Why the Bankruptcy Change is Important
Thanks to Masaccio for explaining what Dick Durbin is trying to do with the bankruptcy provisions on the bailout bill. It sure sounds like it would be a pretty darned sensible way to keep people in their houses. -ew
The Bankruptcy Answer
Why are Democrats pushing to include the bankruptcy revisions in the bailout bill? Let’s see what happens to a troubled mortgage in a Chapter 13. Suppose we have a subprime mortgage. The note has an interest rate of 9%, principle of $200,000, and a 30 year term. The house cost $210,000, so there was a 5% down payment.
The family made the income level by aggregating the income of husband and wife. One loses a job, they get behind, and then they get a new job paying a lot less. They file Chapter 13. The point of the Plan is to offer a proposal to repay their creditors, including taxes, secured debt, and unsecured debt. The Bankruptcy Code dictates how much they have to contribute from their paychecks. The amount is basically the difference between their income and their allowed expenses. Both of these terms are defined in the Bankruptcy Code, and are sort of like your natural understanding, but not quite. The money goes to the Chapter 13 Trustee, who distributes it in accordance with the Plan.
The Plan will deal with the mortgage note by cutting it back. First, we get a fair appraisal of the value of the house in its real estate market today. Let’s say it comes in at $180,000. The current rate for good mortgage loans is 6.0% for 30 years. The family agrees to pay $1,079.19 at that rate and for that term, plus an additional amount for taxes and insurance. If their statutory current income is enough to cover this payment, the expenses defined in the Code, and pay something towards the rest of their debt, the Bankruptcy Court can approve the Plan. If their actual income minus the Plan payments is enough to cover their actual living expenses, they should be able to live reasonably well. So they propose a Plan with those term, including the changes to the mortgage.
When the case is filed, the loan service company gets notice. The notice includes the Plan (or the Plan is sent along later), and the servicing company will have plenty of time to consider it. The servicer sends the notice to the holder of the mortgage. This might be a CDO Trustee with a name like Deutsche Bank as Trustee for MSAMPS Trust Series 103-A, or it may be the actual lender. Either the servicing company or the holder of the note is responsible for dealing with the Plan. They can either accept the proposal, or negotiate an acceptable arrangement with the family, or object and have a hearing and a court ruling. If the note holder doesn’t participate, the Plan goes forward, and the note holder is bound. When that is done, the family can go forward with the revised Plan, or convert to Chapter 7 and give up the house. Actually, I suppose they might negotiate an arrangement to keep the house in a Chapter 7, but they have no leverage.
When the Bankruptcy Judge approves the Plan, the terms of the note and mortgage are changed. The family pays the statutory amount for 5 years, and then just pays the mortgage with the changed terms. The servicer collects the payments, and distributes them as instructed by the note holder. The holder of the CDO gets whatever the Plan says. This eliminates the requirement that the holders of the CDO have to approve by a majority or supermajority. This has proved to be one of the major impediments to voluntary work-outs.
Now the family has a reason to keep the house: they are paying what it is worth at a fair rate, and have the real possibility of owning the house some day.
From the note holder’s point of view, the new price should be workable for the family, so they have accomplished a sale at roughly the current value. This avoids the costs and delays of foreclosure. And, more important, the price at a foreclosure is almost always worse than the current market price. Why is that? Only very rarely is the purchaser at a foreclosure the actual user. Third party buyers want to buy below market and make a profit on resale. So, by selling to the family, the noteholder gets the best possible price.
From the point of view of society, this is a good outcome. It gives stability to the market, by not dumping more houses on the market. It is good for families, by relieving them of financial stress. And, if the government has bought the toxic waste, it gives us all confidence that we got a good deal.
This alternative won’t be available to speculators. They can do exactly the same thing in Chapter 11, or they can just fail. Most of the other complaints are coming from the lenders, whose interests we should ignore. My alternative for them is to wallow in the failure pit where they belong.