The Cram Down Myth

*Disclaimer: nothing in this post should be construed as legal advice. If you think bankruptcy might be right for you, you should consult with an attorney. Your state bar association will be able to refer you to an attorney licensed to practice law in your state.

“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
Ernest Hemingway, The Sun Also Rises

The image of the irresponsible debtor dripping in diamonds, driving around in a flashy car and burning money while nonchalantly filing bankruptcy is a stereotype created by the credit card and banking industries to guilt middle class Americans into thinking of bankruptcy as some shameful act to be avoided on pain of death instead of what it is: a financial planning tool. The vast majority of people who file bankruptcy are honest, hard-working people who paid their bills on time and never dreamed of filing bankruptcy until . . . until that devastating illness kept them out of work for 6 months, until the insurance coverage turned out to be inadequate, until the divorce, until the factory closed, until, until, until. No one is immune.

The law recognizes that sometimes unforeseen, uncontrollable events can lead a consumer to accumulate unmanageable debt that can ruin their lives. For this reason, the Bankruptcy Code was written: to provide the honest but unfortunate debtor with a fresh start. Yet, every single person who walks through my door for a consultation ends up crying in my office. They have spent months without sleep stressing out about how in the world they will ever pay down their overwhelming, soul-crushing debt. Often they have been working two jobs trying to make ends meet. They have been robbing Peter to pay Paul in the hope that something will turn up to enable them to catch up on their bills. I am their last resort and they know it, or they would not have come to see me.

And still they do not want to file bankruptcy. Still they hope against hope that I will be able to tell them that that there is something (anything! can I sell my kidney?) else they can do other than filing bankruptcy. Anyone who expects me to tell the 60 year old hair dresser with no insurance and $100,000 in medical bills from her double-mastectomy who walked into my office a year ago to work until she is 90 and go without “luxuries” (like food) so that she can pay that debt because it is the “responsible” thing to do can just stop reading now. And I suggest you avoid my future posts as well.

Recently, talk of authorizing bankruptcy judges to cram down principal residence mortgages gave the banking industries hacks an attractive opening to gin up propaganda and rile the masses into breaking out the pitchforks and condemning those “irresponsible borrowers who bought more house than they can afford.” What people like Santelli et al are not telling you is that cram downs were allowed until 1993 for principal residence mortgages and are still used all the time in bankruptcy law, especially business chapter 11 (repayment plan) bankruptcy. I don’t hear Santelli yelling about those irresponsible corporations that bought more heavy equipment than they can afford. It is only the consumers who must wear scarlet “Bs” for filing bankruptcy.

In my next post I will explain the differences between the two types of bankruptcies available to consumers: chapter 7 (liquidation) and chapter 13 (repayment plan). For now, here is what you need to know about cram downs. When the amount of the debt is greater than the value of the collateral securing it, the bankruptcy judge reduces (or “crams down”) the value of the secured debt to the value of the collateral. The remainder is treated as unsecured and is subject to the same repayment terms as unsecured debt. Because a plan payment is a prerequisite for cram downs, they are not available in a chapter 7 bankruptcy.

In a chapter 13 bankruptcy all secured creditors, except the mortgage lender on a principal residence, can be subject to a cram down. In a chapter 11 bankruptcy all secured debts are subject to a cram down. In other words, a corporation that owns an office building worth $100,000 secured by a $150,000 mortgage can file a chapter 11 plan wherein the mortgage is paid in full in the amount of $100,000 and the $50,000 remainder is paid as unsecured debt; that is, on a pro-rata basis according to the percentage terms of the plan. When the plan is completed (either over the course of 3 or 5 years) the unpaid portion of the unsecured debt is discharged. However, a homeowner whose principle residence is worth $100,000 but is secured for $150,000 does not have the relief of a cram down available to him.

