Thursday, January 08, 2009

Cramdown

In 2007, Tanta wrote an eloquent description and opinion piece on mortgage principal reduction during bankruptcy, or "cram-downs":

...secured debts can be restructured or modified in a Chapter 13 bankruptcy, and secured creditors, except the mortgage lender on a principal residence, can be subject to what is called a "cram-down." This happens when the amount of the debt is greater than the value of the collateral securing it; the court reduces the value of the secured debt to the market value of the collateral, with the remainder being treated as unsecured (and subject to the same repayment plan/discharge terms as any other unsecured debt).
The cram-down method of restructuring mortgage debt was ruled illegal under current law by the Supreme Court in 1993, so after that time, banks lent money to home buyers with the understanding that bankruptcy judges couldn't discharge mortgage debt as part of Chapter 13. Tanta argued that previous to that time, the threat of arbitrary debt discharge by a court kept lenders on the straight and narrow lending path. Flash forward to 2009, and the cram-down method is back under discussion:
Democratic lawmakers have reached a deal with Citigroup Inc. on a plan to let bankruptcy judges alter home loans in an effort to prevent foreclosures and urged other lenders to follow suit.

The lawmakers aim to attach the plan to President-elect Barack Obama's economic stimulus legislation, and said Thursday the change in bankruptcy law could ease the foreclosure crisis that has dragged the economy into the worst recession in decades.
Taken in isolation, the idea of cram-downs is a good one. Lenders are given an extra incentive to make sure borrowers are taking on affordable loan products, and borrowers are given a fair hearing if they choose the bankruptcy path. The circumstances today are much different, however. The US Taxpayer owns or guarantees almost $6 trillion in mortgage debt. That means when the debt is "crammed," the taxpayer takes the loss, which makes this a bailout by other means. Instead of FHA or FDIC (via its IndyMac proxy) or Barney Frank picking "deserving" home debtors for principle writedowns, bankruptcy judges will do it instead. The taxpayers still eat the loss.

In order for this to work properly, the following caveats must be in place:
  • For any Federal Reserve-held mortgages that are crammed, an equal amount of cash must be retired from the seller's account.
  • For any GSE-held mortgages that are crammed, an equal amount of bondholder equity must be reduced.
  • For any FHA-held mortgages that are crammed, an equal amount of cash must be paid by the originator, builder, or "non-profit" donor organization that assisted in the transaction.
  • For any loan held by the FDIC through a bank seizure that are crammed, an equivalent amount of cash must be paid by over-the-limit depositors, bond holders, or equity holders.
The cram-down concept only works if moral hazard is eliminated. You know what will happen if the taxpayers get the bill.

3 comments :

Darth Toll said...

At some point the Fed is going to have to monetize, or (god forbid) issue their own debt senior to treasuries? That will definitely be crossing the Rubicon...

http://online.wsj.com/article/SB122888021757894023.html

Max said...

I just read that another component of the cram down legislation will be the elimination of prosecution against lenders who violated truth in lending laws.

So it goes.

patient renter said...

I just read that another component of the cram down legislation will be the elimination of prosecution against lenders who violated truth in lending laws.

I was going to say, there has to be a catch. Maybe that's it. Why else would lenders (Citi) voluntarily subject themselves to losses?