qu’s as bmaz.
Also… can you tell whether this ‘bailout bill’ covers just the principle on outstanding loans, or are we also bailing out interest…? Do you have a good source for this info…?
masaccio, I’m unsure of who you mean in the above by “actual user”.
In the olden days (pre-bubble?), and at least here in my neck of the woods, the buyer at a Sheriff’s Sale of a foreclosed home was typically the mortgage provider, and they typically bid at outstanding loan amount.
There was no way the mortgage provider would let a 3rd-party bidder sneak in with a lower bid to “steal” their property.
The rationale by the mortgage provider was to attempt to avoid losing any amount of money due them from the underlying loan.
And again, pre-bubble, the mortgage provider was betting that they could re-sell the foreclosed home at a minimal cost that itself would be covered by perpetual rising home values.
As I say, this was typical here pre-bubble.
From my understanding now, the mortgage holders have been now delaying putting their loan customers into foreclosure until at least the equity versus amount past due zeros out and only then reluctantly because of the post-bubble (but pre-bailout) falling house values means that the mortgage holder is surely going to lose money*.
*PMI (or LMI) – Private Mortgage Insurance (or more accurately Lenders Mortgage Insurance):
Did I say that mortgage lenders would loose money? Because of PMI, a more accurate statement might be that Insurance companies will be biting the bullet. Or not. They, of course, typically then pass their increased costs on to their customers.
So, just who all is losing that money?
Only the Shadow knows!
“Actual user” is “the people who live there”
In current conditions, the mortgagee might let someone slip in if they decided it was worth less than the outstanding amount, or if there was someone crooked in the bank whose cousin-in-law’s brother needed to make some money.
Only a relatively small number of mortgages have PMI, and those will be reasonably safe. The insurance almost certainly has terms that require the lender to foreclose rather than wait for the equity to vanish.
Whether it has anything to do with the fact that Canada has not had a mortgage meltdown or not, the vast majority of residential mortgages in Canada are insured by either a Crown Corporation or one of its commercial competitors, which have fairly stringent underwriting requirements in return for the insurance. By law any high-ratio mortgage by a bank (over 75% LTV) must be insured. Domestic banking in Canada is fairly boring, very profitable business. When our banks have gotten into trouble (nothing they cant handle) it has been when they dabbled in the US markets with their investment bank subsidiaries and in Latin America, looking for big windfalls.
I agree with Masaccio that restricted access to credit is not such a bad thing, although in many cases the temptation that comes from credit cards is exacerbated by stagnant incomes that have not expanded enough to meet the rising cost of living and the cost of actually commuting to far away jobs (gas, cars, insurance, daycare, times two if both partners are commuters). With respect to the treatment of mortgages in bankruptcy, a few thoughts from north of the border. First, I have never had a foreclosure (and I’ve done a lot) cover the first mortgage, let alone any of the subsequent encumbrances, so a form of stay/consumer proposal/bankruptcy or judicial workout is in everyone’s interest, including the family. Should the new mortgage include a covenant to pay by the bankrupt borrowers? From a Canadian perspective, our mortgages are not “without recourse” to the income and other assets of the borrower, which I don’t think is the case in a lot of the US, so no Jingle Mail up here. I don’t know how much this would prevent default or prevent predatory lending, but it is worth considering. How about a covenant not to further encumber the home until a certain percentage of the mortgage is paid down (not just a rise in equity that is only as good as the appraisal). This would prevent predatory lenders from seeking to put new 2nd mortgages (as HELCOs really are), and eating up the social good that the bankruptcy process is trying to accomplish.
The idea of covenants in the revised mortgage is a good one. If we get this bill, I’ll use this and the other ideas from scribe and earlofhuntington.
masaccio, your plan makes total sense. Save the little guy who is the engine of this economy anyway.
That the Bush Administration misses every opportunity to miss every opportunity (to use a well worn phrase in reference to a different world leader now forming dust in the dust bin of history) to help the little guy tells me plenty.
