Posted by Todd Zywicki:
Bankruptcy Mortgage Modification Update:
http://volokh.com/archives/archive_2009_03_01-2009_03_07.shtml#1236371508
One of[1] my concerns about allowing modification of mortgages in
bankruptcy was that it might refreeze credit markets because of
provisions in mortgage-backed securities that allocate bankruptcy
losses above a certain threshold pro rata to all tranches of MBS's.
Yesterday the House passed a revised version of the legislation that
contains [2]this remarkable clause (section 124):
SEC. 124. UNENFORCEABILITY OF CERTAIN PROVISION AS BEING CONTRARY
TO PUBLIC POLICY.
No provision in any investment contract between a servicer and a
securitization vehicle or investor in effect as of the date of
enactment of this Act that requires excess bankruptcy losses that
exceed a certain dollar amount on residential mortgages to be borne
by classes of certificates on a pro rata basis that refers to types
of bankruptcy losses that could not have been incurred under the
law in effect at the time such contract was entered into shall be
enforceable, as such provision shall be contrary to public policy.
Notwithstanding this section, such reference to types of bankruptcy
losses that could have been incurred under the law in effect at the
time such contract was entered into shall be enforceable.
So to deal with the problem, Congress will simply declare those
loss-allocation provisions in those contracts to be simply
"unenforceable... as being contrary to public policy." Well, I have to
confess that provision really just leaves me speechless. Has anyone
ever seen anything like this--just a blanket declaration that a
particular contract term is simply void against public policy, when it
is a freely-bargained for, risk-allocation term? Does it solve the
potential credit freeze problem? I guess it depends on how those
losses will be allocated when there is no longer any contract term by
which to allocate them. Especially given that the whole point of that
contract term was to be the catch-all for losses that are not
otherwise allocated under the MBS contracts. It is hard to see how
this provision alone solves the problem of the uncertainty in valuing
these securities if we don't know how the losses will otherwise be
allocated.
I had also read reports that indicated that there were new protections
in the legislation for recoupment by lenders when a borrower sells a
home for a profit after stripping it down in bankruptcy. If so, I
can't find it. All that I see is the same restrictions, namely that if
the debtor sells the house while in bankruptcy there is a sliding
scale starting at 80% recoupment in the first year down to 20% in the
fourth year, but I don't see anything post-discharge, unless I missed
something in reading through the legislation.
While on this topic should also note that I should correct the record
on one minor point in my WSJ column on which I made a mistake. It
relates to the precise effect of modification eliminating the ability
to modify car loans in the 2005 bankruptcy amendments. In the article
I referred to a recent [3]NY Fed Staff report that looked at the
elimination of the ability to modify car loans ("cramdown") in the
2005 bankruptcy reform legislation. The authors of the study found
that eliminating the cramdown power substantially reduced interest
rates on auto loans. But this finding was not the centerpiece of their
paper and so they didn't report the actual estimate of the reduction
in interest rates as a result. They were interested in the effect of
exemption laws on car loan interest rates, not this intermediate step.
I mis-read the paper as reporting a 265 basis point drop in the spread
on car loans as a result of eliminating the cramdown power (if you
read the paper, or at least the draft as it was at that time, you will
see that it is hard to figure out what the authors are saying). That
was actually the overall mean spread on car loans above the cost of
funds, not the reduction as a result of eliminating the cramdown
power. They stated that it had an effect but didn't report the actual
figure for the reduction in the spread so it turns out that you can't
tell just by looking at the paper itself how large the effect is. The
WSJ asked me for a specific figure that day right before deadline and
I supplied them this figure, which was a mistake.
I asked the authors if they would re-run the regressions and estimate
the actual value of the reduction in the spread as a result of
eliminating the cramdown, which they graciously agreed to do. I
understand that they will be posting an updated version of the paper
that includes this result. But to summarize, they find that the impact
of eliminating cramdown was a reduction in interest rates of 56 or 46
basis points depending on the regression treatment and that this
result is highly statistically significant (at .01 level). So they
estimate that the reduction of the interest rate spread was about 50
basis points off of the 265 average spread, or about a 19 percent drop
in the spread as a result (and an additional 12 points in states with
unlimited exemptions (which is marginally significant). Obviously my
mistake was inadvertent because it was irrelevant to my argument
whether the effect was big and statistically significant or really big
and statistically significant.
