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Emerging Trends in Real Estate Law

5/12/2008 8:28:53 AM EST

Bankruptcy Control over Foreclosures

Posted by Peggy Goodman

Federal Reserve Chairman Ben Bernanke announced that in 2007 there were 1.5 million home foreclosures, up 53 percent from 2006, and it looks as though 2008 the rate of new foreclosures will be even higher. One of the issues debated in Congress is whether a bankruptcy judge should have authority to modify the interest rate on home mortgages in chapter 13 bankruptcy cases in order to prevent foreclosure and allow the homeowners to retain their home.

Pros

One argument presented by consumer advocates, who want to give bankruptcy judges the power to amend the interest rates on home mortgage loans, is based on the large number of people who have "piggyback" loans, second mortgages taken on homes by the purchaser to help cover the down payment, closing costs, and other expenses associated with buying a house. These second mortgages are often taken at the same time as the first mortgage. Advocates argue that while the first mortgagee may be willing, even anxious, to modify the terms of the loan, the second mortgagee prevents the homeowner from doing so.

Another argument presented by advocates is that many people who qualified for prime and reasonable rate loans were steered into subprime loans. Many of these subprime loans had very low teaser rates, but the rates were scheduled to go up significantly after a number of years and very little was explained to the purchaser about the potential increases. Often, the purchasers were told that payments would go up one or two hundred dollars, when in fact the increases doubled the monthly payments. Advocates argue that the bankruptcy judge should be able to modify the predatory interest rates. Advocates also argue that allowing a bankruptcy judge to modify the amount of interest would act as an incentive to mortgage companies to voluntarily modify the amount of interest in order to avoid both foreclosure and bankruptcies.

Cons

Most mortgage brokers and mortgage companies are firmly against the proposal. Some economists have stated that the proposal would not significantly help ease the mortgage crisis, and President Bush has indicated he would veto the proposal, if it passed. The administration is concerned that the proposal would undermine existing contracts. The administration is also concerned that it would increase the number of bankruptcies by encouraging more homeowners to file for chapter 13 bankruptcy protection.

Part of the problem is that the company that holds the mortgage is frequently not the company that solicited and processed the mortgage. Many mortgages were bundled together and sold as a package. The purchasers of the mortgages bundles paid a price based on the expected return on their investment. Any reduction in interest would decrease the expected return. The holders of second mortgages see no benefit in permitting the first mortgage to be refinanced unless the second mortgage is paid in full. All too often the first mortgagee is paid in full, while the second mortgagee receives nothing.

Current Status of the Proposal

Although the proposal was dropped from pending legislation providing remedies for the mortgage crisis, the proposal is likely to be reintroduced again in the future.

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