Mortgages are in the news every day, and that news is not good. The statistics behind the news tells the story of escalating mortgage defaults. Mortgages are going bad, and the bad mortgages are no longer limited to those classified as “subprime”—mortgages extended to those persons with spotty credit histories. Mortgage problems now extend to “Alt A” loans. As problems grow with these higher risk loans, problems also begin to extend to general, or “prime,” mortgages due to stagnant or even declining property values. Houses remain on the market for longer periods, therefore refinancing problem mortgages becomes more difficult.
The problems hitting homeowners, however, is directly felt by the lenders as well. Investors are feeling the impact of mortgage problems as the market value of the securitized mortgage pools experiences the impact of foreclosures and the marked increase in nonproductive loans.
It should come as no surprise that mortgage foreclosures result in substantial losses to all parties to the transaction. It is estimated that the average mortgage lender loses more than $50,000 per foreclosed home.4 These losses are not simply limited to the lender or the investors in mortgage-backed securities. Loan servicers lose an income stream when a home is lost to foreclosure. Mortgage insurers are hit by increased claims, losses that will be passed on to other borrowers in the form of increased premiums. Cities lose tax revenue. Neighborhoods deteriorate as foreclosed homes stand vacant.
The business of mortgage lending has been stung by rising foreclosures. But the hundreds of thousands of homeowners who are in default on their mortgage payments face more than a financial setback or loss of an asset. They face the loss of home and shelter—and tremendous personal and family suffering.
Chapter 13 has provided a means to help homeowners preserve their homes and deal with financial problems under the supervision of the courts. Chapter 13 plans currently modify the rights of creditors, so long as the modifications comply with the terms of that chapter. Section §1322(b)(2) establishes the Section §1322(b)(2) establishes the of all creditors. When the Code was enacted, however, Congress carefully crafted a unique limitation on the ability to modify the rights of some creditors: A plan could not modify the underlying rights of a creditor secured solely in the principal residence of a debtor. The exceptionÑinsulating home mortgages from modificationÑwas designed to preserve the underlying value of the loans themselves, because "mortgage lenders [were] performing a valuable social service through their loans [and] needed special protection against modification thereof...." At the time the Code was written, however, subprime mortgages with unconventional provisions were rare. The Code's mortgage protection was fashioned at a time when the ability to cure a default and maintain payments was all that was needed to avoid the foreclosure, reinstate the mortgage and minimize the loss. Many debtors successfully employ chapter 13 to cure mortgage defaults while still maintaining the regular payments and no modification of the underlying terms was necessary.
The growth in subprime mortgages has been matched by a growth in adjustable rate mortgages (ARMs). These obligations carry fixed rates initially and adjust after a specified period to a new interest rate that may or may not be based on national interest standard, such as the prime rate. The percentage of subprime mortgages that are ARMs rose from 27.6 percent in 1998 to 50 percent in 2006.7 More than 14 percent of subprime ARMs were delinquent in December 2006, as compared to a mortgage delinquency ratev for the overall mortgage industry of 4 percent, a rate that has been steady, even though it has edged upward in the past year.
Traditional tools to deal with mortgage defaults are proving to be inadequate to handle the problem. Loss mitigation programs undertaken by mortgage service providers and supported by the giants of the mortgage world, including Freddie Mac, are of limited usefulness. Reinstatements coupled with a short-term forbearance are often cited as a loss-mitigation option to deal with short-term problems. Servicers will often negotiate repayment plans with delinquent borrowers, establishing a voluntary Òcure and maintainÓ remedy to a delinquency. In addition, programs that "bring the mortgage current" by adding missed payments to the outstanding loan balance or that extend the repayment term present loss-mitigation options that can permit a borrower to retain ownership and maintain the value of the underlying obligation.
Restrictions imposed on servicers by investors, limiting the use of more expansive loss-mitigation tools, have exacerbated the mortgage-default problem. Although mortgage lenders are encouraged to make modifications to the underlying loans by advisors and economists,8 they often restrict servicers from engaging in such modifications. The result is a great loss for the lender, the borrower and the servicer. This is a loss that could be mitigated.
It is time to recognize that a modification to §1322(b)(2) could facilitate the preservation of a mortgage for the benefit of both the borrower and the lender. By altering the protection from modification accorded to loans secured by the principal residence of the debtor and allowing such modified obligations to be paid over a period longer than the typical five-year chapter 13 plan, Congress would be protecting both home ownership and would minimize the losses currently facing mortgage lenders.
This proposal is not unprecedented. Currently, a confirmed chapter 12 plan can rewrite the terms of a debt secured solely by the principal residence of a debtor, and permits the debt to be repaid over a term longer than a traditional five-year plan period. Chapter 12 provides to family farmers the opportunity to restructure the mortgages on their homes, reworking interest rates, payment amounts and terms of repayment.
It may well be that altering §1322(b)(2) to permit modification of home mortgages need not extend to all mortgages. The ability to rewrite a home mortgage could be limited to those mortgages that carry an above- market interest rate, are substantially undersecured or are similarly uncon-ventional. The ability to modify such a mortgage would still be subject to the limitations on modification found in §1325(a)(5)(B): The payments pro-posed must be equal in amount andmust provide present value to thelender. Mortgages that carry an adjustable rate could be converted to mortgages whose interest rates are fixed at a prevailing market rate13 thattakes into account the risk facing the lender. The terms of the mortgage would be reset only with careful scrutiny by the bankruptcy court.
The benefits would be obvious. The debtor could propose a repayment plan as part of a chapter 13 plan that avoids future escalating mortgage payments beyond the debtor's ability to pay. The uncertainty of adjustable rates or other unconventional devices would be eliminated, providing stability and certainty to a borrower. The enormous losses incurred by lenders resulting from foreclosure would be limited, and a nonproductive loan would have the potential to become an accruing-- and profitable-- asset.
The implicit recognition found in the non-modification provision of §1322(b)(2) is that the market woulrespond to its provisions.14 The proposed change to §1322(b)(2) would utilize the market itself to police the high-risk, subprime, unconventional loans. A mortgage loan to an individual with a greater capacity to default would have its potential earnings discounted. A high-interest or grossly undersecure loan would similarly confront a reduce value. Rather than impose statutory restrictions on the ability of a lender to make an unconventional loan, the market would make such high-risk loans less attractive.
The proposed change would also protect the mortgage industry from itself By providing chapter 13 debtors with the opportunity to restructure a home mortgage, the statute would create a type of loss mitigation where much of the value of the underlying obligation would be preserved.
If Congress sought to provide a remedy to the subprime mortgage crisis, this would be one proposal that could work.
ABI Contributing Editor:
Henry E. Hildebrand III
Lassiter, Tidwell & Hildebrand PLLC