Adam Levitin at Credit Slips has a big beef with a lot of the critics of the idea of mortgage cramdowns as an alternative to foreclosure. For the most part, they don’t know what they are talking about.
That charge may sound extreme. but Levitin makes a persuasive case. First, the only empirical work done on the question supports the cramdown case. Second, many of the charges made about cramdowns misconstrue (often badly) how the process works. Levitin charitably assumes these mischaracterizations result from ignorance, rather than a cynical effort to muddy the waters.
Levitin may unwittingly assume that readers have some familiarity with how the proposed mortgage procedures would work They are not being invented out of whole cloth; the same mechanisms have been used for some time in corporate bankruptcies. A key element of the “cramdown” that Levitin mentions merely in passing, is that that mortgage principal is written down to the value of the property (the rest of the mortgage balance is treated as unsecured debt and included along with the borrower’s other unsecured debts. And this makes sense. Push come to shove, if the borrower is upside down, the mortgage is worth no more than the value of the collateral. The bank is in fact going to get less than the market value of the property (it has foreclosure, carrying, maintenance, and selling costs).
From Credit Slips:
I’ve written extensively (see here, here, e.g.) on why permitting modification of mortgages in bankruptcy would generally not result in higher credit costs or less credit availability…. it’s worth repeating some of the key points and making some new ones.
(1) The key comparison is bankruptcy modification versus foreclosure. Opponents of bankruptcy modification often misframe the issue, whether deliberately or ignorantly. It is not a question of bankruptcy losses versus no losses, but bankruptcy losses versus foreclosure losses. If bankruptcy losses are less than foreclosure losses, the market will not price against bankruptcy modification. This is an empirical question, and to date, my work with Joshua Goodman is the only evidence on it. Opponents of bankruptcy modification have only been able to respond with plain-out concocted numbers (e.g., the Mortgage Bankers Association) or insistence on applying economic theory that looks at the wrong question.
(2) Economic theory tells us that cramdown is unlikely to have much impact on mortgage credit costs going forward. The ability to cramdown a mortgage (reduce the secured debt to the value of the property) is essentially an option borrowers hold to protect themselves from negative equity. It is a costly option to exercise–it requires filing for bankruptcy, and that has serious costs and consequences. More importantly, though, cramdown is typically an out-of-the-money option. It is only in-the-money when (1) property values are falling enough that there’s negative equity and (2) likely to remain depressed in the long-term. Long-term declining residential property values have been the historical exception. What this means is going forward there really isn’t much for creditors to worry about with cramdown–homeowners can’t exercise an out-of-the-money option…..
(3) Arguments about bankruptcy court capacity and bankruptcy transaction costs are made by people who have no experience with the actual bankruptcy system. A serious misconception about bankruptcy modification is the belief that the bankruptcy judge would decide how to rewrite the mortgage. That’s not how bankruptcy works. The debtor (and debtor’s counsel) would propose a repayment plan that includes a mortgage modification. The judge either confirms or denies the plan, depending on whether it meets the necessary statutory requirements. This means that bankruptcy judges can actually handle significant consumer bankruptcy case volume. If you want proof that the bankruptcy courts can handle a huge surge in filings, look at what happened in the fall of 2005, before BAPCPA went effective. The courts survived that flood of filings. Today the bankruptcy courts are better prepared; there are more bankruptcy judges (thank you BAPCPA) than in fall 2005. Nor would there be tremendous time and money lost in valuation disputes. After there are a handful of cases decided in a district, all the attorneys know what the likely outcomes would be in future cases and settle on valuations consensually. Court capacity and excessive transaction cost arguments are made by people who have never stepped foot into bankruptcy court.
(4) There’s no other serious option on the table…..Bankruptcy modification is the only game in town, and to pretend otherwise is disingenuous cover for opposing it in the name of “studying all the options.”