Foreclosure fix: Change Chapter 13
Real Estate News from the We Buy Houses Team
RALEIGH - As the mortgage meltdown continues, the federal government has bailed out some financial firms and let others fail. Foreclosures are at unprecedented levels, forcing people from their homes, decimating neighborhoods and depressing the real estate market. An amendment to the bankruptcy law that allows homeowners to modify mortgages in Chapter 13 bankruptcy cases would stem the tide of this financial tsunami.
Why? Many subprime loans were two-year adjustable rate loans (ARMS). The initial relatively low interest rates adjusted in two years to significantly higher rates. A typical initial adjustment was from 7.5 percent to 10.5 percent, increasing the payment on a $200,000 loan by $388.
Wall Street created investment opportunities from these mortgages by taking the “stream of payments” and packaging them into securities. These securities were appealing to investors because the ARMS provided an increasing income stream when the rates adjusted upward.
Unfortunately, the income streams have been illusory. When the payments jumped, many borrowers defaulted, and a defaulted loan has no income stream.
The safety net for the owners of bad loans has traditionally been the value of the real estate securing the loan. The unprecedented level of foreclosures has undermined these values and cut holes into the safety net through which Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae and Freddie Mac have fallen. Reducing the number of foreclosures is the first step in restoring normalcy to the real estate and financial markets.
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CHAPTER 13 ALLOWS HOMEOWNERS TO STOP FORECLOSURES, but not as effectively as it could. Under current law, homeowners who are behind on their mortgages can stop foreclosures by filing Chapter 13, but their rights are limited to making the contractual payments while “curing” missed payments through their bankruptcy plan. The law prohibits modifying the loan to lower the interest rate or reduce the amount of the debt to the value of the home. Without the ability to do so, many homeowners can’t afford to make the payments necessary to stop a foreclosure.
U.S. Rep. Brad Miller, D.-N.C., sponsored a bill last year that allows a Chapter 13 debtor to modify a home loan by reducing the amount of the debt to the fair market value of the home, adjusting the interest rate to current market rates (plus a risk factor) and paying the modified loan over the remaining term of the loan.
Such modifications of secured debts are not unusual. In bankruptcy, all that separates the rights of a secured creditor from those of an unsecured creditor is the secured creditor’s right to repossess or foreclose upon his collateral, sell it and apply the proceeds of the sale to the payment of the debt. The principle underlying the right to modify secured debts is that when all is said and done, the secured creditor receives as much as it would upon selling its collateral.
Under existing law, debts secured by rental or commercial real estate or by personal property can be modified. The exclusion to the modification of loans secured by an individual’s most cherished asset, his home, is puzzling. The removal of that exclusion would enable hundreds of thousands of additional homeowners to avoid foreclosure.
This proposal involves lawyers, bankruptcy judges and other court personnel. Who is going to pay the costs?
The homeowners will pay the costs. They pay for their attorneys and for the administrative costs of the bankruptcy proceeding through their filing fees ($274 per case).
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THE MORTGAGE INDUSTRY OBJECTS TO THE PROPOSED LAW. Its objections have no merit.
* First, it says allowing modifications will increase the interest rates for everyone else. This is not so. The law currently allows modification of car loans, commercial loans and real estate investment loans without any increase in interest rates to other borrowers.
* Second, it argues that it is voluntarily modifying mortgages through industry programs and that nothing more is needed. The industry cites modification statistics, but what those numbers don’t reveal is the quality of the modifications. Mortgage defaults at the end of June were at 9 percent, a record high. If industry programs are working so well, why isn’t the number of foreclosures abating? Furthermore, bankruptcy modifications will not eliminate voluntary ones, just provide an alternative — an alternative that will enhance both the quantity and quality of voluntary modifications.
* Finally, the industry argues that fees from these cases will provide a “windfall” to bankruptcy lawyers.
The clients who voluntarily pay the fees are not likely to agree. In most cases, 80 percent to 90 percent of the fees are paid as part of the bankruptcy plan. If the plan fails, the attorney is not paid. Attorneys have both professional obligations and financial incentives to file cases only for homeowners with reasonable chances to succeed. When a case is successful and the client saves his home, he is more apt to view the fees as money well-earned rather than a windfall.
Amending the law will divert loans from foreclosure. The current remedies aren’t working. It is past time to give it a try.