Mortgage Meltdown and Bankruptcy Laws

By Catherine Brock

In the 2004 film The Butterfly Effect, character Evan Treborn realizes he can travel through time. He uses this skill to correct the mistakes of his past-until he realizes that each correction creates new problems for the future. A similar dynamic may be happening today with financial regulations, as efforts to stabilize the banking and lending sectors threaten to cause bigger waves for borrowers.

Opinion split on court-ordered modifications

There's a war raging in Washington regarding bankruptcy legislation and mortgage market loans. Here's the background in a nutshell: Bankruptcy judges currently have no authority to modify mortgage terms to help a distressed homeowner. If the bankrupt homeowner can't afford the mortgage payments, foreclosure is the likely outcome.

Lenders have long argued that this system keeps mortgage rates low-because no matter what happens, the lender can take the home if the borrower can't pay. Allowing bankruptcy judges to change mortgage terms would put lenders at risk of having to absorb forced and unexpected losses. And that would have to be a consideration when pricing new mortgage loans.

Critics of the no-modification policy say that prohibiting bankruptcy-related modifications makes the foreclosure problem much worse than it needs to be. They also believe that lenders are overstating the impact that such bankruptcy legislation would have on mortgage rates. The national average mortgage rate for a 30-year fixed loan is about 5 percent; the average unsecured consumer credit card rate is about 14 percent.

Bankruptcy reform and the mortgage meltdown

A new report, however, supports the notion that conclusions on both sides may be radically oversimplified. A team of researchers at the Federal Reserve Bank of New York believes that the bankruptcy reform laws of 2005 essentially triggered the subprime mortgage meltdown that began in the following year.

The 2005 laws, intending to stem bankruptcy abuse, made it much more difficult for consumers to have unsecured debt discharged by the court. In practice, this also made it more difficult for distressed homeowners to avoid foreclosure. This makes sense: a borrower whose required monthly debt payments are measurably lowered through a discharge has a much easier time keeping a mortgage current. But take away that clean slate option, and the mortgage loan remains impossible to manage.

Certainly those who supported bankruptcy reform were not expecting a mortgage crisis to result.

Tinkering may not be best solution

Now that Congress is again looking to tinker with bankruptcy laws, you have to wonder if our lawmakers will proceed cautiously enough. It's simple to say that mortgage rates will or won't be impacted-but the truth is that no one really knows.

There's one conclusion, though, that both sides can support: the last thing the mortgage market needs right now is a rash of unintended consequences.