As bankruptcy modification of mortgages (a/k/a Chapter 13 "cramdown") looks more and more likely to become law, it's worth considering what the final legislation might look like. Already there have been some compromises in order to get Citibank's support.
One issue that might be raised is a clawback of principal for creditors if there is future appreciation on a mortgage, the secured amount of which has been reduced in bankruptcy. The question of shared appreciation emerged last year when bankruptcy modification failed to pass Congress and is one that has bedeviled many mortgage modification plans, including the Hope for Homeowners Act, not just bankruptcy modification.
Leaving aside the thorny question of how a clawback would work, I think it's important to consider whether there should be a clawback. How one views this issue, I think, depends heavily on framing. If the comparison is between a modification involving a principal write-down and a loan that performs at its original terms, then permitting an appreciation clawback as part of the modification seems quite fair. In this framework, it makes sense to try to give the creditor as close to its original bargain as possible; otherwise would be a windfall for the debtor.
But if the comparison is between a modification involving a principal write-down and foreclosure, then an appreciation clawback in the modification would result in a windfall for the creditor. When a creditor forecloses on a house, the creditor doesn't benefit from any future appreciation in the property's value after the foreclosure sale. The whole idea behind loan modifications, in bankruptcy or voluntary, is that they are value enhancing. If a loan will perform at 75% of original value when modified, that's a lot better than a 50% recovery in foreclosure. If a creditor is already benefitting from a loan modification relative to foreclosure, why should the creditor then also receive a share of the property's future appreciation? Wouldn't that be a windfall to the creditor?
Another way to see this is whether the modification is a temporary or contingent one or whether it is a life of the loan modification. The danger with a temporary mod is that it just kicks the can down the road. Requiring an appreciation clawback raises the question of modification sustainability. Any which way, this is an issue that is likely to pop up again.
Comments
16 responses to “Shared Appreciation Clawbacks”
Adam – the evidence so far on modifications is that loan-to-value is the best predictor of redefaulting. This is consistent with research on causes of mortgage defaults in general; while life events like unemployment and illness are clearly contributors to defaults, homeowners with equity are much less likely to default. They have options, they can sell the house, and they are motivated to find a way to make payments. In my view if there is any clawback of future appreciation it should expire quickly, in no more than five years. The similar provision in FHA’s Hope for Homeowners program is one of the reasons there are fewer than 500 applications to that program.
I am in favor of the claw back. I would have the loan restructured so that the principal is the current value of the house. I would then have the mortgager and mortgagee share on a 50/50 basis, any profit from selling the house at a later date (with the mortgagor’s portion not being taxable up to the original value of the loan, unless the mortgagor took an immediate loss on restructuring). The buyer will have the option of buying back the mortgagor’s share of the home’s equity at face value plus interest (set at the same rate as the mortgage). This could be done with a refinance if the home’s value rises again. The mortgagor will have no say on the sale price of the house (but this has to be well regulated, as this would be ripe for homeowner fraud).
This will do a couple of good things: 1) it will give the homeowner the incentive to stay and keep the house kept up, while allowing a 100% leverage on the house and 2) it will allow the mortgagor to recoup losses if the market goes up.
So, the mortgagor will have an equity interest, as well as a debt interest. I am sure that the mortgagors do not want this, but it is better than nothing.
The restrictions on treatment of homestead mortgages is an exception — created for now-outmoded reasons — to the standard treatment of liens in bankruptcy reorganization. That standard treatment does not require clawbacks. Those who favor a clawback rule should address whether they seek to insert it for all reorganization liens, or limit it to homestead mortgages, and if why. In fact, any such provision in the prospective Chapter 13 amendment would greatly increase complexity, and very likely significantly impair the effeciveness of the amendment.
Ken,
On the one hand, you are right. On the other hand, restructuring mortgages without a clawback would provide a windfall for a large number of people who file chapter 13. What is good credit worth? 100k, 200k? If a chapter 13 would let these people keep their house and get rid of $200k of debt, with the prospect (almost sure in these days) that the value of the house will go up in the next 10 years and they are doing well enough to buy stuff without credit, why not do it?
Bankruptcies for the well off will become a business decision. Heck, even I would do it.
Imagine, someone earning $150,000 per year, whose only debt is a $800,000 mortgage on a house worth $500,000 declaring bankruptcy. (Of course, I am not 100% sure the bankruptcy courts would approve).
