May 01, 2009

American Royalty:

On Thursday, the Senate took up the issue of whether to eliminate the exception in the Bankruptcy Code which allows mortgage lenders to prevent the bifurcation of certain of their loans into secured and unsecured portions in bankruptcy, or in plainer language, the “cramdown” legislation. It was defeated, 51-45, with a dozen Democrats voting to preserve the Carter Era Valentine to the nation’s bankers. Ironically, it was the most liberal wing of the Democratic Party in the Senate who came out most passionately for the principles of Free Market capitalism, whilst their conservative counterparts on both sides of the aisle voted to maintain the subsidy.

Inevitably, the cramdown legislation voted down will pass, if not in this Congress, then at some future time, since the current law represents governmental protectionism at its most illogical and nonsensical, a business subsidy without rhyme or reason. To understand why, it is helpful to examine the absurdity through an example.

Let’s say an individual buys five identical properties. Each property is the same acreage, contains the same square footage, rooms, and looks exactly the same. Each property looks exactly the same, in fact, and is able to obtain identical mortgages for each property, a thirty-year adjustable-rate mortgage for $200,000.

However, the purchaser decides to use each of the properties differently. One property is going to be his home, where he and his newlywed bride will live out their days, surrounded by their 2.5 children and a lifetime of memories (they hope). As his family grows, he desires to build an extension to his home, so he takes out a second mortgage for $50,000. The second property will be rented out to tenants. His mother-in-law will live, rent-free, in the third home, while the fourth home, overlooking the Pacific Ocean, will be used as a vacation home for his family. Lastly, the fifth property will be used as his office.

Hard times ensue. His wife’s last pregnancy was a difficult one, and her hospitalization lasted longer than normal. Moreover, she had to take longer maternity leave than before, so the family income went down significantly. Not surprisingly, her HMO didn’t cover much of the costs, so he had to max out their credit cards to pay for her hospitalization. To make matters worse, his largest client went to a competitor, and now his business in drowning. He falls behind on each of the mortgages, and a foreclosure date is set. The value of each of his properties falls 40% in two years, leaving him unable to use his investments’ equity to cover his bills. Finally, after trying to scramble, scrimp, save and borrow for a year or so, he has to bite the bullet, and see a bankruptcy attorney.

After reviewing his assets and debts, his attorney sees a potential way out for his new client. In Chapter 13, a debtor may reorganize his position by repaying certain debts over a period of time. The procedure is relatively simple and quick, provided he is able to restructure his secured debts (ie., his mortgage) in such a way that he can repay the amount he has fallen behind. He is confident that his business will recover; he just needs a little breathing space. To make it work, however, he will have to seek a complete discharge of his unsecured debt, such as his credit card bills.

The reason why bankruptcy courts treat secured debt differently from unsecured debt is obvious. A secured creditor gets a lien on the property purchased by the consumer so as to make a loan in which only a small percentage of the overall principal is advanced by the borrower viable; if the borrower defaults, the lender gets the physical asset, which it can resell and thereby recoup its losses. In bankruptcy, the lender’s security interest in the physical property is protected, while anything above the value of the actual property (ie., the unsecured portion of the debt) is discharged, along with the other unsecured debts. In short, it is the free market’s way of ensuring that both the borrower and lender bear an equivalent risk. Bankruptcy lawyers call it a “cramdown.”

When the real estate market is stable, lenders rarely have anything to complain about. Since the value of property has historically gone up, the amount of the loan is usually at or below the appraised value of the property, so even if the borrower defaults, the lender doesn’t lose anything on his investment. Bankruptcy courts have traditionally honored the free market tradition of bifurcating claims from lenders into secured and unsecured portions, and explicitly give debtors the right to modify said claims in the context of reorganization of debts in Chapters 11 and 13, with one exception.

For our friend, his attorney proposes that he bifurcate the secured claims on his real properties. Concerning the property that he lets his mother-in-law live rent-free, the property his business operates out of, the property he rents out, and the property where his family summers every year, he can propose a plan in which he will repay the loans at the secured level, based upon an appraisal for each property. He keeps each of the properties he wants to keep, so long as he repays the secured portion over a five-year period. The one property he cannot do that for, and for which he will still owe the entire amount of the mortgage, secured and unsecured alike, is the property he lives at, his “principal residence.”

But even that’s not entirely true. Remember when he obtained a second mortgage on the property a few years before things went south for his family. He can get rid of that debt easily enough, simply by showing that the appraised value of the home is less than what he owes on the first mortgage, making the second completely unsecured. Many courts permit the vanquishing of such a debt to be accomplished with no more than a motion to the court, seeking declaratory relief that the value of the property makes the second lien totally unsecured. It’s only the first mortgage that receives privileged status in the bankruptcy court.

It is hard to justify giving certain loans special treatment in our courts. In the case of our friend, the lenders had no idea which property he was going to declare, on the eve of bankruptcy, was his “principal residence.” They simply loaned him the money, making what were presumably sound judgments based on his credit history, his ability to repay, the long-term predictability of the value of the properties, and other factors. In fact, had he and his family simply moved in with his mother-in-law’s estranged husband, they could cramdown all five properties under the existing Bankruptcy Code. Such are the advantages of property ownership and wealth in this society.

But of course, most people aren’t able to purchase five properties. For the ordinary Joe Schmoe, it’s hard enough to come up with one payment, much less five or six. Unless he is willing and able to move out of his home on the eve of bankruptcy, thereby allowing him to claim that his “principal residence” is somewhere other than the property he’s paying a mortgage on, he, and he alone out of all real estate purchasers, must repay the entire mortgage in bankruptcy, thereby defeating the purpose of “reorganization.”