How judges might help troubled homeowners

As Congress debates cram-down legislation, it should consider Philadelphia's success story.

Remember fieldtrips? All 535 members of Congress should take one this week to Room 675 of the County Courthouse in Philadelphia. Doing so would bust some myths surrounding the "cram down" legislation – now stalled in the Senate – that would allow bankruptcy judges to reduce payments on troubled mortgages.

Most financial services executives oppose this bill, saying desperate homeowners would flood the courts and inexperienced judges would make uninformed decisions – creating uncertainty about mortgage repayment that would spur lenders to raise interest rates.

But what's happening in Philadelphia might change the minds of both bankers and policymakers. Judges there now require delinquent homeowners and their lenders to talk in mediation before the sheriff can auction off a home. Of the 2,300 homeowners who've participated, 4 out of 5 still have their homes. Philadelphia's experience shows what happens when the lender and homeowner know a judge could take a seat at the negotiating table. That's what bankruptcy judges could do if they were given the power to modify loans.

First, the courts don't get overwhelmed with distressed homeowners. Very few cases in Philadelphia go before a judge. Mediation usually results in an agreement satisfactory to both the lender and borrower. That's because when judges can compel action, successful out-of-court negotiations follow.

The same would be true if bankruptcy judges could modify loans. The mythical floodgates wouldn't swing wide open. If lenders knew a bankruptcy filing could result in a loan modification, they would try to find a settlement out of bankruptcy court. Homeowners also wouldn't rush to court. Bankruptcy under Chapter 13 requires the borrower to adhere to a strict, court-supervised budget and virtually all their disposable income goes to pay down debt. That's not a choice people make lightly. On the other hand, some homeowners might choose it if they could save their home.

Second, the court's involvement in Philadelphia appears to save lenders money. "Our clients are happy," said David Fein, an attorney with Goldbeck, McCafferty & McKeever who represents national and local mortgage companies. "We've been able to work out a fair number of these loans, much more so than before the program was in existence."

Similarly, lenders wouldn't always be financial losers in bankruptcy courts. They would face smaller losses from bankruptcy modifications than from foreclosure, according to Adam Levitin, a bankruptcy specialist at Georgetown University Law School. So there's no reason lenders would raise prices on mortgages to compensate for potential losses from bankruptcies, according to Mr. Levitin, despite the claims of financial services executives.

State and local officials from across the country have visited Philadelphia to determine if they can craft something similar back home. Not every community has the local and state laws and regulations that enabled Philadelphia officials to create their program. So the systemic way to realize similar nationwide benefits is through the bankruptcy courts.

Bankruptcy judges would have ample experience to draw on. The law allows them to "cram down" repayments on debts for cars, credit cards, and even second homes. The approach helps bankrupt borrowers succeed in repaying their debts and assures creditors of at least partial repayment, giving consumers who want to pay off their debts a fighting chance of court-supervised success.

Philadelphia shows us that when borrowers have a judge in their corner, lenders will negotiate in good faith; the courts don't get clogged; and both borrowers and lenders come out ahead. Applying these lessons nationally by changing the bankruptcy code makes sense. President Obama supports this change and the House passed the necessary legislation earlier this month. Now it's the Senate's turn to stand up for cram downs and for the negotiations they will encourage.

Ellen Seidman is a senior fellow at the New America Foundation and was formerly the director of the federal Office of Thrift Supervision. Anne Stuhldreher is a fellow at the New America Foundation.

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