Going For Broke
Wednesday, October 24, 2007
Will Congress reach a compromise on bankruptcy reform? If so, writes LIZ MAIR, the result will probably be less ‘creditor-friendly’ than the 2005 reform.
As Americans are now painfully aware, many homeowners strapped with unaffordable mortgages currently face the prospect of bankruptcy and foreclosure, which further contributes to downwardly spiraling housing prices. Earlier this month, Republican Senator Arlen Specter of Pennsylvania introduced the Home Owners’ Mortgage and Equity Savings (HOMES) Act, which seemingly takes a balanced approach to dealing with the crisis. However, the Specter legislation has already provoked criticism on both sides of the debate. It may ultimately be too interventionist for the taste of banks and yet too timid to win the approval of Democratic Senator Dick Durbin of Illinois, who is pushing for a much more radical overhaul of the bankruptcy code.
The most controversial elements of the HOMES Act are its provisions allowing bankruptcy judges to delay, prohibit, or roll back increases in mortgage interest rates, to waive early repayment penalties (so as to enable desirable refinancing), and to write down principal on a mortgage where the lender agrees. The law would apply strictly to borrowers who took out mortgages before September 26, 2007—and only if they sought relief within the next seven years.
However, the banking industry is concerned that allowing judges to tinker with contracts could introduce uncertainty into the market and increase credit costs for other borrowers. Speaking to The Hill newspaper earlier this month, Floyd Stoner of the American Bankers Association (ABA) said, “Any time you change the terms of a contract at the end you, one, cause uncertainty in the markets and, two, over time, you increase the cost of credit and reduce the number of people who get it.” These are both valid concerns, though it is worth pointing out that under the HOMES Act principal debt could not be written down without the lender’s consent.
The HOMES Act may be too interventionist for the taste of banks and yet too timid to win the approval of Democratic Senator Dick Durbin.
That may console the ABA, but not Senator Durbin, who prefers a more aggressive bankruptcy reform that would not give lenders veto rights over changes to key mortgage terms. Durbin wants judges to decide the adjustment of such terms. So does the Center for Responsible Lending (CRL), which argues that the prospect of lawsuits filed by investors is one reason why lenders have thus far been reluctant to modify mortgage terms. According to the CRL, Durbin’s approach would give lenders “the cover they need” to make any necessary changes.
But the Durbin plan would also adjust the balance of power between creditors and debtors—something that Durbin is no doubt keen to pursue, since he opposed the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). Many Democrats regarded BAPCPA as a sellout to the credit card industry, which reportedly spent more than $100 million lobbying for it. The 2005 legislation clearly moved U.S. bankruptcy law in a more creditor-friendly direction, with apparently mixed results.
As economist Michelle White has written, BAPCPA either dissuades or prevents many non-opportunist debtors—such as those suffering an unexpected financial shock—from filing for bankruptcy, due to the high costs involved, the smaller gains received, and the new eligibility requirements. But it also, writes White, “provides a new bankruptcy exemption for up to $1 million of assets in tax-sheltered individual retirement accounts ($2 million for married couples who file)” and allows “opportunistic debtors” to “pass the means test and qualify for Chapter 7 even if they have high incomes, by spending more on categories that increase their consumption allowances.” So while BAPCPA threatens to hurt honest debtors in need of relief, it has hardly stamped out bankruptcy abuse.
Between his opposition to BAPCPA and his concerns about the current housing crisis, Durbin appears likely to reject any measures that would enable creditors to keep a firm upper hand. That’s bad news for the lending industry, and it could also be bad news for the HOMES Act. While Durbin is talking compromise, his concerns regarding lenders’ ability to veto mortgage changes are, in his own words, “critical.” And since Durbin holds the powerful post of Senate majority whip, any “compromise” legislation he supports will almost certainly lean away from the approach favored by Specter, whether the lending industry likes it or not. What seems guaranteed is that, with the 2008 election just around the corner, and with both parties concerned about a voter backlash over the housing crisis, the bankruptcy debate is not going away any time soon.
Liz Mair is a recovering corporate finance lawyer, and a columnist, commentator, and political consultant operating out of Arlington, Virginia. She writes daily at www.lizmair.com.