Cram Downs

There have been several articles about mortgage cram downs of late. Today there are reports major lenders may even be willing to accept a new bankruptcy provision in which judges can reduce mortgage principal owed unilaterally so that lenders must write off any balance above the market value of the home. Even the National Association of Home Builders (NAHB) is now in favor.

This idea has been around for a while--but forcefully opposed by industry. The problems often cited include: lenders won't issue mortgage loans or will raise interest rates; judges won't know what true market values are; borrowers will rush to file bankruptcy just to get out of a loan they should have known better than to take out (moral hazard); the bankruptcy courts cannot handle the volume in the exisiting system; and, only lawyers benefit from this.

What's to gain? First, this is one of the only proposals where consumers get a direct 'bail out.' Second, the mere threat may force lenders to do more loan modifications, and may even give lenders more power to force investors to let them do more modifications. Third, it uses an existing structure to get through a financial problem.

There is a long history of the bankruptcy law, revisions and court precedents I won't go into. From an economic point of view having bankruptcy laws are important. They allow firms and consumers to take risks -- think of it a bit like an insurance against financial disaster. (Alternatives like debtor's prison have proved to be less than ideal models.) For various reasons education loans and mortgage loans have received special treatment in bankruptcy. The terms of the loans might be altered in bankruptcy during a repayment period, but the principal cannot be washed away. Cram downs change all that.

Is this a good idea? Well, let's just say it is an idea. Like so many other ideas suggested over the last year to address foreclosures. It will have effects, some intended and some not intended. The key will be to set some limits around how this 'cram down' provision is used. The bankruptcy system would choke if the estimated 8-10 million borrowers who owe more than their home is worth tried to file. Some borrowers would no doubt abuse the system. Judges will make mistakes in marking homes to market values. Some lenders would restrict lending for some time. In the end this is unlikely to be either a disaster or silver bullet...

My guess is lenders are now in favor to (1) throw a political bone as they digest their billions in government investments (2) provide some threat to investors to allow more modifications (3) hope maybe this slows the cycle of foreclosures and falling home values (this is the NAHB's talking point).

The reality is bankruptcy is costly for consumers. Not just the fees (which certainly benefits bankruptcy attorneys, a sector of the profession with some less than reputable actors), but also the damage to credit records which remains for 10 years - 3 more than a foreclosure. And to file consumers have to get counseling prior and take financial education after, account for all income, assets and expenses, and restructure their budget. When they do go back to the credit market they will for sure pay more for credit than before.

Will lenders cut back on lending in the future? Probably, but only at the margins. Low downpayment non-recourse loans seem far less likely for lower-income borrowers, especially those more likely to file for bankruptcy or in historically volatile housing markets. This may not be entirely a bad turn of events.

Will more consumers seek out risky mortgage loans armed with the knowledge of a potential cram down? Probably not. The lure of homeownership remains strong, so few are likely will decide to buy a home only if cram downs are passed.

Some homeowners who are on the fence about defaulting because they owe more than their home is worth may ride out a slump in home values, keep on paying and not file for bankruptcy because they know the costs -- which is exactly the 'insurance-like' role we might hope for.

Other homeowners in real trouble - from a job loss or because of a predatory loan - may really benefit from filing and getting principal reduced (let's hope any illegal predatory loans get prosecuted however).

A few sophisticated borrowers may even be able to use the threat of bankruptcy to induce lender concessions in or before default.

Like so many other strategies proposed in this crisis, only time will tell. A few provisions being suggested may help--such as only for loans made before the cram down law passed and only partial reductions in principal unless there was a violation of lending disclosures. Anything that helps target this to the consumers best served will go a long way.