The Onion has a pseudo-survey of what people who are trapped in subprime mortgages are planning to do. In usual Onion fashion, it is both grim and funny. But what ARE families going to do? For all their fulminations, most of the Washington crowd is focused on developing regulations to stop the next credit bubble — not to help millions who will be hurt by this one.
Bankruptcy law is the final arbiter of debtor-creditor rights, but here’s an interesting asymmetry in the law: If a corporation can no longer afford the mortgage on its factory, it has powerful tools to rewrite the mortgage in bankruptcy. But if a homeowner is in exactly the same trouble following an interest rate hike, those same tools are unavailable.
More details: A company that cannot pay its mortgage can declare Chapter 11 and do two things: 1) separate the mortgage into its secured and unsecured portions (called bifurcation), and 2) pay the secured portion at current market rates under a new mortgage and discharge the unsecured portion. So, for example, a $1.2 million mortgage at 12% on a factory worth only $1 million will be bifurcated into a $1 million secured mortgage at, say, 7% interest, and the remaining $.2 million can be discharged. The economic insight behind permitting this move is that the mortgage company will get 100% of the value of the property paid over time, which is a LOT better than the much lower amount it would get in foreclosure. The second insight is that this is precisely the risk the lender took: that the property would decline in value and the debtor couldn’t pay. The Chapter 11 bankruptcy forces the lender to revalue the mortgage to the actual market value of the collateral.
But notice: If a homeowner can no longer afford her mortgage, the homeowner can declare bankruptcy and get rid of the credit card debt and doctor bills, but she cannot force the lender to write down the mortgage to the value of the home or to accept payments at the current market rate. All the homeowner gets is the right to make up past-due payments — in full, with interest. So, for example, a $120,000 mortgage at 12% on a home worth only $100,000 must be paid in full at 12%. In other words, homeowners get a lot less protection in bankruptcy than do businesses.
The distinction was in the 1978 Bankruptcy Code, advanced at a time when the median first-time buyer put down 18% of the purchase price on a home and the typical mortgage was a fixed-rate 20 year loan. Moreover, the lenders were largely Savings & Loans and other heavily regulated companies. At the time, a home mortgage stabilized most family budgets. Exploding ARMs, Liar’s Loans, and other exotics were unheard of.
Mortgage markets have changed, but the bankruptcy laws that balance the rights of debtors and creditors have not. For homeowners, the exit doors usually provided by bankruptcy are blocked. Does that mean the Onion Plan is all that’s left?
