Solving The Housing Crisis Via The Bankruptcy Courts

So how are you going to feel when your neighbor who paid about the same as you for your house and borrowed about the same amount as you did gets his mortgage chopped down by a bankruptcy court? That’s likely to be reality within a month or two.

The WSJ has an article that argues what a lot of others including me have for some time. Cramdowns are going to be a center point of the Obama/Congressional scheme to turn around the economy.

If you are unfamiliar with the term, here’s how the Journal describes the process:

In a cram-down, a judge modifies a loan, often reducing principal so a borrower can afford it. Lenders hate it because they have to absorb the loss. Bankruptcy judges currently have the ability to modify certain personal loans and even mortgages on vacation homes, but they can not cram-down mortgages on primary residences.

President-elect Obama indicated his inclination to bankruptcy reform to allow cram-downs during his campaign and two main Congressional players-Barney Frank and Christoper Dodd-have made no secret of their affinity for the program. Given that sort of backing and the Democratic majority I think you can call it a done deal.

There are only a few problems with the idea.

Think about how the courts are going to handle this. There will be a tidal wave of BK’s. No way on earth that they can handle the crunch of say ten or twenty million petitioners. As the cases wind their way through the system, the payments will likely be stayed and a lot of people will live mortgage payment free while the owners of the mortgage, many of whom we have already bailed out, will get hammered.

Neither the bar nor the American consumer is a fool. This will be a bonanza for the legal profession that will likely rival the asbestos saga. The consumer will look at it and say why not. Miss a couple of payments, suffer a recoverable hit on your credit report and get a hundred thou knocked off what you owe. How hard a decision is that? Who knows, Congress may outlaw reporting the mortgage delinquencies with enough pressure for a double win.

And of course, no investor in his right mind is going to invest in any American mortgage security again without a substantial risk premium. So unless we want to see mortgage rates in the neighborhood of credit card rates, the government is going to have to subsidize the business from here to Kingdom come. Which one of those options do you think is going to come about?

One more little problem. If you happen to go out shopping for a home, how are you going to figure out what it’s worth? Sure you can look at comparable sales, but if the records say a guy bought his house for $250,000 but he got $75,000 knocked off by the courts what’s it really worth? Do you really think that the appraisers or lenders are going to search the bankruptcy discharge records for that many transactions?

So when your neighbor smiles at you one morning as he climbs into his brand new car, you might be wary. You might also be a bit put out when he sells his house for less than you owe and walks away with cash in his pocket.

previous posts on the subject: here and here

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