Vail Valley: Bankruptcies, mortgages and cramdowns, oh my
Continuing with my series of things we all learn about in a financial crisis, let’s look at a new buzzword going around ” “cramdown” ” and what it means in relation to what happens if you are on the brink of bankruptcy and owe more than your real estate is worth.
For many years, bankruptcy judges have had the ability to force some secured creditors into settling a debt for less than face value in certain instances. Primarily these powers have been limited to loans secured by cars, second homes and investment properties. If a lender loaned more than the collateral was worth, the judge could order the creditor to write off the excess. The notable exception to this was a mortgage loan secured by a primary residence.
As a result, for many years mortgage standards have been much tougher for loans secured by investment properties and second homes. A greater down payment was required and tougher income and credit standards were imposed.
In reality, this part of the law seldom came into play for real estate because by the time someone goes bankrupt they usually don’t want their second home anyway and a good investment property can often be sold. If there was a shortfall, the creditor generally accepted the loss without being forced to do so by the courts.
More often, the courts tended to invoke these powers regarding car loans, sometimes to allow the bankrupt borrower to keep at least one car and pay back what the car was actually worth.
The Obama administration is now pushing to amend the bankruptcy code to allow cramdowns on mortgages of owner-occupied homes. This means if your house is worth less than your loan you could potentially file for bankruptcy and have your principal balance reduced to less than what your house is worth.
This is a chilling concept for mortgage lenders to come to grips with because it really could lead to hundreds of thousands of bankruptcies and untold hundreds of millions of dollars in write downs. It also is changing the rules in the middle of the game, and will lead to further tightening of the credit markets and hinder recovery in the housing sector.
It also poses a host of interesting ethical questions. One of the basic tenants of offering long-term financing is the presumption that the borrower is taking the loan out for better or worse. Housing values have always had periods of fluctuation and millions of homeowners over the years have at one time or another been upside down in their equity only to recover a few years later and make a handsome profit.
If cramdowns are allowed, there will certainly be a huge incentive for some homeowners to exploit down markets and declare bankruptcy when they might be well able to afford their house payments, just to get their principal reduced.
In doing so, they may do huge damage to many other aspects of their lives and credit scores but consider it worth it just to play the system and profit when values go back up. Needless to say, lenders don’t like this idea.
If cramdowns are allowed, we will see increased interest rates and tighter lending standards and few mortgage loans being made. Let’s hope this bad idea goes away.
Chris Neuswanger is a mortgage loan originator with Macro Financial Group in Avon and can be reached at 970-748-0342. He welcomes mortgage-related inquiries from readers.