O.K., so the $700 Billion Federal Bailout itself didn’t instill much confidence. May I say, “Duh!” There are many reasons but foremost, it’s because the Bailout (I mean “Rescue”) Plan didn’t do squat to address the underlying crisis in the housing market. The Democrats’ response to the Fed’s initial 3-Page draft of the Bailout Plan, contained the modification to Chapter 13 which I briefly discussed in my last article. The GOP dismissed it as creating too great a risk for mortgage lenders who would fear lending if a borrower could use the bankruptcy system to reduce the interest and/or principal of the mortgage. Well, after 20 years as a bankruptcy trustee and practitioner, I think the idea of modifying our bankruptcy laws in this crisis needs a prompt and thorough rehearing!
For example, Chapter 12 of the Bankruptcy Code was enacted in 1986, on a temporary basis, specifically to deal with financially distressed family farmers during an extended period of high interest rates and tight credit. The primary purpose of this legislation was to give family farmers facing bankruptcy a chance to reorganize their debts and keep their farms. Today, we are witnessing an emergency similar to the farm-crisis of the 1980’s – but with respect to Mr. NASCAR-voter and Mrs. Hockey-mom down the block. In August of 2008, there over 300,000 foreclosure filings nationwide – a 12% increase over July and a 27% increase over August, 2007.
I propose recreating a new Chapter 10 Bankruptcy specifically designed for homeowners seeking to avoid foreclosure. Similar to Chapters 12 and 13 in many ways, new Chapter 10 would operate as follows: Debts would be classified as being either “secured”, “priority”, or “unsecured”. Secured debts are those for which the creditor has the right to pursue specific pledged property upon default, such as a home mortgage or a security interest in a vehicle. Priority debts are those granted special status by the bankruptcy law, such as most taxes and the costs of the bankruptcy proceeding. Unsecured debts include just about every other kind of debt. Within 90 days of filing, the debtor would propose a reorganization plan lasting at least five years. Under this plan, the debtor would pay all projected “disposable income” over the term of the plan to a trustee, who distributes the funds to creditors.
“Disposable income” is defined as income which is not reasonably necessary for the maintenance or support of the debtor or his/her dependents, court-ordered support payments and for the payment of expenditures necessary for the continuation, preservation, and of the debtor’s business, if self-employed. The payments would have to be sufficient to pay all priority creditors in full. However, as long as the “disposable income” requirement were met, unsecured creditors would have to receive only as much as they would if the debtor’s nonexempt assets were liquidated under chapter 7. This could be as much a 100%, or as little as nothing!
Secured creditors would have to be paid at least as much as the value of the collateral pledged for the debt. In the case of home mortgage loans maturing beyond the five year plan period, payments would continue until maturity or sale. During that period, the mortgage principal could be reduced to reflect the value of the property at confirmation of the plan, and to reduce interest rates as well to an affordable level, provided that at the time of sale, the lender would be entitled to receive a graduated percentage of any appreciation in value up to the amount of the reduction in the mortgage and interest confirmed in the plan. In this key respect, Chapter 10 would be different than other bankruptcy procedures because the lender would actually retain a participatory interest.
Would lenders still make these mortgage loans if this law were enacted? Of course they would! Chapter 13 already allows debtors to modify junior liens (second mortgages) on their principal residence where there is no value to support the lien, and to modify even first-mortgage loans on second homes and investment property. Chapter 12 currently allows first mortgage loans to be modified on a farmstead. So why delay?
The operational mechanisms for this approach, as well as a considerable body of case law, already exist. Moreover, no one is going to rush into this process without a legitimate need because, after all, it’s still bankruptcy with all the other attendant negatives. For our economy today, however, it would provide a logical and workable means of deterring foreclosures and stabilizing home prices.