While I haven’t seen the current proposed text, I assume that any mortgage debt that becomes unsecured just because it isn’t actually, you know, secured will have to be dealt with as an unsecured claim under current law. That alone negates any potential windfall as you describe. I repeat my question above: do you advocate clawbacks for all reorganization secured debt, or just Chapter 13 homestead debt? In either case, why?
There are a number of significant policy considerations involved here, as well as numerous practical problems.
The biggest single reason for the “mortgage meltdown” were underwriting and appraisal policies that ran the gamut from completely lacking to downright fraudulent. Most of the mortgages in foreclosure I have seen should never have existed in the first place. Market value numbers were laughable, reflecting inconceivable “market value increases” of 70% over 3 years, loan to value ratios which were impossible for any family to maintain (compounded by what became a growing practice of excluding T&I from the payment to be made by the borrower), and leaving the borrower to his own devices to struggle with those impossible burdens. In other words, they were set up to fail.
Now that all of this is common knowledge, the questions are where should the burden for this mess be borne and what should be done to prevent it from ever happening again ?
The sophisticated financial players who participate in loan origination, servicing, securitization and the secondary market had all the resources in the world at their disposal to evaluate and control risk. An audit of any one of these files would have disclosed queasy or non-existent underwriting practices. However, they chose not to know, contenting themselves with representations and warranties from other parties who chose not to know.
Borrowers as a general rule had no realistic ability to understand. They were drawn in by slick sales talk and overblown promises by loan officers and mortgage brokers which they lacked the tools to properly evaluate, rushed through closings where they were given virtually no time to sign a two-inch thick stack of legal documents, which they did sign, essentially trusting in “the system”. Any number of my clients have expressed to me their th inking at the time that “the bank” would not have agreed to make them a loan clearly would be unable to repay. Of course, they had no understanding of the fact that “the bank” would sell their loan into the secondary market before the ink was dry, and not be likely to know or care if they defaulted.
Borrowers are the meat and potatoes of the process. In order for the mortgage finance system to work, there needs to be borrowers. Much of the motivation for people to buy a house is that it is their home, and it is an investment. When / if the time comes to sell, they should expect to be able to do so without complications, at a price that is reasonable, and to have a realistic picture of what they will net after real estate commissions and costs of sale. Shared appreciation would seriously complicate the process. Furthermore, if sellers lack the ability to pay brokers’ commissions, transfer taxes etc. they in many cases will be unable to sell. A house is not an especially liquid asset normally, but will become seriously more illiquid with a shared appreciation burden.
Had the lenders and servicers exercised legitimate and genuine efforts to work with borrowers on modifications as this mess evolved (as they claim they have done), it may be that cramdown would not be necessary. However, due to their inefficiency and gridlock – and greed, entire neighborhoods are now vacant, while the families that used to live there are now homeless, some living in their cars, while the houses molder into ruin, as pipes freeze and toxic mold proliferates, and vagrants light fires on the tile floors.
There is no shared appreciation for stripping of liens where allowed, or for cramdowns of other kinds of secured debt. There is no potential clawback for creditors of large discharged unsecured debt. To allow this in a first mortgage cramdown scenario would reward the lenders for their irresponsible and dishonest behavior, instead of imposing discipline and requiring that they act responsibly when evaluating potential loan applications.
Mortgage securitizations have a very finite life, which is based on the roll-over rate of the mortgages they hold. This is, even in normal times, about 6.5 years, and so the rate of collapse of the trusts is something shorter than that, and given the current default rate, shorter yet. That means that there will be many instances where, at the time many of these properties are sold or refinanced, the trust which own the mortgages now will not even then exist. The result of shared appreciation at that point would be a windfall to the holder of the residual rights, often the same bad actor who was responsible for the poor origination practices in the first place.
Perhaps someone could explain to me a reason to care about home mortgage lenders? Or their miserable excuse for a business model? What makes them more deserving than, say, a pawn shop?
Claw back, reach back or draw back. At what price? Consumer gets a mortgage modification, the Court moves $150,000 to an unsecured debt ( of course with the other unsecured debts)and the consumer’s case is dismissed. Then the lender who is owed the $150,000 proceeds to State court to obtain a judgement which in most states remains for more than the state SOL laws. Also, prepare for the creativity of advertising, abuse, but lets focus on success based on pre BAPCPA results. Anyone have that data?
The Cramdown will be a greater incentive to finish out a plan, especially in non-homestead States.
