Back Door Cramdowns?

The general rule under the United States bankruptcy code is that when loans are secured by collateral in a reorganization (rather than a liquidation), that the loan is broken up into two parts for bankruptcy purposes - one equal to the value of the collateral which is entitled to receive value in the bankruptcy equal to at least the value of the collateral (often by being given a loan with a principal amount equal to the value of the collateral and otherwise the same interest rate, amortization period and other terms as the original loan), and with the othe part equal to the remainder of the loan that receives the pennies on the dollar or no payout that other general unsecured creditors (like ordinary corporate bond holders and credit card copmanies) receive. The reduction of the loan to the value of the collateral is called a cramdown. Mostly, cramdowns apply to business property bought with secured credit and vacation properties with mortgages.

Residential mortgages and most car loans aren't eligible for cramdown treatment in bankrupty. The debtor must either reaffirm the loan in full, even if the collateral is worth less than the loan, or surrender the property.

There is a gray area in the case of residential mortgages that is turning out to be quite relevant. Often, a house in bankruptcy in an areas where there has been a housing price bubble collapse will have two mortgages. The first mortgage will clearly not be eligible for a cramdown. But, what about the second mortgage? If the value of the house is less than the amount of the first mortgage, is the second mortgage really a mortgage at all? Or, is the second mortgage really just an unsecured debt like a credit card because its claim against the collateral is contingent and only a remote future possibility?

A recent newspaper article in the Mercury News reviews this legal battle. According to the article, "bankruptcy lawyers say the provision has been used effectively on hundreds, if not thousands, of cases in the Bay Area during the past two years." The California Mortgage Bankers Association is unhappy about this trend, but sees few options on the legislative front in a divided Congress. On the other hand, "there are no complaints from investors in first mortgages, like the pension and retirement funds represented by the Association of Mortgage Investors."

Income tax deductability and funding from mortgage backed securities made splitting low down payment mortgages into a a conventional first mortgage with an 80% loan to value ratio, and a second mortgage with a higher interest rate that covered the balance except for a small down payment, attractive compared to a single larger first mortgage with title insurance. Second mortgages used to extract cash from a house that had appreciated in value during the housing bubble were also popular.

The issue has a special tenor in California where residential mortgages are generally non-recourse. There, the only way that a lender can collect is out of the collateral, so a bankruptcy proceeding that wipes out a second mortgage lien wipes out any remedy for the lender.

There are two narratives that explain the trend to deny the cramdown to residential mortgages.

One is that it protects lenders from being penalized by artificially low appraisals in bankruptcy court. If the property is really worth less than the loan, a rational bankruptcy debtor would give up the property and escape the mortgage debt in bankruptcy, so a cramdown should only take place if the appraisal undervalues the property providing an undeserved benefit to the debtor. Similarly, an appraisal based only on current comparables fails to capture appreciation in real estate that may be available in a short time during a temporary real estate price slump. These concerns don't seem to have been well supported, however, by the experience in Chapter 12 farm bankuptcies, where cramdowns are allowed.

The other narrative is that home owners aren't rational. They attach sentimental, and dignity related and moving cost related value to their home that no lender could realize if the home were foreclosured upon or surrendered. In this narrative, denying residential home owners a right to cramdown mortgage loans is a way of giving residential mortgage owners more than their fair share in a bankruptcy every time a debtor keeps a home that has a fair market value of less than the face value of the loan.

It is unclear how common this situation is in Denver. Internet real estate appraisal service Zillow.com says 41% of meto Denver homeowners owe more on their mortgages than their homes are worth, and many of those homes would have second mortgages. But, Standard & Poor's/Case-Shiller, which experts believe is more accurate (Forbes actually dropped them as a source after obvious gross errors in their statistics were pointed out), concludes that housing values have declined far less than Zillow concludes, and hence far fewer homeowners are upside down. Case-Shiller consistently ranks Denver as one of the twenty major housing markets least impaired by the housing bust, while Zillow counts Denver as the second hardest hit market in the nation. Like other observers, I'm strongly inclined to give Case-Shiller more credit than Zillow for accuracy on this point. Too much other data corroborates the conclusion that Denver's real estate market has declined less than those of many other markets in places like California, Arizona, Nevada and Florida.