October 19, 2009
Obamanomics and the Future of Bankruptcy
Posted by Usha Rodrigues

Instructed to be provocative, the illustriously named former Sen. Gordon Smith’s opening remarks included the observation that "All great nations in history presaged their declines with massive debt" and a reference to the "awful arithmetic" of our national debt. He closed by asking whether there should be a bankruptcy remedy for states, as there is for municipalities or counties. David Skeel responded that he doubted whether Congress would allow this, but hypothesized that states could issue bonds with voting provisions in place that would allow the debt to be restructured midstream. Smith was skeptical of the market’s appetite for such debt.

There was a lot of debate over the Chrysler and GM bankruptcies, and in particular the "aggressive" use of Section 363 of the Bankruptcy Code, the provision that allowed for a quick sale of Chrysler’s assets in bankruptcy. The question came down to whether the sale was a good thing (Claude D. Montgomery 's view, because it was fast and the company had effectively been "on the block" for months) or a troubling thing (Skeel's view, because there wasn’t a robust auction, and the creditors and shareholders of Old Chrysler wound up owning the lion’s share of New Chrysler). Michelle White observed that economists in general want fast sales in bankruptcy, but also want "true" sales--which Chrysler was not. Because she characterized only 20% of Chrysler as "worth saving," she was unhappy with the government bailout.

White also gave a helpful summary of the issues in mortgage crisis. First she framed the high costs of foreclosures: homeowners and renters must relocate; moving makes kids switch schools, and families lose established neighborhood ties. Vacancies cause blight, tax revenues fall, so cities cut public services. Foreclosures cause more foreclosures by driving down values.

Given the above, lenders foreclose too often. Although they lose 1/3 to 1/2 of their investment, many of foreclosure’s costs are borne by others. Although the Obama administration’s Help for Homeowners program has resulted in 500,000 modifications, only a few thousand have permanent modifications—ie., a reduction in principal.

Why so few? Because lenders can and do veto permanent modifications, and for rational reasons. Securitized mortgages come with "pooling and servicing agreements" that compensate lenders for the cost of foreclosure, but not for the cost of modifying loans. Couple that with the fact that 30% of mortgage defaults "self-cure" (debtors scrape together the money), and that 30-45% of modifications re-default within 6 months (so lenders just have to renegotiate modifications, or foreclose on a property that’s now worth even less), and you have no lender incentive for modification.

Chapter 13 is supposed to help homeowners save homes, but White calculates that only 1% save them that otherwise would have lost them. So what if we let bankruptcy judges cram down mortgages in Chapter 13? Smith thought this wouldn’t be worth the cost to the mortgage market as a whole—presumably lenders would charge more upfront to compensate for the risk of cramdown at the back end. Moderator and bankruptcy judge Leif Clark suggested the market effect would be ameliorated by time-limiting the cramdown power to the loans made during the bubble, and then sunsetting it.

Skeel then made a shrewd observation. Despite the title of this panel and blogpost, the Obama administration has really just continued Bush’s economic policies. Skeel had thought that there would be support from Obama for mortgage cramdowns, and has been surprised not to see a departure here from Bush policies—at least, not yet.

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