Todd J. Zywicki, professor of law at the George Mason University law and a senior scholar at the university's Mercatus Center, has an article in the Wall Street Journal in which he says, Don't Let Judges Tear Up Mortgage Contracts: That's the last thing troubled securities markets need. One could go further and suggest not letting ministers or the leader of the opposition tear them up either.
Zywicki opens his piece by saying
The nation faces a foreclosure crisis of historic proportions, and there is an understandable desire on the part of the federal government to "do something" to help. House Judiciary Chairman John Conyers's bill, which is moving swiftly through Congress (and companion legislation introduced by Sen. Richard Durbin) would allow bankruptcy judges to modify home mortgages by reducing both the interest rate and principal amount on the loan. This would be a profound mistake.Take note politicians. Zywicki continues
In the first place, mortgage costs will rise. If bankruptcy judges can rewrite mortgage loans after they are made, it will increase the risk of mortgage lending at the time they are made. Increased risk increases the overall cost of lending, which in turn will require future borrowers to pay higher interest rates and upfront costs, such as higher down payments and points.He also notes that incentives matter,
Allowing mortgage modification in bankruptcy also could unleash a torrent of bankruptcies. To gain a sense of the potential size of the problem, consider that about 800,000 American families filed for bankruptcy in 2007. Rising unemployment and the weakening economy pushed the number near one million in 2008. But by recent count, some five million homeowners are currently delinquent on their mortgages and some 12 million to 15 million homeowners owe more on their mortgages than the home is worth. If even a fraction of those homeowners file for bankruptcy to reduce their interest rates or strip down their principal amounts to the value of their homes, we could see an unprecedented surge in filings, overwhelming the bankruptcy system.Zywicki also notes that the law of unintended consequences could come into play,
Finally, a bankruptcy proceeding sweeps in all of the filer's other debts, including credit cards, car loans, unpaid medical bills, etc. This means that a surge in new bankruptcy filings, brought about by a judge's power to modify mortgages, could destabilize the market for all other types of consumer credit.But there are other problems,
A bankruptcy judge's power to reset interest rates and strip down principal to the value of the property sets up a dynamic that will fail to help many needy homeowners, and also reward bankruptcy abuse.Zywicki sees as more worrisome is the opportunity for abuse.
Consider that the pending legislation requires the judge to set the interest rate at the prime rate plus "a reasonable premium for risk." Question: What is a reasonable risk premium for an already risky subprime borrower who has filed for bankruptcy and is getting the equivalent of a new loan with nothing down?
In a competitive market, such a mortgage would likely fetch a double-digit interest rate -- comparable to the rate they already have. Thus, the bankruptcy plan would offer either no relief at all to a subprime borrower, or the bankruptcy judge would set the interest rate at a submarket rate, apparently violating the premise of the statute and piling further harm on the lender.
Imagine the following situation: A few years ago a borrower took out a $300,000 loan with nothing down to buy a new house. The house rises in value to $400,000, at which time he refinances or takes out a home-equity loan to buy a big-screen TV and expensive vacations. He still has no equity in the house.But sill other problems could arise as any modification of a mortgage during bankruptcy will almost certainly increase the losses of mortgage lenders, and this may further freeze credit markets.
The house subsequently falls in value to $250,000, at which point the borrower files for bankruptcy, the mortgage principal is written down, and the homeowner keeps all the goodies purchased with the home-equity loan. Several years from now, however, the house appreciates in value back to $300,000 or more -- at which point the homeowner sells the house for a tidy profit.
The reason is that when mortgage-backed securities were created, they provided no allocation of how losses were to be assessed in the event that Congress would do something inconceivable, such as permitting modification of home mortgages in bankruptcy. According to a Standard & Poor's study, most mortgage-backed securities provide that bankruptcy losses (at least above a certain initial carve-out) should be assessed pro rata across all tranches of securities holders. Given the likelihood of an explosion of bankruptcy filings and mortgage losses through bankruptcy, these pro rata sharing provisions likely will be triggered. Thus, the holders of the most senior, lowest-risk trances would be assessed losses on the same basis as the most junior, riskiest tranches.In summary,
The implications of this are obvious and potentially severe: The uncertainty will exacerbate the already existing uncertainty in the financial system, further freezing credit markets.
If Congress wants to deal with the rising number of foreclosures, it should not create a new mess by converting the mortgage crisis into a bankruptcy crisis. Doing so will open the door to a host of unintended consequences that will further freeze credit markets, raise interest rates for new home buyers, and spread the mortgage contagion to other types of consumer credit.The logic of this applies outside of the US. The problems Zywicki identifies would arise if politicians attempt to interfere with mortgages even in countries with different legal rules.