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Cramdown: Why Were the Misleading Arguments of the Mortgage Bankers Association Successful?

Banks get everything they want, including a huge dose of taxpayer money. How does that happen? A lot of it is the money they pour into lobbying and campaign contributions. Personal relationships and good will created by community involvement play a role. Another part is the kinds of arguments they make. This is from a briefing paper prepared by the Mortgage Bankers Association on bankruptcy cramdown:

Today, home loans are granted priority over unsecured debt, such as credit cards. This is a fundamental principle of secured credit. Proposed legislation, however, erodes this principle. The current distinction granted to home loans does not mean borrowers lose their homes in bankruptcy. On the contrary, bankruptcy is used to reduce unsecured debts and other lesser priority debts to free up income to pay the secured home mortgage. Proposed legislation seeks to disadvantage secured home loan creditors by diverting the borrower’s disposable income to pay unsecured debts.

This is completely misleading, but it was enough to snow a lot of people who should have known better. The argument works because it fits into the general world-view among non-experts. They know that secured debt is treated differently from unsecured debt, but not exactly why. It sounds right because government policy supports home ownership over other interests.

The mortgage bankers also say that cramdown will drive up the cost of borrowing money, which also seems right. If you don’t think for a second, you might miss the fact that the problem is that the value of the collateral has fallen, and is now below the debt. That just didn’t happen with houses in the past. Higher interest doesn’t deal with that problem. And if it were a real problem, it would be solved by the amendment which limits cramdown to existing mortgages. Future mortgages will be more realistic (until the next bubble), so they are not at risk.

In other words, these are arguments that do not challenge existing ways of thinking. They do not require actual thought. They slide into the existing world-view smoothly, no ripples. They just seem right.

Now suppose I show up to try to explain to a staffer why cramdown is a good idea. First, I have to establish I am competent and trustworthy, then I have to explain my position and how it will lead to a good outcome, even for the opponents, and then get to work on the false arguments of the mortgage bankers. Good policy ideas, like cramdown, don’t fit into the worldview of the staffer. Cramdown isn’t liberal or conservative, it is unconventional. It seems to pop in from nowhere. It takes a lot more work to make progressive ideas seem acceptable.

Here’s the short version of my argument. Home loans have priority over other loans because they are collateralized. Cramdown doesn’t "erode this principle". Cramdown is the term given to 11 U.S.C. § 506. That section says that in a bankruptcy case, the bankruptcy court values the collateral, and the creditor has a secured claim in the amount of that valuation. The balance of the amount owed to the secured creditor is an unsecured claim.

The idea of Chapter 13 is to encourage people to pay what they can towards their debts. One of the incentives is the chance to preserve the equity in their houses. They have to pay their unsecured creditors at a minimum more than they would get in a Chapter 7 case. For most people, this is closely related to the equity in the house. If there isn’t any equity, there isn’t anything to protect. So,there is no incentive to pay anything to unsecured creditors. Chapter 7, full liquidation, is a better option, because you get a complete fresh start. Your future earnings are your own. Chapter 13 cramdown provides an incentive to stay in the house, pay the fair value of the house, and pay something to unsecured creditors. Without cramcown, the secured creditor is a loser too.

Suppose a Chapter 13 debtor has a car worth $6,000 but owes the bank $10,000 (we ignore the 2005 amendments for this example). The bank is a secured creditor for $6,000, and an unsecured creditor for $4,000. If we make the debtor pay $10,000 to keep the car, the debtor is wildly overpaying for the car, and the unsecured creditors get screwed out of $4,000. If there weren’t a bankruptcy, the secured creditor would get no more than $6,000 for the car, so why should it get a better deal in bankruptcy?

Well, that’s how we treat homes in bankruptcy. By the way, under the 2005 amendments, brought to you by the corporatist party, we do the same thing for a lot of cars, too.

The idea that cramdown will increase the cost of mortgage is debunked here.

Let’s face it, a constituent phone call won’t be enough to overcome the self-interested and untrue arguments of the lobbyists.

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