Jan 13, 2009

Expand the Mortgage Modification Program to Chapter 7 Bankruptcies

Throughout the mortgage meltdown crisis, many democrats and bankruptcy professionals have favored a change in the bankruptcy laws to allow Chapter 13 bankruptcy judges to modify residential mortgages -- something they can't presently do. Legislation to this effect was originally introduced in mid-2008, but failed because of staunch opposition by the mortgage and banking industries.

The legislation has been reintroduced in both houses of Congress (SB 61 and HR 200) and is expected to pass this time around (in modified form), due to the severity of the foreclosure crisis, the change in administrations, and, most recently, the support of a major bank. Last week, the Wall Street Journal reported that Citibank had broken ranks with the Mortgage Bankers Assocation and is supporting the new legislation -- provided that homeowners be required to seek a voluntary modification first. As with other legislation regarding bankruptcy and foreclosure prevention, its highly probable that this proposed legislation will change in many respects prior to its final passage.  

As I've pointed out in earlier posts on this subject, I'm not against the concept of mortgage modifications in bankruptcy. I am, however, concerned that the Chapter 13 remedy for foreclosure prevention is limited to a relatively small number of would-be filers due to Chapter 13 eligibility requirements, and the associated legal costs consisting of fees that can reach upwards of $3,000. Keep in mind also that over 2/3 of Chapter 13 bankruptcies fail and are either dismissed or converted to Chapter 7 -- although it's sometimes possible to modify the plan or obtain what's known as a hardship discharge. Most importantly, modifications initially obtained in a Chapter 13 bankruptcy may no longer apply if the plan fails.

In short, I think the Chapter 13 remedy is being over-hyped as a solution to the foreclosure crisis. Of course, less plans will fail if mortgage payments are reduced, but there is no way to tell what effect -- if any -- the reductions will have on the success of Chapter 13 plans overall. Another less-heralded part of the proposed legislation should add to the success of Chapter 13 plans -- under the legislation, mortgage payments are to be made directly to the lender by the homeowner. This is very important because many Chapter 13 trustees currently require payments to be made as part of the plan, which entitles them to a 10% commission on all mortgage payments over the life of the plan. This extra amount often makes Chapter 13 plans unaffordable for many would-be filers. For example, 36 monthly mortgage payments of $2,000 payable through the plan would generate a trustee's fee of $7,200, whereas no fee would be generated if under the direct payment requirement, so filers will save some serious cash.

To address the shortcomings of Chapter 13, the mortgage modification remedy should be extended to Chapter 7 bankruptcies. Like Chapter 13, Chapter 7 has a system for assessing the current value of personal property and reducing the obligations accordingly. This same system could be used to assign a current value to homes and both reduce the mortgage to that value and reduce the interest rate to the current prime rate, plus a point (the going formula for assigning interest rates in bankruptcy).

Simply put, Chapter 7 bankruptcy is far less expensive than Chapter 13 bankruptcy and is far more available to the millions of homeowners who may be in need of relief to prevent a foreclosure from occurring.

To learn more about how to use bankruptcy laws effectively, see The New Bankruptcy: Will It Work for You?, by Stephen Elias (Nolo).