By Mark S. Scarberry, Pepperdine University School of Law
Abstract: Proposed amendments to the Bankruptcy Code permitting strip down of under secured home mortgages to the court-determined value of the homes and other modifications of home mortgages in Chapter 13 would substantially alter the risk characteristics of home mortgages, with likely substantial effects on future mortgage interest rates and future mortgage availability. Thus, the future societal cost of such a change in the law likely would be large.
This article explains and supports that thesis, primarily on the ground that the proposed changes would leave mortgage holders with all of the future downside risk in the real property market while denying them the benefit of future appreciation. This article also explains why a common argument made in favor of allowing strip down as a matter of fairness is simply mistaken; enactment of the proposed amendments would not treat home mortgages the same as other secured debt in Chapter 13 bankruptcy, but in fact would treat home mortgages much less favorably than other secured debt. Home mortgages would be the only secured debts that could be stripped down and paid off at a court-determined interest rate, with monthly payments lower than those required by the credit contract, over a period of up to nearly forty years, rather than the no-more-than-five year period that would still apply to other secured debts.
Additionally, the article provides a brief critique of Professor Adam J. Levitin's empirical studies. Even though serious flaws in his empirical studies have been pointed out, Professor Levitin continues to claim in congressional testimony that "permitting bankruptcy modification is unlikely to result in higher mortgage costs or lower mortgage credit availability." Supporters of strip down in Congress continue to rely heavily on Professor Levitin’s studies as showing that the proposed changes in the law would not substantially affect mortgage interest rates or mortgage availability.
Unfortunately, Professor Levitin's empirical studies, though thoughtful and creative in their design, rely on incorrect understandings of current and past bankruptcy law and of the proposed legislation. They, in effect, compare apples with oranges - or perhaps a bumper crop of apples with a frost-ravaged crop of oranges - by comparing the effects of the kind of strip down that would be widely available under the legislation now before Congress, with the effects of the very different kinds of strip down that, in limited circumstances, are currently available or were at one time available. His studies also fail to take into account the very different incentives that the proposed legislation would create were it to be enacted, both in terms of encouraging debtors with large negative equity to file Chapter 13 bankruptcy petitions and encouraging Chapter 13 debtors to argue for a low value for their homes rather than to report an inflated value. The empirical studies thus do not provide a solid foundation for the making of public policy.
In addition, adoption of the proposed amendments to the Bankruptcy Code would cause somewhat perverse results. Strip down provides the greatest benefit to debtors who have the greatest amount of negative equity. Homeowners who made the lowest down payments, paid the most inflated prices for their homes, and refinanced to take equity out of their homes for purposes of consumption thus would receive the greatest benefits - benefits that would include, in essence, a free option on future appreciation and that would not be well calibrated to the homeowners' financial need - while homeowners who made large down payments, were careful not to pay inflated prices, and did not use their home equity to finance consumption would receive the least benefits.
These perverse results are not only undesirable in and of themselves from a public policy "moral hazard" perspective. They also may cause resentment among those persons who could not benefit from them or who would receive a perversely smaller benefit were they to encounter financial distress and need bankruptcy assistance. In the longer term, such resentment may undermine public support for the primary function of consumer bankruptcy laws: "to grant a fresh start to the honest but unfortunate debtor".
On the other hand, homeowners with substantial negative equity may have little incentive under current law to continue to make mortgage payments. We could expect then that if many homeowners have substantial negative equity, the rate of foreclosures on home mortgages will be high. A high rate of home foreclosures in turn helps to further depress the market prices of homes, harming not only mortgage holders whose homes are sold in foreclosure at low prices, but also homeowners who have faithfully paid their mortgages and whose home values drop when foreclosure strikes nearby homes. Thus, the foreclosures that occur due to negative equity have an indirect effect on the wealth of homeowners who have not defaulted on their mortgages. On a broader scale, the effect may be a downward spiral in which negative equity causes a high foreclosure level, which causes home prices to drop, which creates additional negative equity, which then causes foreclosure levels to remain high, which causes home prices to drop further, and so on. It is possible that steps taken to reduce the levels of negative equity, including allowing homeowners to strip down their mortgages, could help stop the spiral, help home values stabilize, and help bring the current high foreclosure rate back to a historically normal level.
But how could this be accomplished without causing unacceptable effects on future mortgage affordability and availability, without creating perverse results, and without triggering substantial resentment? First, any legislation that permits strip down should include a strong provision for recapture by the mortgage holder of a substantial portion of any future upturn in the value of the home. Such a provision would minimize the effect of strip down on the risk characteristics of mortgages by preserving for mortgage holders most of the benefit of a future upturn in the market for homes. It would also minimize the perverse effects of strip down by denying the homeowner the free option on future appreciation that strip down otherwise would provide, and it would, as a result, help to minimize resentment. Second, any such legislation should have clear eligibility criteria designed to minimize the negative effects that likely otherwise would occur. And third, alternatives should be considered to the kind of strip down that the current legislative proposals would permit, perhaps alternatives based on approach taken in the Obama administration's program for modification of home mortgages, the Home Affordable Modification Program. Any such legislation should limit home mortgage modification to mortgages originated prior to January 1, 2008, by which time it had become very clear that the nation had entered a serious mortgage crisis, such that Congress was actively considering legislation to deal with the crisis, including home mortgage strip down legislation.
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Response from Adam J. Levitin, Georgetown University Law Center:
Abstract: Professor Mark Scarberry has put forth a formidable critique of my empirical study of mortgage market sensitivity to bankruptcy modification risk. As this response shows, however, his critique does not hold up under scrutiny.
Professor Scarberry argues that my study design is invalid because, as he reads the current state of the law, cramdown is virtually impossible. Therefore, he contends, we should not expect markets to exhibit sensitivity to cramdown risk, so no policy conclusions can be derived from my finding of market insensitivity.
Regrettably, Professor Scarberry overreads the state of the law. The law is in fact unsettled, and that is all that is necessary to uphold the validity of my study’s design because the market can be expected to price for uncertainty about the law, and the absence of such a premium is significant.
This response article also challenges Professor Scarberry’s contention that Chapter 13 relief should be limited lest it engender “resentment” of debtors. The article questions whether prevention of resentment even provides a sound basis for limiting bankruptcy relief, much less when relief would further an important macroeconomic goal of housing market stabilization.
More broadly, the article takes issues with claims about the sanctity of secured credit. Debates about the efficiency of secured credit have all played out in the business context. In the consumer context, however, the inefficiency is manifest. Treating secured credit as inviolable would take us back to the unhappy future of Chapter XIII with higher costs for unsecured credit and the abusive consumer finance world of Williams v. Walker-Thomas.
Download response here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1534912&rec=1&srcabs=1520794