Somewhat on topic: Why are Democrats so eager to cave on this bail out, too? Reading Ian’s posts on Firedoglake today, I’m left flabbergasted with the inability of our Congress to walk straight.
Is there any overarching meaning to this madness? a wish to keep foreign investors from owning America and her secrets for instance?
Who actually owns the banks we (meaning Congress) are talking about bailing out?
Is Merril Lynch majority-owned or near-majority-owned by foreign powers? Lehman Bros? How about Citibank?
How about the banks in less dire straits (that we are aware of) such as Goldman Sachs? I read an unsubstantiated rumor a while ago that Goldman Sachs is CIA’s bank of choice).
Just wondering if the kabuki has any backstory we (correction, “I”) don’t hear about…yet.
By the same logic, failed lenders should be required to attend financial education classes to learn enough to protect themselves from the embarrassment of having to beg for a government handout after a lifetime of posturing about The Holy Wisdom of Unfettered Markets, to learn to live without exorbitant leverage, and to save up for the next trendy wave of innovative relaxations of the regulatory framework.
Not to go a little OT…
It seems an easy question to ask on the “McCain” insurance plan…
Those firms, you think can buy up all the bad credit and pay insurance…What do we do when they belly up and cannot pay? Of course, THEN we are back bailing out again.
masaccio, this bankruptcy plan needs LOTS of press. It will sit well with voters.
There have been efforts to get press at the national level, but it just doesn’t penetrate the fog of nonsense out there. A number of years ago, I was in state government, and a large financial institution failed. I got several calls from the big city newspapers, and not one of them understood the regulatory structures, let alone the possible solutions.
Then we need to spotlight this post like crazy…It might make an impact?
masaccio, I have been trying to get an answer to a question since yesterday. Why isn’t the netroots taking a stand on specific policy ideas on this? I’ve asked and no one answers…A few of us emailed hugh’s list to specific parties yesterday…But no netroots movement is emerging…
I thought the netroots was the modern day equivalent to Thomas Paine’s Common Sense which began some pretty amazing grassroots movements… if I recall correctly…
I’ve asked myself that question. I think it must be that people think this problem is so complicated that only experts can offer solutions. Of course there are problems only solvable by experts, like epidemics or flood protection. It may be that in broad outline this problem is one of those. That probably makes most of the leaders of the netroots reluctant to get involved.
But, the bankruptcy answer is one of the solutions offered by experts. I know some of the people who are working for it, and they are smart and connected. There is tremendous pushback from the lending industry over this, and for some reason the dems don’t have the spine to tell industry lobbyists to sit down and shut up. I would. The anger in the country is great enough to overwhelm the foolish industry that caused the problem.
(my bold)
All the more reason for the netroots to get involved and give them some spine.
We, the netroots, will not be able to criticize the Dems about a lack of spine ever again if we do not mobilize a policy and get it out there.
Thanks for answering my questions. Thanks for taking the time on such important issues.
Obama doesn’t want bankruptcy reform added to the bailout! Is this because he’ll think about it if he’s elected, some time during his rein, because it’s too complicated, or because it’s show that Biden, who thought the change in bankruptcy was the best thing since sliced bread or is it because Obama is a closet DLCer?
I don’t know why he doesn’t like the plan, particularly because Dick Durbin is pushing it. I know the industry hates it, which may make it impossible to pass, but I don’t understand why anyone cares about the industry either. So, who knows?
Hey masaccio,
I think a policy point list for people to fax or call in might be helpful right now. My credit union just issued a statement that our funds are safe and insured.
There are “runs” starting to happen at banks… The banks are having to put out PR statements to calm fears.
Buyer Beware:
This may work just fine in markets that have already seen the bottom. However in the most bubbly markets this is just setting folks up for failure because the markets take a long time to go back to equilibrium. They could still end up owing much more than the house it worth which also makes them much more likely to default a second time.
A second wave of defaults will impact the paper that the Treasury is proposing that we buy.
I agree that it may not be the bottom. From the standpoint of an owner, however, the question is whether they can make the payments. If they can, they have a house and a hope of equity in the future. If they can’t, they should just let the property foreclose and move now.