Giving Foreclosures the One-Two Punch: Why the Making Home Affordable Program Can Knock Down Foreclosures But Needs the Backup of Bankruptcy Cramdown Legislation to Broaden its Scope

Abstract

Profound contractions in the housing market and the economy as a whole have had distressing effects on homeowners. Many prudent borrowers who have stayed current on their mortgage payments have watched their property values plummet until they no longer have sufficient equity to refinance to lower interest rates. Additionally, due to massive layoffs and a lean job market, millions of these recently unemployed borrowers must now bend over backwards to make each monthly payment. Currently, nearly 2,900 families are losing their homes each day, with many more struggling to meet their monthly mortgage obligations. Many of these foreclosures are not preventable. For example, investors may no longer wish to retain a property whose value has depreciated significantly, and some “borrowers - perhaps because they were put into an inappropriate loan or because personal circumstances have changed - cannot realistically sustain homeownership.” However, when a borrower desires to stay in her home and the foreclosure is preventable, the high legal and administrative costs and the destabilizing effects on communities and property values militate towards avoiding foreclosure.Foreclosure prevention programs to date, largely in the form of loan modification efforts, have failed to effectuate affordable mortgages, and therefore, have done little more than delay foreclosures. In fact, recent reports have shown that 68% of loan modifications have involved capitalizing unpaid interest and fees into a larger mortgage debt, and 45% have actually increased monthly payments. Lenders, who have a fiduciary duty to protect investors’ interests, have been unwilling and unable to make affordable modifications. The lack of any incentive for lenders to make meaningful and affordable changes to a loan’s repayment terms caused the historic failure of modification programs, as evidenced by re-default rates approaching 60%. Unlike previous efforts to encourage voluntary modification, the Making Home Affordable program’s (“MHA”) refinancing and modification plans could be the vehicle to achieve more permanent foreclosure prevention because of its focus on actual affordability and tripartite incentives for lenders, investors and borrowers. For example, MHA will reduce mortgage payments to 31% of qualified homeowners’ monthly gross income, with the government subsidizing interest rate deductions made by lenders to achieve this monthly payment affordability goal. Simultaneously, MHA provides lenders with payments of $1,000 per loan modified and pay-for-success bonuses if borrowers stay current. These provisions give lenders previously nonexistent financial incentives structure payments that borrowers can actually afford, and complement similar inducements for mortgage investors to permit restructuring qualifying loans and borrowers to stay current on their post-modification payments. However, while MHA tackles the borrower affordability and lender incentive shortcomings of prior foreclosure prevention programs, it fails to effectively address the main problem arising from the recent mortgage crisis: Severely underwater borrowers who are foreclosing because they purchased homes at an enormously inflated price and now have outstanding mortgage balances two or three times the actual value of their homes. Reformed bankruptcy laws permitting judges to modify mortgage terms if lenders do not make sustainable modifications are necessary to bolster MHA’s affordability - and incentive-based foreclosure mitigation program. While bankruptcy should never be the first option for a distressed borrower, the proposed cramdown legislation offers “the only remedy available that will provide the stick to go with the carrots that [Congress has] offered lenders to modify mortgages voluntarily.” This paper considers the current mortgage crisis, specifically looking at the Making Home Affordable program and proposed Chapter 13 bankruptcy mortgage cramdown legislation. Part I analyzes the policy rationale for and against government intervention in the residential foreclosure market. Part II establishes the historical context of ineffective voluntary mortgage modifications, looking at the former Hope for Homeowners plan as an example of recent failure. Part III explores the Making Home Affordable program, evaluating the potential efficacy of preventing foreclosures and inducing voluntary modifications based on the two primary impediments to modification plans: Affordable new terms for borrowers and incentives provided to obtain widespread lender participation. Looking at incentives, MHA induces lender participation through a combination of carrots and sticks, including monetary per-modification payments and judicial modifications of mortgages (i.e. “cramdowns” - decreasing principal, reducing interest rates, and extending repayment terms) in bankruptcy where borrowers have no viable options left. Part IV discusses the necessity of bankruptcy cramdown legislation, which would cast a broader curative net and offer a remedy to the many underwater borrowers currently outside the scope of MHA’s modification program. This cramdown legislation would provide further incentive for lenders to make a good faith effort at modification because it increases bargaining power for any borrower in modification negotiations, given that all parties - lender, borrower, and investor - will know that bankruptcy courts have the power to make equitable modifications.