Monday, November 12, 2007

Bankruptcy Judges May be Given New Sub-Prime Related Authority

by Nancy Osborne, COO of ERATE


It is estimated that over 2 million homeowners who have acquired their homes by means of a sub-prime mortgage either have or will lose their home in foreclosure. It is also estimated that 25% of all sub-primes loans which were funded in the past 3 to 4 years will end in default wiping out approximately $145 billion in equity wealth as housing prices are on tap to continue declining over the next few years. Consumer action groups are taking the position that as home prices have already begun to decline on a nationwide basis, consumers, lenders and their investors will continue to lose much more over time if the pace of foreclosures is not stopped now. Compounding the problem for the consumer is the fact that current bankruptcy laws will make things more difficult for them in recovering from the devastating financial impact of losing ones home and trying to move forward with tarnished credit. As an unfortunate and untimely result of the 2005 changes to the bankruptcy code, an individual in financial trouble cannot pursue a bankruptcy filing option until they have first sought out credit counseling from a court approved credit counseling agency. This is a time consuming requirement which an individual facing foreclosure cannot afford as time is in very short supply.

Frustratingly only 1% of risky sub-prime mortgages have been modified during the period of January through September of 2007 and for the month of October only a nominal number of so called loan work-outs or modifications occurred. The loan modification or workout process can be extremely complicated and time consuming because of the number of players involved in a mortgage loan transaction, each may be required to sign off on or approve any changes to the original loan terms. Those players are as follows: the consumer, the mortgage broker (if applicable), the funding lender, the loan servicer and the investor in the loan's mortgage backed security or now infamous collateralized debt obligation (CDO). Because all the players may have a legal stake in the process the water gets murky and everybody is either afraid of being sued or may be considering suing another player. This makes for an extremely hostile and difficult process under which to modify original mortgage terms. The process is far easier for the consumer who obtained their loan through one source that processed, underwrote, funded and serviced the loan all under one roof.

So now it appears that what’s in the best interest of the consumer may be in the best interest of all parties involved and it may be left in the hands of a bankruptcy judge to decide. A bill sponsored by a congressional representative from North Carolina, Brad Miller (D), will allow bankruptcy judges to re-set mortgage payment terms at their discretion. This will bring mortgage debt in line with all other consumer debt from the perspective of how bankruptcy law handles insolvent homeowners. A judge would be allowed to change the interest rate on the loan, extend the loan term or even reduce the loan amount altogether, just as they would be permitted to do so with auto loans or with credit card debts. Bankruptcy courts have long been permitted to change the terms of mortgages on second or vacation homes as well as on family farms and now the primary residence would be given the same consideration.

While consumer groups are squarely behind the bill, the lending industry is naturally in strong opposition to it. Lending industry representatives claim that this legislation will end up harming the consumer in the long run because it will raise the cost of obtaining a mortgage by increasing the uncertainty and risk involved to all parties who extend credit to the consumer. They claim that rates and lending costs have been low historically because a home is secured by a real asset and if someone is allowed to come in and arbitrarily change the value of that asset, the cost of borrowing will rise for everyone. If the terms of an original loan contract, initially agreed upon by all parties, can be altered down the line, this will bring added risk and uncertainty, thus increased costs, into the entire mortgage equation. In the end it would appear that how the law is applied, and under what conditions and circumstances, will be the ultimate test of whether the lending industry’s claims bear out. However given the prevailing complicated circumstances, it would appear that no one but a judge may be able to ultimately determine the right thing to do in each individual case given the specific circumstances involved.

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