Proposed amendments to the Bankruptcy Code permitting strip down of under secured home mortgages to the court-determined value of the homes and other modifications of home mortgages in Chapter 13 would substantially alter the risk characteristics of home mortgages, with likely substantial effects on future mortgage interest rates and future mortgage availability. Thus, the future societal cost of such a change in the law likely would be large. This article explains and supports that thesis, primarily on the ground that the proposed changes would leave mortgage holders with all of the future downside risk in the real property market while denying them the benefit of future appreciation.
This article also explains why a common argument made in favor of allowing strip down as a matter of fairness is simply mistaken; enactment of the proposed amendments would not treat home mortgages the same as other secured debt in Chapter 13 bankruptcy, but in fact would treat home mortgages much less favorably than other secured debt. Home mortgages would be the only secured debts that could be stripped down and paid off at a court-determined interest rate, with monthly payments lower than those required by the credit contract, over a period of up to nearly forty years, rather than the no-more-than-five year period that would still apply to other secured debts.
Additionally, the article provides a brief critique of Professor Adam J. Levitin’s empirical studies. Even though serious flaws in his empirical studies have been pointed out, Professor Levitin continues to claim in congressional testimony that “permitting bankruptcy modification is unlikely to result in higher mortgage costs or lower mortgage credit availability.” Supporters of strip down in Congress continue to rely heavily on Professor Levitin’s studies as showing that the proposed changes in the law would not substantially affect mortgage interest rates or mortgage availability. Unfortunately, Professor Levitin’s empirical studies, though thoughtful and creative in their design, rely on incorrect understandings of current and past bankruptcy law and of the proposed legislation. They, in effect, compare apples with oranges – or perhaps a bumper crop of apples with a frost-ravaged crop of oranges – by comparing the effects of the kind of strip down that would be widely available under the legislation now before Congress, with the effects of the very different kinds of strip down that, in limited circumstances, are currently available or were at one time available. His studies also fail to take into account the very different incentives that the proposed legislation would create were it to be enacted, both in terms of encouraging debtors with large negative equity to file Chapter 13 bankruptcy petitions and encouraging Chapter 13 debtors to argue for a low value for their homes rather than to report an inflated value. The empirical studies thus do not provide a solid foundation for the making of public policy.
In addition, adoption of the proposed amendments to the Bankruptcy Code would cause somewhat perverse results. Strip down provides the greatest benefit to debtors who have the greatest amount of negative equity. Homeowners who made the lowest down payments, paid the most inflated prices for their homes, and refinanced to take equity out of their homes for purposes of consumption thus would receive the greatest benefits – benefits that would include, in essence, a free option on future appreciation and that would not be well calibrated to the homeowners’ financial need – while homeowners who made large down payments, were careful not to pay inflated prices, and did not use their home equity to finance consumption would receive the least benefits. These perverse results are not only undesirable in and of themselves from a public policy “moral hazard” perspective. They also may cause resentment among those persons who could not benefit from them or who would receive.