According to several reports, negotiators in the Senate may be
on the verge of finalizing a compromise version of legislation that
would give bankruptcy judges the power to modify home mortgages, a
practice known as "cramdown" or "strip-down." This potential
compromise, unlike the House's version of the legislation (H.R.
1102), would limit a judge's discretion in reducing the portion of
a mortgage that must be repaid and otherwise altering the terms of
However, no matter how strict those limits seem, they do not
alter the fundamental problems caused by mortgage cramdowns. Even
with these limits, this proposal would still increase the cost of
homeownership and especially hurt both first-time homebuyers and
families with low to moderate incomes. It would also deal a blow to
banks and other lenders at a time when many are faltering. Worst of
all, allowing bankruptcy judges to rewrite mortgages would prevent
few foreclosures while imposing high costs on many who tried this
A False Compromise
The current bankruptcy code carefully balances the need for
predictability and stability in mortgage lending with the needs of
borrowers who have temporarily fallen behind on their payments.
Instead of being forced to bring a mortgage up to date all at once,
a borrower suffering a temporary financial setback can spread the
burden over a period of up to three to five years while still
making regularly scheduled mortgage payments. In addition,
homeowners frequently obtain relief outside of bankruptcy by
renegotiating the terms of their mortgages with those who hold or
Congressional cramdown proposals, including the reported
compromise, would upset the current law's careful balance.
According to reports, the Senate compromise would allow bankruptcy
judges in Chapter 13 cases to cramdown the value of an outstanding
mortgage loan to a "fair market value" and reduce interest
payments. The judge may also be able to modify other terms of the
loan, such as its duration and scheduled changes in interest rates
Though these powers would apply only to loans made before 2009
and worth less than about $730,000, the proposal would still give
judges enormous discretion to rewrite the terms of billions of
dollars in millions of outstanding mortgage loans.
Problems with Cramdowns
Granting judges the power to modify mortgages in this way
- Raise mortgage costs. The added risk that a mortgage
contract would not be repaid as written would require lenders to
demand increased down payments from mortgage borrowers-as much as
$60,000 for a median house. In addition, lenders would also require
higher interest rates and fees as compensation for taking on the
added risk of losing money if the loan is crammed down. While all
borrowers, no matter their creditworthiness, would face higher
rates on mortgages, the biggest increases would fall on first-time
homebuyers and moderate and lower-income families -- those who could
least afford the additional costs.
- Worsen the bank crisis. U.S. banks and thrifts hold
about $315 billion worth of highly rated mortgage-backed
securities. As a result of the added uncertainty about mortgage
repayment produced by even limited cramdown authority, many of
these securities would be downgraded to a lower credit rating.
This, in turn, would force banks and other financial firms to write
down these assets to reflect their lower value and set aside
additional capital to satisfy regulatory requirements. Some banks'
already overburdened balance sheets could not absorb those
- Tighten consumer lending. Allowing cramdowns could
encourage millions more Americans to file for bankruptcy. In
Chapter 13, unsecured creditors (those whose loans are not backed
by property that can be repossessed or foreclosed) typically
receive less than 20 percent of what they are owed. Facing this
risk, lenders would further tighten credit standards and reduce the
ability of many moderate income borrowers to get the credit that
they need. Alternately, certain lenders would greatly increase fees
to enable them to recoup their loans faster and to generate
additional profits to offset increased losses through
- Fail to help homeowners. Only one-third of all Chapter
13 filers complete the process successfully and get the fresh start
that bankruptcy promises. The rest pay court fees, pay attorney's
fees, pay fees to the bankruptcy trustee, invest time and money to
restructure their financial affairs, and then wind up with nothing
more than temporary relief. Nearly one-thirds go on to file for
bankruptcy again. Further, a Chapter 13 bankruptcy damages credit
scores and impairs access to credit for a significant period of
time. These facts clearly show that an approach that promises
significant relief from mortgage debt to encourage more individuals
to file for Chapter 13 bankruptcy is bad policy. At best, Chapter
13 would serve only to delay some foreclosures while imposing
enormous costs on those who are already financially vulnerable and
losing their access to credit.
- Undermine more promising approaches. Fannie Mae and
Freddie Mac, private banks, or portfolio lenders all have the power
to renegotiate the mortgages that they hold and face strong
incentives to do so. Cramdowns, however, would undermine these
efforts by encouraging some homeowners to believe that they can get
an even better deal in a bankruptcy court. As a result, cramdown
proposals would only delay foreclosures while blocking more
promising alternatives that protect consumers' financial
- Subvert the rule of law. When an individual borrows
money and signs a mortgage agreement, he accepts the responsibility
to repay the loan under its terms and pursuant to the law. When
Congress changes the law in the middle of the game to benefit one
or another party to an agreement, it weakens the rule of law and
the enforceability of private agreements across the entire economy.
And the precedent of such an act, even if it is limited and
temporary, undermines the certainty of all agreements, increasing
the costs of doing business across the economy.
A Dangerous Policy
By causing additional write-downs of mortgage-backed assets,
mortgage cramdowns would prolong and worsen the banking crisis,
delaying economic recovery. In exchange, the policy would provide
only temporary and extremely limited assistance to a fairly small
number of homeowners while subjecting many more to the pain and
expense of failed bankruptcies.
Rather than risk adding to the turmoil in the housing and
financial markets, Congress should consider approaches that do not
undermine investors' expectations and, ultimately, homeownership.
Even with the recent compromise, mortgage cramdowns are the essence
of bad policy and should be avoided at all costs.
Andrew M. Grossman is
Senior Legal Policy Analyst in the Center for Legal and Judicial
Studies, and David C.
John is Senior Research Fellow in Retirement Security and
Financial Institutions in the Thomas A. Roe Institute for Economic
Policy Studies, at The Heritage Foundation.