Allowing cram downs on principal residence mortgages will help consumers who want to stay in their homes, and who can show they have the ability to pay both their mortgage and plan payment, prevent their homes from going into foreclosure. Now if you are cold, dead and shriveled up inside, you can take a hard-line against these people about what they should have done but that doesn’t change the fact that whatever mistake they made getting that house in the first place helping them keep it now helps the rest of us in that the housing market will stabilize more quickly. And contrary to popular (or propaganda) belief, this is not a “give away” — it is 5 years of hell being in a chapter 13.

The prohibition of court-ordered modifications for mortgages on principal residences was created in 1978. Between 1978 and 1993 most bankruptcy courts interpreted the law to mean that while interest-rate reduction or term-extension modifications were not allowed, home mortgages could still be crammed down. In 1993, with Nobleman v. American Savings Bank, the Supreme Court held that the prohibition on modifications of principal-residence mortgage loans also included cram downs. The result is that borrowers whose homes are worth significantly less than what they owe on them and/or who have toxic, high-rate mortgages are, for all practical purposes, unable to maintain their homes in chapter 13.

During the discussions leading up to the Bankruptcy Reform Act of 2005 (Public Law No. 109-8, 119 Stat. 23, April 20, 2005) (“BAPCPA” or, as I like to call it, the credit industry’s dream bill), the bankruptcy bar and consumer groups attempted to persuade Congress to allow cram downs for principal residence mortgages, thus legislatively overturning Nobleman v. American Savings Bank. The banking industry hacks (who had a lot more money to spread around than the consumer groups) argued that allowing judges to actually value homes at market price would destabilize the mortgage backed securities market and hinder the ability of thousands of Americans to get an affordable mortgage. The gist of their argument was that because home mortgage lenders provided a vital social service, they should be treated differently from every other lender in the world.

Now I might have been sympathetic to that argument if I grew up under a rock. Think about what we actually got by giving home mortgage lenders special treatment by completely eliminating the possibility that any loan they made could be restructured in a chapter 13 bankruptcy. On the one hand, post-1993 era lenders made low- or no-money down loans at interest rates that were slightly lower than what they would have been if the lenders had feared bankruptcy court restructurings. But we also got no money down 100% financed homes where borrowers were allowed to “pick their payment.” We got “no document” mortgages, where consumers were given loans without having to provide proof of income and without even a pretense of credit history review. We got appraisals that were not worth the paper they were written on. We got ridiculous housing bubbles that were begging for someone to come along with a big sharp shiny pin.

And while the lenders were lavishing obscene bonuses on each other, propping up those insane housing bubbles and celebrating the “go-go” days of the sub-prime mortgage, it turned out that a lot of those people they were providing a “vital social service to” could only “afford” those homes for two or three years. Make no mistake — the only reason the banking industry is continuing to oppose cram downs is because even though the house of cards they engineered and built is crashing down, they don’t want to look even more insolvent than they already do. Lenders have some serious karmic smack downs coming to them, and bankruptcy judges are the perfect ones to do it.

Banking industry hacks yammer on about the “moral hazard” of allowing consumers to cram down their principal residence mortgages. Setting aside the sheer lunacy of anyone in the banking industry talking about “morals,” the reality is that if lenders were faced with having their loans restructured in chapter 13 via a cram down, they will start doing what they should have been doing these past ten years or so: model negative HPA in their ratings models, start getting realistic appraisals and *perhaps,* if a loan does get into trouble, decide that it might be better to work it out directly with the consumer rather than risking the bankruptcy judge telling them what they will accept.

The bottom line is that the possibility of the cram down being used to restructure principal residence mortgages is one of the most valuable “sticks” society can have to put a check on lender stupidity, negligence and down-right thievery. The late Doris (Tanta) Dungey at Calculated Risk summed it up best in 2007:

“Any industry that wants special treatment under the law because of the socially vital nature of its services needs to offer socially viable services, and since the industry has displayed no ability or willingness to quit partying on its own, then treat it like any other partier under bankruptcy law.”

Dungey hit the nail on the head. I only add that not only is allowing cram downs of principal residence mortgages the equitable thing to do, it will help the economy more than anything in the stimulus bill and will cost the taxpayer a lot less to boot.