Even pre BAPCPA, 13s were not especially designed for the type of loans we are dealing with now. “Option ARMS”, ARMs , 80/20s, and 80/20 ARMS etc… I mean, Servicers especially pre BAPCPA had the “run of the house” and before we started conduit payments here was tough to audit their POCs or their claims for post-petition default (times five) if your doing any kind of volume. The question here should they get there grubby Mitts back on that money if there is a “true” appreciation? (to me it has to be a “True” profit) And since its tough to get all of the “investors” to agree on a mortgage mod and they are scattered to the wind. My question would be “who will get the clawback” and how do we know for sure they are the right party?
If it is the government that “ACTUALLY” bought that troubled asset (like they were supposed to do) then yes government should get a clawback (a % of a “true” profit). A bank with what they call a “portfolio” (not pooled and cut to pieces) loan, yes they should get (some) of that shared profit (if any). Things get a bit dicier when the thing is cut into so many pieces we are not sure exactly who owns it.
Since the very first day when the idea was floated to allow bankruptcy modification of mortgages, the following phrase has been repeated over and over without challenge in news articles: “Under the existing powers, bankruptcy judges have the authority to rewrite the terms of car loans, student loans, credit card debt and even mortgages on second homes or vacation properties.”
Now, I ask you, when was the last time you heard of a bankruptcy judge rewriting the terms of a student loan?
As someone who has no hope of ever obtaining a mortgage to buy a home because of the ever increasing balances on the private student loans that I owe, I am more sympathetic to my own plight than I am to those in foreclosure who can walk away with their fresh start.
Take a look at the comments posted above by Margery Golant and Masaccio and compare the circumstances as to how both kinds of borrowers (mortgage debtors, and private student loan debtors) got in over their heads with unmanageable debt . Then tell me, please, how the reasons given for why private student loans should not be dischargeable have merit, while no one questions the necessity of bailing out the homeowner? Not saying they should not be helped, but will you please devote some of the enviable brainpower on this website to solving this private student loan mess for those of us in the unenviable position of owing money to predatory lenders like Sallie Mae? We desperately need your help.
Adam, there are three reasons why cram down is highly problematic for the lending industry – re-default risk, moral hazard and invalidation of mortgage insurance. Without addressing each of those risks, cram downs could be the straw that breaks the back of the financial industry. The good news is that appreciation claw back, if done right, could mitigate the first two risks and get you half way addressing mortgage insurance. Let me explain:
Invalidation of mortgage insurance is the easiest risk to explain. Neither government insurance such as FHA and VA nor private insurance provide lenders with protection against cram down losses. This will create huge unintended losses for GNMA Servicers, Fannie and Freddie. However, if the claw back is structured as a principal deferment by the bankruptcy court, the mortgage insurance will remain in tact and the borrower will receive the same payment relief as in a principal reduction. There are a number of funding issues related to FHA and VA, but they can be easily addressed through an expansion of the partial claim program.
Re-default risk is the likelihood that the restructured loan will re-default in the future when house prices may have declined further thus increasing losses by the lender. This is especially important in today’s environment of continuously declining property values and high failure rate of Chapter 13 plans, which is a whole other issue that needs to be explored. Keeping the appreciation potential will enable lenders to mitigate the re-default risk, as is the case with voluntary modifications.
The moral hazard is the incentive for borrowers to write down their debt while keeping use of the property and the potential for future appreciation. The overwhelming majority of mortgages are current. Even in the worst subprime deals, more than half of the borrowers continue to make their payments despite the fact that their property is under water. The general public is highly tuned to changes in the bankruptcy code as demonstrated by the spike in filings right before the 2005 restrictions took effect. With a powerful incentive to file for bankruptcy, filings will escalate dramatically above and beyond people who are faced with foreclosure.
Interestingly, the current bankruptcy code has a very effective mechanism to deal with both re-default risk and moral hazard. Secured liens subject to cram-downs have to be paid in full within the 3-5 year period of the plan. The fast pay down reduces the risk of additional future loss as well as discourages unbridled filings. This control in effect ensures that a secured creditor’s losses in a bankruptcy restructuring will not exceed liquidation losses.
Clearly, the 3-5 year control is not practical for primary residence mortgages. An effective appreciation claw back can serve the same purpose and provide some protection to the lenders against dramatic escalation in losses. Without it, lenders are sitting ducks.
So my final point: if you want the lending industry to recover and start lending again, you should support an appreciation claw back. Seems like a smart compromise.
