Many Americans believe that the financial crisis stems from the Bush administration’s running up the federal debt and out-of-control spending by the American consumer. But much of the blame for the country’s current economic woes lies with the Obama administration’s failure to forcefully tackle the biggest threat to the American economy today: the housing crisis.
Nearly 6 million Americans have already lost their homes to foreclosure since the housing bubble popped, and about 3.5 million are in foreclosure proceedings. But the worst is yet to come. This past September, a US Senate Banking subcommittee heard testimony from a prominent mortgage industry analyst that 10.4 million mortgages, approximately one of every five outstanding mortgages in the country, could default, if Congress does not take action to address the housing crisis.
Over the past several months, editorial pages and economists such as Paul Krugman and Carmen Reinhart have stressed that restructuring US household debt would be one of the most effective means of speeding economic growth and putting Americans back to work. According to a recent report by The New Bottom Line, a coalition of labor groups and grassroots networks, if all underwater mortgages were written down to market value and refinanced into thirty-year fixed mortgages, it would add about $71 billion a year to the economy and create 1 million jobs.
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But despite the outcry, Washington currently does not have a viable plan to deal with the plight of the more than 14 million Americans who are currently underwater on their mortgages by more than $700 billion. With the mortgage meltdown showing no signs of abating, it is the time to set the record straight on the best plan we have had for reviving the housing market: the 2009 bankruptcy reform bill known as the cram-down bill. That controversial piece of legislation would have given bankruptcy judges the authority to write down mortgages on a primary residence to the current fair-market price of the property. In addition, cram-downs would have enabled bankruptcy judges to monitor and stop some of the widespread robo-signing abuses—where banks have been using fraudulent documents to foreclose on homeowners.
Proponents of the bill believe many if not most of the homeowners who would have benefited from it would not have even needed to file for bankruptcy. Indeed the cram-down provision would have provided homeowners and their advocates with a critical bargaining chip to negotiate sustainable loan modifications from the banks.
When Senator Barack Obama was running for president he told voters that he would support legislation to allow homeowners to get relief in bankruptcy court. The legislation would have repealed a bankruptcy provision that prohibits modifications of mortgages on a primary residence. “I will change our bankruptcy laws to make it easier for families to stay in their homes,” he told voters at a campaign rally in September 2008, describing the bankruptcy exemption for mortgages as “the kind of out-of-touch Washington loophole that makes no sense.”
Today cram-downs make even more sense than they did in 2009. The various bank proprietary loan modification programs and the government-sponsored loan modification programs are widely acknowledged to be failures for not helping enough homeowners and also for having high re-default rates. But one of the biggest unmitigated disasters about these programs is that homeowners who have succeeded in obtaining loan modifications actually have become mired in more debt. That is because instead of reducing homeowners overall debt, these loan modification programs have focused on lowering monthly payments on a homeowner’s primary mortgage by reducing interest rates and extending the term of the loan. In 2010, nearly 95 percent of active, permanent loan modifications resulted in homeowners’ actually owing more debt on their homes than before the modification according to a Congressional Oversight Panel report.
The reason that we don’t have cram-downs is that the banks lobbied heavily against the 2009 bill. They said it would further destabilize home prices and that they would have to raise interest rates to account for the risk of underwater homeowners’ having their mortgages modified in a bankruptcy. They also argued that bankruptcy reform would create a “moral hazard” by rewarding irresponsible borrowers who took out mortgages that they couldn’t afford.
The misleading message on cram-downs that stuck in the minds of many voters came from CNBC host Rick Santelli. It was Santelli’s 2009 rant about cram-downs that launched the Tea Party. “This is America!” Santelli told cheering traders on the floor of the Chicago Mercantile Exchange, “How many of you people want to pay for your neighbor’s mortgage that has an extra bathroom and can’t pay their bills?”
In contrast to candidate Obama, President Obama was conspicuously silent on cram-downs. According to ProPublica, Treasury Department staffers actually cautioned lawmakers against the bankruptcy reform legislation. Unfortunately for underwater homeowners, although the cramdown legislation passed Congress in March 2009, it was defeated the following month in the Senate by a vote of 45 to 51. Georgetown Law School professor Adam Levitin, who has written extensively on cram-down legislation, says that Obama’s lack of support doomed the bill. “Had Obama put his weight into it, it would have passed,” says Levitin, “It would have been a fight, but he was too chicken to have the fight.”
