A recent study, "The Effect of Bankruptcy Strip-Down on Mortgage Interest Rates," by Adam J. Levitin and Joshua Goodman of Georgetown Law School offers important predictions about the potential effects of some proposed changes to bankruptcy law.
For more than 100 years, U.S. bankruptcy law has been written so that mortgage loans cannot be modified by bankruptcy judges during reorganizations.
According to the study, this measure was originally meant to encourage homeownership—if people were required to pay their mortgages, the mortgage industry would have a steady stream of money coming in and would be able to keep interest rates on mortgage loans low.
Those low interest rates would then encourage more people to take out home loans, become homeowners, etc. But, since the various innovations in the lending market made home loans available to those who couldn't afford them, the restriction on bankruptcy judges has had the opposite effect.
Now, those who file for bankruptcy in hopes of saving their homes from foreclosure are often disappointed by the limited power of the court to ease the strain of their mortgage loans.
Known in the U.S. House of Representatives as the Emergency Home Ownership and Mortgage Equity Protection Act of 2007 and in the Senate as the Helping Families Save their Homes in Bankruptcy Act of 2007, the bill in question would lift the mortgage modification restriction currently on bankruptcy judges.
If the bill is passed into law, bankruptcy judges will have the power to create a new mortgage payment plan for bankruptcy petitioners, just as they currently have power to mandate new payment schedules for other secured debts in Chapter 13 bankruptcy cases.
In its current form, the bill has provisions that would restrict mortgage modifications to those petitioners whose income was too low to cover basic living expenses and mortgage payments and whose mortgages were subprime or nontraditional.
The Mortgage Bankers Association, the group that protects the interest of those in the mortgage lending industry, has protested the changes proposed in the bills. Members of the MBA have testified against the bills in front of Congress, insisting that the proposed changes would not benefit homeowners or the mortgage industry.
MBA spokespeople have argued that, if borrowers are permitted to pay lower interest rates than those originally agreed upon, mortgage lenders will have a lower overall income. This, they say, will mean they're not able to offer potential borrowers very attractive interest rates on mortgage loans.
The MBA has released various estimates about the exact increase in interest rate that would occur if the proposed changes in bankruptcy law were passed. In front of Congress, the estimate was two percentage points. In later press releases, the MBA estimated an increase of 1.5 percentage points, but offered no explanation for the change.
In their study, Goodman and Levitin examined data from the 1980s and 1990s to determine how mortgages modified by bankruptcy judges would affect the overall mortgage market.
They found that foreclosure proceedings would actually be more expensive for everyone involved than mortgage modifications. In fact, according to the study, the actual interest rate would increase by an amount that is "statistically indistinguishable from zero," according to the report.
The findings of this study could influence the decision Congress ultimately makes on whether or not to institute the proposed changes to bankruptcy law. If the changes do go into effect, many petitioners who are trying to save their homes by filing bankruptcy will have a better chance of doing so.
The strains of the foreclosure crisis could be eased, since the incentive of modifying mortgage terms could serve as an incentive for people to file bankruptcy rather than abandon their homes.