Are Wrongful Homeowner Policies Blocking Economic Recovery?

Complications in the way the US finances mortgages may be at the heart of stalled economic recovery.

Packaged, bundled and resold mortgages may be the tail wagging the homeownership dog. Mortgage-backed securities were supposed to be a vehicle for providing additional liquidity which would enable the provision of broader availability to more potential buyers. The problem became that this secondary mortgage financing business became an end in itself. Its scale and profitability became the dominant factor in the business.

As the US attempts to dig itself out from the financial crisis and economic recovery, the legal and contractual obligations entailed in these complex securities may be making it harder for banks to renegotiate mortgages whose value no longer reflects market reality, let alone value. The result is that rather than helping to revive the housing market, fear of violating covenants - or even entering into the conversation with investors - is proving counterproductive. The result is that too many people are stuck with unrealistic mortgage obligations. They have as little interest in bailing out the banks as the banks have in assisting them. The market is flooded with useless paper and stasis rules. Until sensible interest in growth returns, the housing market and the economic recovery will continue to falter. JL

Richard Gibson reports in Marketwatch:

Discrimination against homeowners is blocking economic recovery. Our legal system permits every kind of property owner to reduce their mortgages, with one exception; homeowners are given no way to reduce excess mortgages.

As a result, four years after the crash of real estate, homeowners are still buried in debt. This is why consumer demand has not recovered and a big reason why the recovery has been so weak.
We have had many prior cycles, in which real estate prices soared, tempting property owners to take on high mortgages, and prices then crashed, leaving owners “underwater” with real estate worth less than the debt against it.

When this happens to commercial property owners, our law gives them an escape route. They can file a Chapter 11 reorganization. While Chapter 11 filings are expensive, risky and uncertain, Chapter 11 gives commercial property owners the power of “strip down:” They can reduce the principal of their mortgages to the current fair market value of the property.

The rest of the mortgage, the amount by which the mortgage exceeds the value of the property, can be “stripped down” under Bankruptcy Code Section 506, or converted into unsecured debt, which can be discharged. “Strip down” gives underwater commercial property owners a reasonable chance to reduce their debts, and to return to profitability.

Since 2007, residential real estate prices have fallen nationally by more than 30%. Tens of millions of homeowners have homes worth less than the mortgages against them. “Strip down” could have solved the problems of these underwater homeowners.

Middle class individuals can file Chapter 13 or Chapter 11 reorganizations. Were they able to “strip down” their mortgages, they could reduce their debts to a reasonable level. Like business Chapter 11 cases, consumer bankruptcies always involve substantial risks and costs; among other things, a bankruptcy filing is very damaging to a person’s credit.

Many Chapter 11 and Chapter 13 cases fail, and lead to Chapter 7 liquidation or dismissal. If homeowners could use “strip down,” however, many of them would decide that it was worth incurring these risks and costs to gain the power to reduce their mortgages.

If homeowners, in general, had the possibility of filing bankruptcy, and using strip down, this would give banks a huge incentive to negotiate voluntarily with homeowners to reduce their mortgages, even if they did not file bankruptcy.

But homeowners cannot use strip down. Under bankruptcy law, the only mortgages that cannot be stripped down are those against the principal residences of individuals or families. Donald Trump can use strip down to reduce multimillion-dollar mortgages against his casinos. A middle-class family, however, can’t use strip-down to save their home from foreclosure.