“The principal objective of the Obama administration and the Bush administration before that was to let the banks avoid taking immediate losses,” says Democratic Representative Brad Miller of North Carolina, who sponsored the cram-down bill, “The bankruptcy law change was incompatible with that, it would have required the banks to recognize a lot of losses immediately and might very well have revealed some of them to be very nearly insolvent or actually insolvent.”
The country’s four largest banks stand to lose the most from cram-downs. The legal fees they would face in bankruptcy courts would be enormous. In addition, these banks hold a substantial amount of the outstanding unsecured debt on underwater homes in the form of hundreds of billions of dollars of second loans and home equity lines of credit. Because they are in second-lien position, with the drop in housing prices, many of these loans have become partially or completely unsecured, meaning they no longer attached to any underlying equity in the home. And while some bankruptcy courts have allowed wholly unsecured second-lien mortgages to be written off completely, other courts have ruled against writing down these mortgages. Under the 2009 proposed cram-down legislation, the law would have been much clearer, and many of these junior loans would be written off completely.
Aside from propping up the country’s largest banks, there’s very little reason not to pass bankruptcy reform. In contrast to the Obama administration’s Home Affordable Modification Program, under which the taxpayer is partially footing the bill, court ordered mortgage cram-downs would cost the federal government nothing. Indeed, cram-down legislation requires no government bailouts or financial incentives for lenders or for borrowers. The 2009 CBO cost estimate of the proposed cram-down legislation shows that the federal government actually would have made money on the bill through the increase in bankruptcy filing fees.
What about the argument that cram-downs would force banks to raise interest rates, thus making credit more expensive for borrowers and depressing home values in the very neighborhoods hit hardest by the meltdown? Interest rates on fixed-rate mortgages have been on a downward trajectory, and in early October the rate on a thirty-year fixed-rate mortgage fell below 4 percent, the lowest it has been in recorded history. But prospective homeowners still are not buying. In an era of falling home prices, lenders understandably are worried about lending on an asset that is losing value and prospective homebuyers understandably are worried about making a bad investment. Indeed the debate over whether or not cram-downs would have resulted in market crippling higher interest rates proved to be a major red herring from the main ailment afflicting the housing market today—the inflated mortgages, many of which were based on fraudulent appraisals, that were originated during the bubble.
The argument that cram-downs would have rewarded irresponsible borrowers is also misleading. Chapter 13 Bankruptcy is not a get-out-of-debt-free option. It requires borrowers to live on a court-monitored budget for three to five years. Further, in many parts of the country, there are Americans who owe more than twice as much on their mortgages as their homes are worth. Many of these people are victims of predatory lending and appraisal fraud. The most authoritative official report that we have on the events that led to the 2007 meltdown, the Financial Crisis Inquiry Commission’s final report cites widespread instances of predatory lending during the housing bubble. For example, the commission’s report discusses how the quality assurance department of New Century, once the nation’s second-largest subprime lender, found evidence of predatory lending, legal and state violations and credit issues in 25 percent of the mortgages that they audited. Yet instead of reforming the company’s business practices, New Century executives dissolved their quality assurance department and terminated its personnel.
In addition to potentially helping millions of Americans get back on track, bankruptcy reform actually would have benefited the entities that own most of the outstanding secured mortgage debt in this country—Fannie Mae, Freddie Mac, pension funds and private investors. “Investors recognize that a 20 or 30 percent principal write down creates re-performance,” says Joshua Rosner, managing director at Graham Fisher & Co, a company that advises investors, “and it beats absolutely a 70 percent plus loss in a default.”
Even one of the major unstated reasons for not passing the bankruptcy reform bill, protecting the nation’s largest banks, no longer holds water. Failure to pass the cram-down legislation has not in fact saved the banks from their travails. Bank of America, the nation’s largest bank, is going wobbly due in large part to its continuing problems with mortgage meltdown. If the cram-down legislation had passed and BoA had failed as a result, then so be it. Millions of Americans facing foreclosure would have had a much better shot at saving their homes, and that would have been a much bigger boon to the overall economy than bailing out the banks.
However, although the big banks are tottering, they still appear to call the shots in Washington. “There seems to be an unstated but perhaps conscious policy of not forcing them [banks] to recognize losses,” says Miller, “ And almost everything that we can do to help the balance sheet problems for households—to help reduce household debt—would require the banks to recognize losses.”