January 22, 2009

Real Estate Finance Committee
Federal Issues Committee

(The following is for study only and has NOT been approved by the Board of Directors.)

Issue:
The issue of including primary mortgages in bankruptcy proceedings was last addressed in the early 1990’s.  At that time, NAR and C.A.R. were against the concept, specifically the cramdown provisions allowing bankruptcy court judges to reduce mortgage principal.  However, in the early 1990’s, loans were predominantly fixed rate mortgages, and ALT-A and subprime loans with exploding interest rates were not prevalent in the market.  Times and mortgages have changed dramatically since the last time this issue was taken up by REALTORS®.  Is it time for C.A.R. to revisit this issues considering the current market conditions?

Action:
Action is not required at this time; however, this issue may be included in legislation as early as January including the next economic stimulus package.

Options:
1. Support giving bankruptcy court judges the authority to modify the first-mortgage on a principal residence.
2. Take no action and continue to oppose giving bankruptcy court judges the authority to modify a first-mortgage on a principal residence.
3. Take a neutral position and monitor and report on the issue as it moves forward
4. Support giving bankruptcy court judges the authority to modify a first-mortgage on a principal residence with restrictions and/or guidelines.

Status/Summary:
Senator Durbin (D-IL) has introduced S. 61, the Helping Families Save Their Homes in Bankruptcy Act.  This bill would allow bankruptcy judges to modify mortgage loans on a debtor’s principal residence, so that primary mortgages are treated the same as vacation homes and family farms.  This would allow judges to modify the terms of the loan, including mortgage principal reduction, interest rates, prepayment penalty and length of the loan.  Representative Conyers (D-MI) has introduced a companion bill in the House.  California Senators Feinstein and Boxer have already signed onto the Durbin bill as cosponsors.

The concept of reducing the principal of the loan is known as a “cramdown”.  A cramdown is used when the value of a home is less than the outstanding principal of the loan.  The overall mortgage is not eliminated; however, the judge can reduce the principal of the loan to what the market value of the house is currently at.  The amount reduced on the original principal then becomes unsecured, which is a lower priority in bankruptcy courts, and would likely be discharged.  The bankruptcy judge would have the option of reducing the principal of the loan as well as changing the terms of the loan, including the interest rate.

Similar legislation in the past has been vehemently opposed to by the lending community.  Recently though, Citibank has broken ranks with the lending community to support a stripped down bankruptcy reform proposal.  Citibank has agreed to support a bankruptcy proposal allowing for cramdowns and in return was promised that the legislation would:

• Require borrowers to contact their lender to seek modification at least 10 days before filing for protection.
• Loans would have to have been originated before the bills enactment date.

Many in the lending community are appalled by Citibank’s unilateral movement to secure a deal.  Additionally, many think Citibank should have asked for other concessions such as:

• A sunset date.
• Its application to only nontraditional mortgages, such as Alt-A and Subprime loans.
• A longer notification period than 10 days.

While the lending community is upset with Citibank’s compromise, their statements of missed negotiating opportunities would suggest they are open to the idea of giving judges authority to do cramdowns if it came with certain restraints.  This may be in response to the overwhelming democratic majority’s and president-elect Obama’s calls for quick passage of this legislation.

Background:
The issue of including primary mortgages in bankruptcy proceedings was last addressed in the early 1990’s.  At that time, NAR and C.A.R. were against the concept, specifically the cramdown provisions.  Home loans were not viewed as a threat to a family’s financial wellbeing because it was a steady non-changing payment.

Currently, first mortgages on primary residences cannot be included in Chapter 13 bankruptcy proceedings.  However, mortgages on second homes and investment homes are allowed to be included.

In a bankruptcy proceeding, a judge tries to determine what debts need to be paid, which can be reduced, what terms can be changed to help payoff debts, and if any debt should just be written off.  Unsecured debts, such as credit cards, are lower on the priority list than a secured debt, such as a car payment.  Mortgages would be a secured debt and therefore be higher on the priority list.  The judge would be allowed to address the terms of the loan, the interest rates, and even the principal of the loan in an effort to find a way to create a payment plan so the filer could payoff their debts and emerge from bankruptcy. 

Pro:
These changes to the bankruptcy laws could help address some of the issues of the subprime, Alt-A, predatory lending, homeowners upside down on their loans, and help stem the tide of foreclosures.  Homeowners have little recourse currently available to them as they fight to maintain their mortgages and keep their homes.  Many homeowners have found that their lenders are unable or unwilling to do a loan modification and many loan modifications being done are having little to no effect on actually reducing the monthly costs for a homeowner.  A recent study has shown that over 50 percent of workout loans re-default after six months.  Allowing mortgages into bankruptcy court could give these homeowners the potential to challenge some of these loans and give them an avenue to alter the terms of their loan and allow them to keep their home and continue to pay their mortgage. 

Additionally, it could encourage lenders to be more proactive in helping these struggling homeowners before the mortgage enters into bankruptcy court.  If lenders are worried about a bankruptcy court decision, they could face added incentive to work with the homeowner and find terms acceptable to both the lender and homeowner before the homeowner is forced to decide between foreclosure or bankruptcy.

Con:
There are some fear who allowing mortgages to be included in bankruptcy procedures.  First, if mortgages are allowed in bankruptcy procedures and their principal allowed to be reduced, their value as a security on the secondary market could be put at risk.  This could lead to a reduced secondary market, which would decrease the available capital for the mortgage market.

Additionally, lenders will not be willing to take this increased risk on mortgages without offsets.  This means that lenders could increase interest rates on all mortgages in order to add a layer of security in case large amounts of mortgages enter bankruptcy court and are reduced.  These two changes could dry up an already unstable supply of capital for mortgages as well as possibly increase the costs for mortgages for every homeowner looking to obtain or refinance a mortgage.

Finally, there is a question as to whether or not we want to leave these financial decisions in the hands of a bankruptcy judge.  Are they the right people to make these dramatic financial decisions about loans, especially loans that are bundled and already sold on the secondary market?  Do we want to give a bankruptcy judge the power of acting as the mortgage underwriter, the appraiser, and the judge over other debts and assets as well?

Impact on REALTORS®:
These reforms to bankruptcy law could impact REALTORS® that are working with homeowners in their efforts to keep their homes and/or avoid foreclosure.  This would give homeowners another option, albeit a drastic and potentially adverse option, in fighting to retain their home.  Additionally, it could add leverage to help REALTORS® and homeowners negotiate the terms of the mortgage with the lender and avoid having to go into bankruptcy or foreclosure altogether.

Additionally, it could impact REALTORS® by driving up interest rates and potentially decreasing the amount of capital in the market for mortgages, making it tougher for buyers to secure a mortgage; leading to more deals running into issues if the buyer is unable to secure a mortgage.

Finally, there is a concern that REALTORS® support or opposition to these reforms could carry the risk of alienating group that we have a strong working relationship with and whom have traditionally supported our issues.  This could include consumer groups, lenders, and the secondary mortgage market to name a few.

NAR Policy:
NAR currently has policy from the early 1990’s that opposes cramdowns.  At this point, NAR seems satisfied to not alter their policy, but also not object to bankruptcy reform being included in a stimulus package. 
 
C.A.R. Policy:
C.A.R. currently has policy from the early 1990’s that opposes cramdowns.

Should C.A.R. change its policy on the issue of giving bankruptcy court judges authority to change the loan terms of a first-mortgage on a principal residence?