One thing that I should add here is that the effect of bankruptcy
reform is not just 15 basis points and marginally significant, as some
readers apparently have concluded. Ironically, I have even been
criticized because I did not accept this finding as the conclusion of
the study. The reason I did not report that finding is because it has
nothing to do with the issue I was looking at. That estimation in the
paper relates to a completely different question--it is a
difference-in-difference regression that looks at whether state
exemption laws have an independent effect on top of the general effect
of eliminating the car loan cramdown. It was obvious to me at the time
that this was not and could not be the correct figure. I knew that I
was looking for a general baseline figure of some sort, and the
authors only mention one baseline figure and read in context I thought
it was the correct one and it was obvious that the
difference-in-difference results was not the correct one. But in fact,
there was another baseline number that they did not report. I won't
belabor the point except to note that the findings in the
difference-in-difference regressions simply are not the correct
estimates of the impact of BAPCPA on car loan interest rates.
So the authors found that effect of BAPCPA on car loan spreads was
substantial in size and highly statistically significant although I
supplied the incorrect point estimate. I should note that the purpose
of citing the study in the article was to simply illustrate the point
that if you increase the risk of lending (such as by allowing
modification of loans) this will lead to higher interest rates and
costs for borrowers, which was shown with statistical significance. I
was not to try to make a prediction about the exact size of the
interest-rate increase that will result.
In fact, whether the effect for cramdown of home mortgages will be
bigger or smaller than for car loans will depend on several factors.
First is the expected risk that property values will fall in the
future, which is different for car loans because cars are depreciating
assets so they will almost certainly decline in value. Second, the
size of the decline--for car loans it is probably a large number of
relatively small decreases in value while for houses the value
declines are likely to be much larger. The size of the decline is also
relevant to how much value a lender might lose relative to losses from
a foreclosure. Third is the risk that bankruptcy judges will tend to
set the interest rates on mortgages in bankruptcy at a below-market
rate, so that the lenders will get less from the modified mortgage
than they would by reinvesting the money. For reasons discussed in my
op-ed, this is likely to be a real risk.
Fourth, and perhaps most importantly, is what will be the effect of
permitting mortgage modification on leading to increased bankruptcy
filings. Cramdown of car loans were different from mortgages in
several ways. Car loans were shorter-term loans and would be paid off
during the Chapter 13 case. As a result, cramdown of a car loan
reduced the payments owed to the secured lender but those savings were
instead just made available to unsecured creditors. So there was no
incentive for borrowers to file bankruptcy just to cramdown car loans
because the debtor would not be able to capture the surplus. With
mortgages, however, it is likely that most homes that are underwater
today will rise in value in the future. And the cramdown will apply
for the entire duration of the loan--up to 30 years. So it extends
beyond the time of the chapter 13 plan. This means that an underwater
borrower today who believes his home will rise in value in the future
will have an incentive to file chapter 13 and capture future
appreciation--an incentive that is absent in the context of car loans.
This means that permitting cramdown of home mortgages will almost
certainly have an incentive effect of increasing bankruptcy filings at
the margin, unlike for car loans. Moreover, there are certainly at
least some people out there who would not be willing to permit
foreclosure on their homes, but would be willing to file bankruptcy if
it meant that they can strip-down their mortgages and capture future
appreciation. So while there will be some substitution of foreclosure
for bankruptcy, there will be a new pool of people who would be
unwilling to permit foreclosure, but would be willing to file
bankruptcy.
We don't know how big this group might be. Supporters of the mortgage
modification proposal argue that this group is likely to be small
because of the difficulties of bankruptcy and the negative impact on
their credit scores and so that those who will file bankruptcy will do
so only as a last resort. That seems unduly optimistic to me. In fact,
a year or two ago there was a general belief that few people would
walk away from their homes just because they were underwater, because
of the hardship of foreclosure and the negative impact on their credit
score. But I think it is abundantly clear at this point that there are
a lot of people who are doing exactly that. And I don't see why we'd
expect the use of bankruptcy to be any different. In fact, in his
recent paper, Eric reports that 48% of homeowners reported in a survey
that they would consider walking away from their homes if underwater
by over $100,000. Moreover, given the huge surge of filings that are
likely to result from allowing mortgage modification, bankruptcy
judges are going to by necessity given only passing scrutiny to these
cases, so the opportunities for fraud and abuse are likely to increase
substantially as well.
So what this means is that we don't know how many people will choose
to file chapter 13 and write-down their mortgage who otherwise would
have not defaulted and instead paid their mortgages. But if the number
of homeowners is nontrivial--and the events of the past two years lead
me to believe that it probably is nontrivial--this will significantly
increase bankruptcy filings. More importantly, it will increase
bankruptcy filings among people who otherwise would not have been in
foreclosure but instead would have paid their contracted loans. So for
this group of borrowers it is a pure loss to the lenders because they
are not saving foreclosure losses.
References
1. http://online.wsj.com/article/SB123449016984380499.html
2. http://thomas.loc.gov/cgi-bin/query/F?c111:1:./temp/~c111lmFAjA:e28327:
3. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1310304
_______________________________________________
Volokh mailing list
[email protected]
http://lists.powerblogs.com/cgi-bin/mailman/listinfo/volokh
