Friday, February 27, 2009

Responding to Schwartz on Mortgage Modification

By Bob Lawless (Credit Slips):

Professor Alan Schwartz of Yale University has an op-ed in today's New York Times arguing against the proposals to give bankruptcy judges the power to modify home mortgages. For our readers who do not know him, Professor Schwartz is a respected academic and bankruptcy expert, but with all due respect, I think he just gets this wrong. He makes three principal points, but none of them are a good reason not to move forward with this much-needed legislation.

First, Schwartz says that the proposal would swamp the bankruptcy courts and the nation's 300 bankruptcy judges. That seems empirically dubious given that my forecast of 1.4 million filings this year is below the number of filings in 2002 - 2004, when the annual filing rate was around 1.6 million filings and we had about the same number of bankruptcy judges. Even if the mortgage modification bill resulted in hundreds of thousands of extra filings in the short term, we still would be below the 2 million bankruptcy cases in 2005 when filings surged ahead of the draconian new bankruptcy law. The bankruptcy system survived those filing levels and should handle any increases that would come from mortgage modification.

Schwartz's tag-along point--that the "flood of new cases would delay the resolution of business bankruptcies, to the detriment of the economy"--is opaque and seems especially tendentious. If we're talking about big corporate bankruptcies, we're talking about a couple hundred cases per year concentrated in a few jurisdictions like Manhattan and Delaware. It does not seem likely mortgage modification would act to the detriment of the judicial docket in these jurisdictions. In any event, the federal courts can and do assign judges to a different jurisdiction when necessary to meet a temporary increase in caseload.

Schwartz's second major argument against mortgage modification is that many debtors will be disappointed because they will not get as much relief as they think. Mortgage modification is essentially a battle over the valuation of the residence. Debtors and their lenders will put on competing evidence at a trial. Schwartz notes lenders will win many of these cases because they have more expertise and more resources. Debtors certainly are at a disadvantage when dealing with powerful and large financial institutions, but that is true inside and outside of bankruptcy court. The disadvantage would seem to be a reason to get consumer debtors into court rather than leaving them to the mercy of the financial institutions outside of court.

Schwartz also says that the proposal would worsen economic uncertainty because banks would not know what their collateral is worth. He is right to say that valuation is tough. I'm not as quick to agree that bankruptcy judges are not experts in valuation. It is a lot of what they do, and their judgments are at least not tainted by financial incentives that inescapable in so many professional appraisals. Schwartz also seems to argue against himself when he says that valuations are a shot in the dart that will be affected by the judge's personal sympathies. He had just said that debtors would lose a lot of these cases because of the financial institution's resources, but now he seems to be saying they would win a lot of the cases because the judges will sympathize with the consumers. (I am assuming the financial institutions would not attract the sympathy of very many, bankruptcy judges included.)

This last argument seems to come down to an argument that we're hearing a lot from the mortgage industry--bad stuff will happen if we give bankruptcy judges this power. Lending will shrink, exactly at a time when we can't let it, and interest rates will go up. It is, of course, easy to point to an unknown future and say it will be bad (just as it is easy for me to assure people it will be OK). A point I often make is that before the 1993 decision in Nobelman, many courts had decided the bankruptcy law did give bankruptcy judges the power to modify home mortgages. The sky did not fall then, and I don't expect it to happen if that power is restored.

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