Strip It Down: A Bankruptcy Solution to
the Foreclosure Crisis

by Mark Cantora
Hofstra University School of Law

Semifinalist

I. Introduction: The Bankruptcy Solution

The scourge of foreclosure has already affected millions of Americans, and the fear of losing one's home looms over millions more. President Obama's "Making Home Affordable" program has been a step in the right direction insofar as it encourages homeowners to work with their lenders to modify their mortgage loans. These modifications have helped borrowers by allowing them to keep their homes, and they have helped lenders by allowing them to receive more money than they would typically receive in the auctions sale which almost always inevitably follows a foreclosure. However, there is more that can and should be done in order to help a larger portion of homeowners, especially those facing immanent foreclosure as a result of having less equity in their homes than the amount owed on their mortgage loans (i.e. homeowners with "underwater mortgages").

The best, clearest, and most comprehensive solution is the Bankruptcy Solution. First, this paper will explain the basic components of the Bankruptcy Solution. Next, this paper will explain why the bankruptcy court system is the best venue for solving the foreclosure crisis. Then, this paper will answer the three most common criticisms of the Bankruptcy Solution. Finally, this paper will conclude that the Bankruptcy Solution is the only program that contains all the necessary components to act both as a short-term and as a long-term solution to the foreclosure crisis.

II. The Bankruptcy Solution: An Overview

The Bankruptcy Solution is based around one primary concept: Homeowner-borrowers should be allowed to bifurcate and reduce — to strip-down — home mortgages. Although the intricacies of the concept of "stripping-down" a mortgage can be confusing, the fundamentals of the idea are fairly straight-forward. Oftentimes, a debtor will own personal property — such as an automobile — for which the debtor took out a loan in order to purchase that property. Typically, that purchased property is pledged to the lender as "security," for the loan, meaning that if the debtor fails to repay the lender, the lender can then repossess that "security-property," in order to satisfy the loan.

Frequently, when a debtor enters the bankruptcy process, that debtor will owe more money on the loan than the actual value of the property. In these instances, Section 506(a) of the Bankruptcy Code allows some (but not all) debtors to reduce the secured debt owed to the lender to the value of the property securing the debt. The rest of the debt — the difference between the value of the property and the amount owed on the loan — becomes general non-priority unsecured debt. Because in Chapter 13 Bankruptcy, debtors' plans must contain provisions requiring the debtor to repay secured debt in full, but oftentimes may also contain provisions requiring the debtor to pay only pennies on the dollar of general unsecured debt, this stripping-down essentially allows the debtor to keep her property by paying only slightly more than the value of the property over a period of time.

This process, which allows buyers to keep their property, restructure their payment options over a longer period, and pay an amount nearly equal to the value of the property, is currently unavailable to homeowners with home mortgages. Section 1322(c) of the Bankruptcy Code explicitly disallows this strip-down, so that no matter how much the loan amount exceeds the value of the property, strip-down is unavailable to homeowner-borrowers who have taken the serious and substantial step of declaring bankruptcy.

The Bankruptcy Solution would change this state of affairs. Under the Bankruptcy Solution, Section 1322(c) of the Bankruptcy Code would be repealed and replaced with language explicitly allowing all Chapter 13 debtors to strip-down their home mortgages. For example, if a debtor owes 300,000 dollars on a home mortgage loan secured by a home only worth 250,000 dollars, this debtor could declare bankruptcy and strip-down the home mortgage loan so that 250,000 dollars of the debt would be paid in installments over a 3-5 year period, and 50,000 dollars would become general non-priority unsecured debt — only a fraction of which may need to be paid under the Chapter 13 Disposable Income test requiring debtors to allocate all of their future "disposable income" to the repayment of debt to unsecured creditors.

III. The Benefits to Homeowners and Mortgage Lenders

The most desirable aspect of the Bankruptcy Solution is that it is beneficial to both homeowners and mortgage lenders. Homeowners are given all of the relief and benefits for which bankruptcy was invented, including the ability to have a "fresh start" — the raison d'être of American Bankruptcy. Most importantly, homeowners are given the opportunity to keep their homes for at least another 3-5 years while they attempt to complete the restructured repayment plan developed from negotiations between the homeowner, the mortgage lender, the bankruptcy judge, and the Chapter 13 trustee. And if the homeowner completes the new, less-harsh repayment plan according to the schedule, then they are entitled to own their homes fully and for all time.

