Today, one of my favorite bloggers in this planet or any other -- that would be Tanta over at CR -- took on the issue of whether or not federal bankruptcy law should be amended to allow bankruptcy courts to modify a borrower's mortgage while in Chapter 13. I'm going to discuss a few points she missed, and why I can't agree with her "just say yes" campaign. FWIW, I'd chalk this up to a difference of opinion moreso than a difference in market understanding; I think she and I have a very similar understanding of market dynamics. First things first: read the full post for some background on how federal bankruptcy laws have impacted mortgage banking through the years, if you aren't already familiar. (You'll need this information if you're going to have any chance at understanding the debate in this post.) HW readers already likely know my stance on this issue: that altering the BK code to allow for cram-downs will hurt all borrowers indirectly through higher rates, and in particular hurt the subprime credit class the most. But I wanted to lay out in far more detail why I feel this way, and why in this case I think the MBA has a very good point in opposing any legislation in this area. Tanta mentions that cram-downs were allowed in Chapter 13 restructurings until 1993 -- and that mortgage rates did not particularly suffer as a result. While I don't want to simplify her rather eloquent argument, this is one very important leg to the "yes to cram-downs" chair. And while a review of historical mortgage rate data suggests she is technically correct, there is a very important fly in the ointment here: the Bankruptcy Abuse Prevention and Creditor Protection Act of 2005. Section 707(b) of the Act establishes a "means test," a screening device intended to steer filers away from Chapter 7 and into Chapter 13. And while I think there is still some question as to whether or not the test has had its fully intended effect, it's hard to argue with the numbers that show a relative increase in Chapter 13 utilization by filers. According to the Administrative Office of the U.S. Courts, for bankruptcy filings in the 12-month period ending June 30, 2007, there were 450,332 Chapter 7 filings and 294,693 Chapter 13 filings (these numbers comingle business and non-business numbers, of course, but business filings represented just over 3 percent of total filings). That's a ratio of 65 percent, dividing Chapter 13 filings by Chapter 7 filings. Comparatively, for the same ratio calculation, the following was observed for previous 12 month periods:
  • 26.8 percent in 2006
  • 36.2 percent in 2005 (the year BAPCPA was enacted)
  • 39.1 percent in 2004
  • 40.5 percent in 2003
It's worth noting that overall bankruptcy filings are down dramatically in 2007, which leaves some question as to whether the "means test" has achieved its fully-intended goal (or if it has discouraged filing altogether) -- but it seems clear from a simple ratio comparison that BAPCPA's means test has at least steered those who do file bankruptcy towards Chapter 13 and not into Chapter 7. With more borrowers steered into Chapter 13 than in the past, it seems pretty reasonable to think that the proposed changes would have a significantly more material effect on the industry than they might have back in the period of, say, 1991-1993 -- when the vast majority of non-business BKs went Chapter 7 rather than Chapter 13. A second confounding factor here is the emergence of the secondary markets after 1993; I don't have any neat charts handy here, but it should go without saying that we've got far more invested into secondary mortgage markets than we did back in 1991 through 1993. What this means is that the re-introduction of "restructuring" credit risk, made material thanks to bankruptcy reform in 2005, could cause mortgage credit markets -- much different today than the markets of a decade ago, and the market that by-and-large enabled subprime borrowing -- to tighten even further. Secondary market investors will reprice their risk accordingly, pushing up mortgage rates for the credit class most likely to face such a cram-down risk. If legislators want to kick the secondary markets while they're down, and manage to make things more difficult for the one credit class they are purporting to help, this seems to me a sure-fire way to get the job done. This a complex issue, of course, so there are still many unanswered questions here: for example, if BAPCPA is actually making it more difficult for potential filers to file bankruptcy altogether, as I alluded to earlier, a change in the bankruptcy code for Chapter 13 filings would have less positive effect on troubled borrowers than perhaps some other ideas that can reach more of the note-holding public. It also means that this discussion may not matter much, since it won't affect a large enough pool of borrowers (and perhaps then the discussion should center on the means test itself). And there are issues surrounding philosophy as well -- a primary residence has always been seen as "the American Dream." Whether or not I agree with that philosophy is a moot point; what's important is that the cram-down exception for primary residences was clearly rooted in legislators' support for that ethic. (The "valuable social service" language Tanta referenced comes in here). If the current housing boom/bust cycle has so sullied the public's view on what the role of mortgage banking is -- making it no different (at least philosophically) than financing an automobile -- I think the industry as a whole need look no further than the mirror to see who to blame.