Monday, December 26, 2011

Housing and/or Bankruptcy Reform

So far, we’ve fixed Social Security and reformed personal income taxes to make them both more equitable and reduce the deficit. We’ve also solved the problem of corporate personhood, as well as finally acknowledging the equal status of women. And we’ve established the need for another stimulus package, shown that it can be done on the cheap, and proposed one targeted at providing aid to states, addressing dramatic infrastructure needs and helping out the little guy a bit.
On to housing. Or bankruptcy reform.
Let’s do both.
Right now, housing is a mess. At least 22% of all mortgages are under water, and maybe as many as 29%. That's 10.7 million homes at a minimum, and 14.1 million homes as the max. One out of every twelve mortgages is delinquent, and one in every twenty-five mortgages is in foreclosure. All told, one in eight mortgages is either delinquent or in foreclosure -- some 6.4 million homes. And, with the size of the average American household being 2.6 people, that means that 16.6 million people are at risk of losing their homes. That's bigger than the population of fourteen states plus the District of Columbia!

And for those homes in foreclosure, they tend to be massively delinquent. Seventy-two per cent haven’t made any payments in at least a year, and almost 40% haven’t made a payment in two. In July of this year, the average delinquency for loans in foreclosure was 599 days
Foreclosure obviously sucks – hard – for the borrower. But it also sucks for the lender. Foreclosure processes are costly, take a long time, and then the lender has to sell the home into a depressed market. In 2010, loss severity – the percentage of the principal lost – was 44% for prime loans. For Alt-A loans, loss severity was 59%, and sub-prime loss severity was 75%. And Fitch (the lesser known of the three major rating agencies, after Standard & Poor’s and Moodyz) predicted that things would get a couple notches worse in 2011, with sub-prime loss severity going to 80 -85%.
And it gets worse. The lender is responsible for the foreclosed home until it’s able to resell it. On a banal note, that means the lender is on the hook for property taxes, further reducing its net take. But the lender is also responsible for the upkeep of the home, though few take this seriously. As a result, many foreclosed homes are now turning into mold factories, as many as 50% in some states.
Black mold in a Los Angeles home.
Foreclosure, in the best of times, is a brutal and ugly process. Foreclosures during a massive recession are a nightmare.
So what’s the way out of this mess? A couple of years ago, it looked like HAMP (Home Affordable Modification Program) and HARP (Home Affordable Refinancing Program) might do the trick. HAMP was designed to help homeowners at risk of foreclosure, and HARP was a more general refinancing program. Both have been disasters. 
HAMP actually resulted in increases in principal – not reductions – for some 80% of participants. Perhaps not coincidentally, the default rate for modified loans runs as high as 40% within one year of the modificationHARP was supposed to help three to four millions homeowners, but so far only about 900,000 folk have participated.
Oddly, if the mortgage were pretty much any other kind of debt , the borrower could seek refuge in bankruptcy. Bankruptcy judges have the power to “cramdown.” What this means is that the judge can disregard the original contract and ostensibly fashion a new one, with a reduced principal amount, a lower interest rate or a longer term – or a combination of all three and more. The bankruptcy judge then crams this new contract down the throat of the lender.
(For a more technically accurate but still eminently readable explanation of how this works, see this CreditSlips post. And, by the way, it didn't always work this way. Cramdowns on mortgages were permitted until 1993. )
While the lender isn’t happy – lenders in bankruptcy never are – they often should be. The simple idea behind this practice is that liquidation – foreclosing on the home and distributing the proceeds – often doesn’t maximize returns to the lenders. It seems weird to forgive a borrower his debt – this idea is known as moral hazard – but it’s often the most economically sound thing to do. It’s making the best of a crappy situation.
So one solution would be to treat mortgage debt like every other debt. And that’s what Congress tried to do in 2009, before the Senate killed the bill. But there’s actually a better solution -- Chapter M bankruptcy -- proposed by Adam Levitin, a professor of law at Georgetown. 
In a Chapter M, all foreclosure actions would be automatically removed from state court to federal bankruptcy court. If the lender prevailed in the foreclosure action, then the homeowner would be offered a standardized pre-packaged bankruptcy plan. The plan could be based on HAMP modification guidelines (interest rate reduction to achieve 31% DTI goal, but without federal funding) plus cramdown to address negative equity. 
If the homeowner were willing and able to pay under the plan, the homeowner would keep the house. Otherwise, the foreclosure sale would be completed on an expedited, standardized basis (say 45 days to sale) through a bankruptcy trustee’s sale, which gives good title to the purchaser. The homeowner’s non-mortgage debts would “ride-thru” unaffected. If the homeowner redefaulted, the same expedited foreclosure process would apply. 
A Chapter M process would address negative equity (including second liens), as well as affordability. It would also remove mortgage servicers from the modification process, thereby eliminating servicer capacity and incentive issues. 
A Chapter M might be more attractive to mortgage lenders than traditional Chapter 13 cramdown option because it offers a fast-tracked, standardized foreclosure process, quick foreclosure upon redefault, court-ordered protection of property against homeowner destruction during foreclosure, and the ability to provide clean title. 
Chapter M would have no affect on non-mortgage lenders. Like Chapter 13 modification, Chapter M would have no cost to the federal government and would be immediately available, using existing courts and Chapter 7 panel trustees for sales. Unlike Chapter 13, Chapter M would avoid the adverse selection problem, as all homeowners in foreclosure choose between paying per standardized terms or losing the house quickly.
One of the chief advantages to both the traditional cramdown and Chapter M ideas is that they don’t actually need to be used to be effective. Knowing that this option exists for homeowners should act as an incentive for lenders to agree to loan modifications and refinancing before turning to more drastic --and expensive -- alternatives.
This solution is actually a win-win situation. People get to stay in their homes, and lenders end up with more in their pockets than they would have had by foreclosing.
We can do this.

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