Mortgage lenders also benefit from the Bankruptcy Solution. Outside the bankruptcy process, a mortgage lender's only option is to foreclose on the home securing the mortgage loan and resell that home — usually at auction — in an attempt to recover at least the value of the home. Then, if the selling price of the home is less than the amount of the loan, the mortgage lender frequently must obtain a deficiency judgment against the original homeowner in order to be repaid the full amount of the original loan. Oftentimes, it is at this point that the homeowner will declare bankruptcy, in which case the mortgage lender will end up in the bankruptcy process anyway. And in the bankruptcy process, the mortgage lender will eventually find itself receiving little or none of the deficiency judgment — all after the mortgage lender has suffered through this whole time-consuming, costly, and complex legal process.

Therefore, instead of forcing mortgage lenders to waste all this time and money, the Bankruptcy Solution allows the entire process to be streamlined in one court, in one venue, and with one set of rules. The Bankruptcy Solution would assure that the mortgage lender will receive the value of the secured home on a stable and predetermined schedule.

And as an added benefit, strip-downs as applied to home mortgages would be no different from other strip-downs currently allowed, in that they would require the homeowner to pay the mortgage lender "present value interest," which takes into account inflation and the time-value of money. Outside of bankruptcy, the mortgage lender merely receives the price of the home sold when it is sold at auction, at which point the value of the home may have plummeted even further. But in the Bankruptcy Solution, the mortgage lender receives the value of the home, as if it were all paid at the time of the start of the bankruptcy plan, meaning that the mortgage lender will not receive less money because of any administrative, bureaucratic, or business delays (as would be the case outside the bankruptcy process).

IV. The Benefits of Using the Bankruptcy Process

Whenever a new policy solution is proposed, a frequently overlooked aspect is the difficulty of implementing that policy. Logically and economically, the most difficult policies to implement are the ones that require new government systems and manpower. On the other hand, the easiest and most effective policies are the ones which can be implemented using already existing government systems administered by professionals already skilled in implementing similar policies. By dealing with foreclosure crisis inside the bankruptcy process, the Bankruptcy Solution offers a substantial amount of streamlined effectiveness and stability.

The entire bankruptcy system has been built-up to deal with the very same problems emanating from the foreclosure crisis. Every day, bankruptcy judges and Chapter 13 trustees deal with the intricacies of working with debtors and creditors to restructure loans. Determining and compromising between the best interests of borrowers and lenders and guiding the creation of restructured repayment plans acceptable to all parties involved are the daily "bread-and-butter," of bankruptcy judges.

Instead of creating new government systems from scratch — requiring timely and costly logistical innovations — the Bankruptcy Solution requires only the repeal and redrafting of one provision in the Bankruptcy Code. The implementation of the Bankruptcy Solution then proceeds within the already existing bankruptcy system, guided the entire time by professionals with expertise in solving the very problems stemming from the foreclosure crisis.

V. Answering Criticisms of the Bankruptcy Solution

Plans equivalent to the Bankruptcy Solution have been proposed — albeit half-heartedly — in the past. A variant of the Bankruptcy Solution was proposed in the House of Representatives. However, every time these plans have been proposed, they have been instantly shot down by the three following unanswered and supposedly fatal criticisms: (a) Allowing borrowers to strip-down their mortgages to the value of their homes will reduce the availability of homeownership to Americans, (b) The Bankruptcy Solution is only a temporary solution, and (c) Allowing judges to strip-down mortgages arbitrarily determine the proper value of homes will wreak havoc on and distort the market.

a. Criticism that the Bankruptcy Solution Hurts Americans

The most vehemently argued criticism against the Bankruptcy Solution is the argument that allowing homeowners to strip-down their mortgages to the value of their homes will force lenders to raise interests rates so high that home loans — and consequently homeownership — will become unaffordable for most Americans. This argument is supposedly based on simple laws of economics. However, deductive logic and empirical evidence cuts against this criticism.

First, even using the concepts applied by neo-classical economics, mortgage lenders would not be "economically induced" to raise interest rates to an untenable level. Mortgage lenders are as economically rational as anyone else. Therefore, it is insulting to the intelligence of mortgage lenders to assume that they would understand the long, unstable, unpredictable process of getting back un-repaid loans through the foreclosure process, and then chasing the homeowner-debtors through the state-debt-collection and/or bankruptcy systems as being less costly than the streamlined Bankruptcy Solution. If instability and unpredictability is a catalyst for higher interest rates, than the Bankruptcy Solution, being exponentially more stable, predictable, and efficient than the current process, should actually result in lower interest rates.

