Modifying Residential Mortgages: Obama's Policy Failure

(To preface, I just had to write this; it’s been eating at me since I first heard it mentioned months ago, and it’s particularly relevant as the bailout is being reconsidered. I may also try and have this printed somewhere, because I think it is important. The intention was to pull all partisan politics out of the piece, and to focus solely on the issue itself.)

Barack Obama has said time and time again that bankruptcy judges should be permitted to modify the terms of residential home mortgages. While likely well-intentioned, that policy has not been thought through and, like the Bankruptcy Reform Act of 2005 (BAPCPA), carries with it a number of side effects that will worsen the current economic problems.

First, some background on myself. I’m an attorney licensed to practice in Ohio. I have filed several hundreds of personal bankruptcies for individuals and families under Chapter 7 and Chapter 13. I have dealt with debtor and creditor issues in my legal career and have significant experience in dealing with the bankruptcy court. So, it’s not like I haven’t read the entire bankruptcy code (sans Chapter 11) from front to back and analyzed much of the code in my daily life.

Second, some background on the bankruptcy provision in question, with the caveat that I’m not attempting to argue the nuances of bankruptcy law, but will if needed or requested. Generally speaking, Obama is correct in stating that bankruptcy judges have the backing of the law if they seek to modify all mortgages except for mortgages in first lien position on the principal residences of debtors. In a vacuum, you might also argue he’s correct in pointing out the apparent inconsistency and impracticality of that provision.

However, the position fails on several levels. At a basic level, the provision itself takes into account that on investment properties, both the borrower and the lender have taken into account with the terms of the loan contract that the loan is to be an investment loan on investment property. Further, many of the federal and state protections for borrowers do not apply to investment properties and properties where the borrower does not intend to immediately occupy the property as his principal residence, so there is more reason to examine these loans with scrutiny because some of the safeguards at origination do not exist. Finally, other factors are generally at play on investment properties; namely, profitability on these properties is determined on many external factors such as the housing market and economy that cannot be predicted by either party when the investment is undertaken. The borrower and creditor, when entering into a loan on a principal residence, typically only must look at internal factors (which were themselves relaxed, but that is a different argument for a different time).

On a more advanced level, the Obama policy fails because of the side effect it would have in worsening the economic conditions that the nation currently faces. It is important to note that the overwhelming majority of residential mortgages in the United States are first lien mortgages secured upon the principal residence of the borrower. It’s next important to note that when mortgages are bundled into mortgage-backed securities, it is highly typical that these residential mortgages are bundled together.

Much has been made of the current inability to accurately value these assets. The valuation issue is related solely to the value of the assets upon which the loans are secured; the contracts are what they are, and the amounts owed (both the principal amount due and the rate of interest that is to continue to accrue) are easily calculated. If you can’t see the problem yet with Obama’s proposal, you soon will.

To recap, in these mortgage-backed securities (in which large pools of loans are bundled into a single instrument to be transferred amongst investors), you have two main valuation calculations: the amount due on the commercial paper (the aggregate running total of the amounts due on each note) and the value of the individual assets upon which each note is secured (the mortgaged properties). Thus, one variable is easily known and tracked (the amount outstanding) and one is causing the majority of the financial crisis we now face. Currently, unless the owner of the securities (or, most likely, the servicing agents) changes the terms of the contracts, the one side of the valuation issue is not a problem here.

If Obama has his way, unfortunately, bankruptcy judges will have the opportunity to alter the one constant that is available on these mortgage-backed securities, and can do so at irregular times (i.e., whenever each borrower files for bankruptcy protection and whenever the court is petitioned under the code to alter the loan provisions). The logistical nightmare outlined does not even take into consideration the costs of litigating the valuation of the commercial paper, assuming that the attorneys involved (for both borrowers and the banks) disagree (you can insert any sarcastic comment you like here).

You should now easily see the problem. Congress, in its infinite wisdom, could formulate a piece of legislation intended to bailout the markets and facilitate liquidity into this market (the liquidity problem centers around the inability to accurately formulate the value of the securities) and worsen the problem by allowing bankruptcy judges to make the mortgage-backed securities even more of a crapshoot to analyze, and to cause these valuation issues on an unmanageable and unpredictable scale.

Obama’s policy on utilizing the bankruptcy court to modify residential mortgages is misguided and poorly formulated. It is incumbent upon Obama to drop this plan from his platform and to focus on other methodology in order to achieve his goals.