One of the things that wasn’t approved in the Helping Families Save Their Homes Act of 2009 was allowing federal bankruptcy judges to modify loans on debtors primary residences.  That was curious to me at the time and has become more curious as bankruptcy judges are now modifying the terms of these loans.  The practice is called a “cram down” as the principal is reduced to fair market value in the process.

I don’t know exactly what the solution is, but if a borrower is bankrupt and a bankruptcy judge, who happens to be a federal judge, modifies the mortgage on their home, that seems like a good thing to me.  However, I can see where things could get sideways. 

For example, a borrower who has lost income, or a catastrophic event that has forced them into bankruptcy, maybe they couldn’t get a response from their lender and filed bankruptcy to save their home.  These are normal scenarios.  While they are playing out more right now, they happen and have happened in every market.  I used to be a title officer.  Title officers used to be paid six figures by the time salary and bonuses were worked into the mix.  Let’s say Bob, our title officer used to make six figures and makes around $40,000 now.   His income isn’t coming back any time soon much of his job is now done overseas, but maybe if he sold their house they could buy the same house around the corner and afford it on his salary.  He files bankruptcy to save his home instead of doing a ditch strategy.  The home was purchased for $500,000 and is now worth $270,000.  It’s encumbered to $400,000.   The bankruptcy judge crams down the pay off to $270,000 and modifies the note.  Now Bob can afford the house.  Makes sense right?  Seems like it to me. Except….

They are predicting a housing shortage in the next five years.  Now it’s 2014.  Prices are spiking and Bob decides to take advantage of it and sells his house for $550,000.  Could happen.  The bank took a haircut at the hands of the bankruptcy judge on Bob’s behalf and now Bob takes all the equity and moves on.   What will the banks do at that point?  Can they do anything?  Is it right for the bankruptcy judge to cram down the principal too just because of the current economic condition?  I don’t know.  I don’t think anyone can see into the future as to what is really going to happen.  Maybe nothing comes back for 20 years.  I think that’s doubtful, but possible.  At that point, the cram down makes sense. 

I don’t know what the answer is exactly but I do think bankruptcy judges should be able to modify the loans on primary residences.  Perhaps it makes more sense to move some of the indebtedness to some sort of silent balloon payment where they have to return to the court and have the court approve any sale within the next 10 years.  If they don’t there’s a good chance of the bank’s lobbyists coming in and pushing Congress to stop a practice that is helping homeowners.