Furthermore, it is important to note that between 1978 and 1993, numerous court decisions in multiple jurisdictions interpreted the Bankruptcy Code in such a way that home mortgages were allowed to be stripped-down, as per the Bankruptcy Solution. (Warren & Bussel, 2008, p. 128). In one of the most detailed analyses of the empirical evidence of mortgage interest rates in these jurisdictions during this period, Law and Economics experts concluded that allowing strip-down of home mortgages had no effect on home mortgage interest rates. (Leviton & Goodman, 2008)

b. Criticism that the Bankruptcy Solution is not a Permanent Solution

Another criticism of the Bankruptcy Solution is that it is only a temporary solution. "Only 1/3 of debtors complete the bankruptcy process," so goes the argument, "while the other 2/3 fail to complete their payment plans, thus making bankruptcy only a temporary solution, merely putting off the day when the homeowner will lose her home."

Similar to the criticism above, this argument fails by failing to understand the implications of its own arguments. Perhaps only 33% of homeowners will be able to keep their homes under the Bankruptcy Solution. However, both the recent "market-based" process of mortgage lenders and homeowners bargaining to restructure mortgages, and the government's executive branch modifications, seem to be keeping much less than "33%" of homeowners facing imminent foreclosure in their homes. Foreclosure rates continue to rise (Trumbull, 2009) and the Home Affordable program has only had a "1%" success rate to date.

(Indiviglio, 2009) If the Bankruptcy Solution is only a "temporary" solution, it is at least more permanent than the "market-based" solution, the Home Affordable programolution, and any other policies advocated or implemented thus far.

The third major criticism is that judges should not have the discretion to arbitrarily determine the value of homes, thus subjectively determining the amount that homeowners have to repay to mortgage lenders, leading to a severely distorted and unfair housing market. This criticism is the easiest to refute by simply pointing out this criticism's misunderstandings of the bankruptcy process.

In bankruptcy, the judge determines the value of secured property in a specialized trial procedure. Property appraisers, real estate experts, expert witnesses, and evidence is all presented to the bankruptcy judge, who then makes a decision as to the value of the home based on all of this evidence. On the other hand, outside of bankruptcy, mortgage payments are made on an understandably inflated property value that no longer exists. When mortgage lenders control the "restructuring process" outside of bankruptcy, there are no evidentiary hearings or expert witnesses. The mortgage lenders determine the value of the property and effectively tell homeowners that the lenders' valuation must be taken as "correct" or the homeowner will lose her home (which will be subsequently sold at auction for far less than the mortgage lender's supposed pre-foreclosure "valuation"). This is not to criticize mortgage lenders; mortgage lenders are businesspeople and must do everything they can in their own best interests. However, while this self-interest is desirable and understandable in a free-market economy, it does not lend itself to an objective and proper valuation of property, as does the bankruptcy process.

Therefore, far from distorting the housing market, the Bankruptcy Solution actually restores the true market valuation of homes, instead of keeping them at the artificially inflated prices used outside bankruptcy which ends up forcing both homeowners and mortgage lenders into undesirable foreclosures.

VI. Conclusion: The Bankruptcy Solution is the Best Solution

Conclusion: The Bankruptcy Solution is the Best Solution Politicians, policy-wonks, think-tanks, and independent consultants all have proposed various solutions to the foreclosure crisis. In proposing the Bankruptcy Solution, this paper does not seek to denigrate the good intentions of the people expounding these plans. However, in spite of all these planners' best intentions, the foreclosure crisis continues unabated. Whatever the merits of the other proposed solutions, they have not succeeded in solving the crisis. The Bankruptcy Solution is the only plan that is beneficial to homeowners, mortgage lenders, the government, and the general American population. Therefore, the Bankruptcy Solution should be implemented as soon as is logistically possible so that the United States can take the first crucial step towards what will surely be a long, yet successful recovery.

Bibliography

Indiviglio, Daniel, "1% Success Rate for Obama Administration Mortgage Modification Program," The Atlantic (Dec. 11, 2009) available at http://business.theatlantic.com/2009/12/1_success_rate_for_obama_administration_mortgage
_modification_program.php.

Levitin, Adam, & Goodman, Joshua, "The Effect of Bankruptcy Strip Down on Mortgage Markets," Georgetown Law & Economics Research Paper No. 1087816 (Feb. 6, 2008).

Trumbull, Mark, "Home Mortgage Foreclosures Rise in the Third Quarter," The Christian Science Monitor (Dec. 21, 2009) available at http://www.csmonitor.com/USA/2009/1221/Home-mortgage-foreclosures-rise-in-third-quarter.

Warren, William D., & Bussel, Daniel J., Bankruptcy: 2008 Supplement 128 (Foundation Press: 7th ed. 2008).

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