I watched a middle-aged widow lose her home recently. Her story was familiar. She owned her simple brick residence outright until four years ago, when a mortgage broker stopped by and offered her a loan too good to be true. In exchange for taking on a modest monthly payment, she could make some needed repairs and consolidate other debts.
More sophisticated than many borrowers, she realized she was getting an adjustable-rate mortgage. What she didn't realize was that, in the biggest "bait-and-switch" ever pulled by an entire industry, her ARM was not tied to the prime rate or any other index, as adjustable-rate mortgages have traditionally been. Her rate adjusted periodically, ever upward. When it hit 14 percent, her social worker's salary could no longer cover the payments.
I watched this story unfold in court, from my seat in a bankruptcy judge's chair. While a Chapter 13 filing temporarily stopped the foreclosure on this woman's home, it did little more than buy a few months' time.
Under existing law, bankruptcy courts cannot modify the terms of home mortgages. To keep her home, this debtor needed to demonstrate sufficient income not only to make her ongoing payments but also to cover the payments she had defaulted on. Her proposed plan was clearly not feasible based on her salary, so I had no choice but to lift the stay and allow the foreclosure to continue.
Homeowners are the only ones who cannot modify the terms of their secured debts in bankruptcy. Corporate America flocks to bankruptcy courts to do precisely this – to restructure and reamortize loans whose conditions they find onerous or can no longer meet. Airlines are still flying and auto-partsmakers still operating because they have used this powerful tool of the bankruptcy process. But when the bankruptcy code was adopted in 1979, the mortgage industry persuaded Congress that its market was so tightly regulated and conservatively run that it should be exempted from the general bankruptcy rules permitting modification.
How far we have come. For more than a year, a number of legislators, academics, and judges have advocated removing this ban on home mortgage modification to help stem the increasing number of foreclosures.
Allowing modifications is a solid solution. This homeowner could have restructured her loan to terms resembling those of a conventional mortgage. If the court found that the market value of her home had fallen below what she owed, the secured portion that must be repaid in full would be reduced to the house's actual value; otherwise, the amount to be repaid would stay the same. The interest rate would be adjusted to reflect the prevailing market. However, because this home-owner is a riskier borrower than most, I would have raised her rate to account for that increased risk, as Supreme Court precedent requires. Instead of 14 percent, the rate would probably have been in the high single digits. This homeowner – with her steady income – could have made the reduced payments.
Such a solution would have been better for everyone. Obviously, it would have been good for the homeowner and the community in which she lives. Instead of another abandoned house tied up in foreclosure, her residence would be owned by a taxpaying citizen. More important, it would have been good for the lender. Whatever unknown mortgage syndicates hold pieces of this loan, they are never going to get their 14 percent return. Instead, the total recovery will be limited to the proceeds from a foreclosure sale in a depressed market. Any deficiency owed by the homeowner will be discharged as part of her bankruptcy. No one has been able to explain to me why it is not better for mortgage holders to get a fair return of principal, albeit at a lower interest rate, than to take a lump sum through foreclosure that is probably much less than the value of the note.
There is a simple answer to the frequent, hyperbolic assertion that such a process would be abused: Chapter 13 is no walk in the park. It requires public disclosure of every aspect of your life, examinations under oath by a trustee and creditors, allowing creditors to haul you into court on any objection, and relinquishment of control of your financial life for up to five years. If you falter, your case will be dismissed and you will lose the entire benefit of the bankruptcy law, including having your original contract terms reinstated. That is precisely why allowing mortgage modifications is such a good approach. It would elegantly separate those homeowners who desperately need to stay in their homes and have sufficient incomes to make reasonable payments from those investors who bet on lax regulation, easy credit, and an appreciating market in buying residential properties. Those in the latter category will have no use for this process, but for the first category, it could be a powerful step back to financial stability.