Mortgage "Cramdown" Rules Could have Major Impact on Debt Buyers

There are plenty of unknown issues surrounding the potential cramdowns of first mortgages as the government considers ways to try to pull the economy out of the tailspin brought on by the credit crunch, sharply declining real estate values and growing foreclosures.

“Cramdown” refers to provisions in current legislation that would allow bankruptcy judges to adjust the terms of mortgages on primary residences for distressed borrowers.

One of the biggest questions is the valuation of the portfolios containing those debts, said Dan North, chief economist at Euler Hermes ACI, a trade credit insurance firm. “How would you value future portfolios?”

However, North said that any loss in value of a portfolio due to the cramdown of principle has to be weighed against the other likely alternative – default of the debt.

Another issue is the implications cramdowns would have on contract law, added John Jay, senior analyst at Aite Group. The bonds were collateralized by the mortgages and sold off by the financial institutions to buyers, including investors, pension funds, and others who expected a certain return on their money. Some of those debt purchasers include foreign countries, many of which the U.S. has always counted on to buy government obligations.

That’s not to say the cramdowns won’t happen. Jay called the practice “one of a number of suboptimal solutions. Some people are overleveraged.”

Though admitting that it sounds cold, foreclosure is probably the best solution in many cases, according to Jay. He pointed out that if someone bought a car or other asset and didn’t keep up with the payments, it would be repossessed without a lot of the commotion surrounding home foreclosures. If cramdowns are allowed, they should be determined on a case-by-case basis, Jay added.

President Obama defended some of the cramdown provisions in a speech Tuesday night before a joint session of Congress. Calling the language a “mortgage prevention plan”, Obama said, “It’s a plan that won’t help speculators or that neighbor down the street who bought a house he could never hope to afford, but it will help millions of Americans who are struggling with declining home values—Americans who will now be able to take advantage of the lower interest rates that this plan has already helped bring about.”

U.S. House Speaker Nancy Pelosi said on Monday that Democratic leaders hoped to bring the mortgage bankruptcy legislation containing the cramdown provisions to the House floor on Thursday.

An accounts receivable management industry source, speaking on the condition of anonymity, added that mortgage modification rules under HR 200, as the legislation as originally written, would lead to cramdowns via bankruptcy court that could affect holders of other debt.

For example, if the buyer of a $450,000 home had a $400,000 outstanding mortgage, but the amount was reduced in bankruptcy court to $300,000, the $100,000 difference would become an unsecured debt, subject to a payoff plan in bankruptcy proceedings. But the payoff plan would include other types of debt as well, including credit card payments, creating a dilutive effect for the other debts.

The debtor might have another $30,000 in credit card debt. If the bankruptcy judge determined that the debtor should repay $15,000 of the outstanding debts (beyond the primary mortgage), rather than repaying $15,000 in credit card debt over the next five years, the debtor would now repay $15,000 to be split between the credit card and mortgage debt.

This would greatly erode the holdings of any debt buyers owning accounts that go into bankruptcy, according to the source.