The Rich Strategically Defaulting and the Merits of Cramdown

The New York Times had an article on Biggest Defaulters on Mortgages Are the Rich with the above graph. Yves Smith, Annie Lowrey and Tim Fernholz have more.

It’s not clear how they define strategic defaulters. It seems that CoreLogic, who they consult with for the data, uses straight up delinquencies. Another definition that is becoming common would also likely show up with the rich more strategically defaulting: the definition used by Experian and Oliver Wyman that we discuss here (“a strategic defaulter is someone who misses six straight months of mortgage payments without missing multiple payments on auto loans and other consumer debts…All this definition means is that someone has enough money to pay their car payment and the minimum on their credit card but not enough money to pay their mortgage payment…The definition you want is whether or not someone has income to make all their payments, not how they allocate payments.”)

But still those second houses and investment properties are showing up in the data, and the break between above and below 1 million is a little hard to rationalize except for the obvious conclusion that the rich are different than everyone else. Our gut reaction should be the other way, that someone who can make some payments on a $1m home is probably much less liquidity constrained, much less likely to have to eat cat food in order to pay for a worthless mortgage. I’d like to see the data controlled for unemployment too – if the $1m homes are higher there then something is much more likely to be up.

Are there policy solutions that could provide relief without increasing this inequality, the ruthlessness in which the rich appear to be defaulting? Yes. And for the record, it’s mortgage cramdown. From Adam Levitin’s Resolving The Foreclosure Crisis: Modification of Mortgages in Bankruptcy: (my bold)

Permitting modification of mortgages in Chapter 13 bankruptcy would be unlikely to result in wealthy or spendthrift debtors receiving unmerited relief. Traditionally, wealthy debtors rarely file for bankruptcy. The mean income of Chapter 13 bankruptcy filers in 2007 was $35,688, and less than 10 percent of all debtors earn over $60,000. Indeed, wealthy debtors with significant secured debt are not eligible for Chapter 13. To file for Chapter 13, an individual must have less than $336,900 in noncontingent, liquidated, unsecured debts and less than $1,010,650 in noncontingent, liquidated, secured debts. This means that a homeowner with a million-dollar mortgage cannot avail himself of Chapter 13. Instead, if that homeowner wishes to keep his mansion, he must file for Chapter 11 bankruptcy, where creditor controls are much stronger because creditors must vote to approve a plan. And, if a high-income debtor has low enough secured and unsecured debt levels to be eligible for Chapter 13, Chapter 13 would be of limited benefit as the debtor would be required to pay all of his disposable income—as determined by a statutory test—to unsecured creditors, including any unsecured mortgage claim resulting from claim bifurcation under section 506.

Speculators, too, are unlikely to benefit from bankruptcy modification. The secured-debt limit will keep many out of Chapter 13. The parts of the country where there has been the most real-estate speculation are also the parts of the country with the highest home prices. In California, where the average loan amount is $331,926, three of these mortgages plus a $15,000 car loan would make a debtor ineligible for Chapter 13. Thus, a speculator with a fairly average car, a mortgage on his own home, and two investment properties would not be eligible for Chapter 13 bankruptcy.

Even if the speculator is eligible for Chapter 13, he is unlikely to be able to retain his investment properties, much less modify the mortgages thereon. A mortgage-loan modification in bankruptcy can occur only as part of a plan. The automatic stay would likely be lifted on an investment property (or second home) before a plan could be confirmed. The automatic stay must be lifted either if the property is underwater and not necessary for an effective reorganization, or for cause, including lack of adequate protection. Strip-down is only useful for underwater properties, and unless the debtor’s business is being a small-time landlord, the property is not necessary for an effective reorganization. The areas that have been hardest hit by the decline in housing prices are areas where there had been price run-ups fueled by speculation. These are the parts of the country where investor properties are most likely to be underwater, and where the mortgagee would most likely be able to have the stay lifted.

If you look at the data the mortgage interest tax deduction is a giant giveaway for the richest homeowners in the country. And my gut reaction is that something like cramdown would also work that way – ignoring the people who need the most relief while shoveling money to the top 10% of Americans. Nor do I want to benefit speculators. They made their bets, and if they lost they deserve to eat those losses and not get special relief outside what they would normally get.

But cramdown actually doesn’t work that way. In fact, mortgage cramdown is designed to filter out the rich who are strategically defaulting and the speculators always out to make a quick buck, and zone in on suffering households who are willing to pay a penalty to stay in their homes but whom paying a deeply underwater makes no productive sense. It’s instant relief for those with a high propensity to spend in a recession (hint hint stimulus fans), the struggling working class and middle class people in a deep recession with high unemployment.

Wouldn’t cramdown have been an excellent solution to put into place 3 years ago?

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1 Response to The Rich Strategically Defaulting and the Merits of Cramdown

  1. Pingback: Do the rich strategically default? « Beats and Pieces

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