A New Tool for Foreclosure Avoidance

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  • The proposed bankruptcy law reform will allow a judge in a Chapter 13 filing to reduce or "cram down" the balance of a mortgage securing a principle residence to the current property value, along with other rate and amortization term changes.
  • During the implementation of the bankruptcy plan, the crammed down portion of the mortgage will be treated as an unsecured claim of equal priority to other unsecured claims such as credit card debt. The crammed down amount may therefore be partially recovered from a borrower'a disposable income over a 3 to 5 year period. The benefit of a mortgage cram down to the borrower is contigent upon successful completion of the bankruptcy plan.
  • The fact that close to 70% of delinquent non-agency loans have negative equity, compared to only 37% of current loans with negative equity, indicates that lack of equity potentially is an important driver of todau's performance deterioration.
  • Overall we think the bankruptcy reform will be a net positive in terms of foreclosure reduction, as it may be an effective way to improve both home equity and affordability. It has several attractive features relative to other loss mitigation alternatives, such as comprehensive debt restructuring, less moral hazard, and direct dealing with second liens. Though it is an important new tool in the toolkit, we can't dismiss unintended consequences such as; (1) many more borrowers filing them than who qualify, (2) bankruptcy bar ramping up its marketing machine, and (3) new defaults created by borrowers who believe (falsely or otherwise) bankruptcy will be their salvation.
  • Only borrowers who can service the secured portion of the mortgage and a portion of the unsecured portion will be eligible. However, it's not entirely clear wether borrowers with high income relative to debts or very low income would file bankruptcy anyway. Likewise some very marginal borrowers may be confirmed, but will ultimately fail the plan.
  • We expect the bankruptcy plan will provide about 20% reduction in foreclosures. This is based on our belief that many delinquent loans are too far underwater relative to borrowers' income, many properties are empty, and many borrowers wouldn't want to go through the onerous bankruptcy process.
  • We expect the new bankruptcy reform will increase loan mods, particularly principle reduction mods, as it is likely to both pressure and also give justification to servicers to more actively pursue principle reduction mods.
  • One paradox of the bankruptcy reform is that it is premised on the assumption that the bankruptcy courts can handle an upsurge in fully documented loan mods while at the same time the government and industry has given up on a fully documented streamlined loan mod protocol. If servicers can't handle documenting a large amount of loan mods, why would the government assume the bankruptcy courts can handle it? Though we don't have a clear view as to whether the bankruptcy courts can handle it, we do believe servicers should attempt to create a streamlined mod program that mimics some of the features of a bankruptcy plan(e.g., strict oversight, monitoring of the plan, all income and expenses documented). As we've written previously, we believe that with government support, the industry can use technology to create a fully underwritten, though streamlined, mod plan. The streamlining would be done via technology rather than failing to fully document the borrowers financial status.
  • The impact of mortgage cram down on a subprime senior bond will depend on its relative position in the AAA stacks, the success of mortgage cram down in foreclosure reduction, and the structural feature of whether the principle distribution of sequential AAAs will change from sequential to pro rata after all subordinates are wiped out, and how the cram down will affect the timing of change. We present a hypothetical sample to show how the cram down will affect the values of front pay, penultimate and LCF AAAs.
  • The cram-down law will be a distinct negative for many senior prime RMBS bonds that have a unique feature wherein bankruptcy losses are set at a maximum dollar amount, beyond which additional bankruptcy related losses will be allocated to all bonds regardless of seniority. Because this bankruptcy threshold is set very low, should the bankruptcy law pass, it's likely that such senior prime bonds will see accelerated default and loss realization.
  • The plan is a negative for card and auto lenders, as these lenders will be forced in bankruptcy to share the pain with mortgage lenders. Currently, given the limited benefits to homeowners under the existing bankruptcy law, many borrowers may continue to pay their cards and autos and default on their mortgage. For those borrowers filing for bankruptcy cram down, the credit card and auto lenders will be forced onto the same repayment plan as the mortgage lenders. Or put another way, some losses due to the appallingly weaker underwriting decisions on the mortgage loans will get socialized with the car and auto lenders which, thus far, have not appeared to have gotten out of hand in terms of underwriting.

Download the full draft PDF here: Dreamhosts Files Forever courtesy of Credit Suisse Research(membership required).

Date published: Jan 17, 2009

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