Val,
I disagree with you. Carrying nonperforming loans is what will kill financial services, not a forced house cleaning. And the losses here will be borne mainly by investors, not the financial intermediaries that are necessary for the lending process. Investors are fungible and will return if they can trust the paper, but intermediary institutions are harder to replace, so I don’t think that cramdown will kill lending. But if investors don’t trust the paper in the market, good luck getting lending going again.
Redefault. Of course redefault risk exists. 2/3s of Ch. 13 plans fail. Many, though, do not deal with the mortgage under the plan, so plan failure is irrelevant, and even when a mortgage is covered by a plan, just knowing the total failure rate isn’t very informative. We don’t know _when_ in the plan those fail–a failure a 4 years and 9 months of a 5 year plan is very different that a failure at 2 months into a plan. And some of those failures are due to an inability to deal with mortgage debt in 13s. But what are the loss severities for a mortgage that is foreclosed now versus a loan that performs on a modified basis for three years and then defaults and is foreclosed? Another three years of payments and a stronger housing market in a few years should more than compensate for the rather minimal costs of filing a bankruptcy claim.
Moral hazard. Will permitting bankruptcy modification of mortgages result in a spike in fillings? You betcha. But it should also result in a sharp fall off in foreclosures. As long as bankruptcy modification losses are smaller than foreclosure losses, this is a good deal for lenders, and no one has presented any evidence that bankruptcy modification would result in larger losses. Indeed, less foreclosure sale inventory on the market will help lenders in general by limiting housing supply and thereby raising prices.
Mortgage Insurance. The mortgage insurance issue is more complicated than you present, and I’m not sure that anyone has quite unraveled this (myself included). But here’s the story as I see it: First, some, but not all of the seven private mortgage insurers exclude modification (voluntary or in bankruptcy, regardless of form) from coverage. So it doesn’t really matter if there’s a principal reduction or not. That said, many PMI companies will agree to some modifications. So we don’t really know what will happen with PMI coverage. Second, a lot of PMI is reinsured by captive reinsurance subsidiaries of mortgage lenders. It is really the lenders that get off the hook with their subsidiaries’ reinsurance obligations. Third, GNMA, FHLMC, and FNMA are going to be able to get out of a lot of mortgages simply by pursuing recourse for non-conforming loans.
Finally, do I want “the lending industry to recover and start lending again.” Yes and no. I want to see credit available on fair and reasonable terms for credit worthy borrowers. But “lending industry recovery” could also mean going back to partying like it’s 2006, and I don’t want to see that. And the failure of some of the more thinly capitalized actors that helped drive the rotten lending practices of the last few years might help ensure that we do have a sustainable and responsible lending market.
The beauty of the “party system of 2006” the bad actors got off clean, while the captives (companies/people holding the bad paper and the consumers)are left to deal with “market forces”. Capitalism is a great money maker, but left to itself, (the beauty that no one seems to want to let go) the bad actors often got away with the money. I can see why those people don’t want anything to change (deregulators mount up!). They thrive on risk, risk = a huge potential for a huge return and they have found that way of getting off without a scratch. You have to have some rules right? Communism no way!, but with no rules (deregulation) we have Capitalistic Anarchy. They feed off of the middle class and the middle class pays for everything! Lets do something new and lets call it “subsistence lending”. Lets be able to keep it going indefinitely, not squeeze the ever living life out of the thing for a quick very fleeting (2-3 years worth)profit.
Sorry, not quite a “Clawback” rant.
Ustoo:
In addition to identifying and punishing those who are to blame for the mortgage debacle, I suggest we identify and reward those who had nothing to do with it at all: savers and renters. Here’s my plan:
1. Government buys MBS for current bids, i.e., substantial discounts to par
2. Government forecloses on defaulted loans, evicts the homeowner and transfers title to a RTC-type entity.
3. RTC gives favorable lease option to first time homeowners whose rent payments build equity with an option to purchase the property on favorable terms within 5 years
4. First time homeowners with student loans can get a payment holiday while they make the payments and forgiveness of their loan up for each dollar they pay in rent. When they sell the student loan entity receives 50% of the profit.
Mr. Goodrich…Bring in from the cold all the renter-student loan debtors who have no hope of home ownership, ever. This is creative problem solving at its finest. I’m in, if your proposal means that the 50% profit that I share with the student loan entity upon sale, will be accepted as payment in full of my student loan debt. Where do I sign up?
If you have no mortgage on your home it is free and clear can you still get aH4H loan and give up 50 % of future increase?