It is gaining popularity among some in the political class. The idea is being floated to change the law and allow "cram-downs" on owner/occupant loans.
Cram-down: Basically, on many commercial (investment property) loans, a bankruptcy judge can alter the terms of the loan during a bankruptcy proceeding. Let's say that the property has deflated in value and won't support the payment it once did, the judge could lower the balance of the loan to allow the owner's payment to cover servicing the new lower debt. In effect, the new value is crammed-down the throat of the mortgage lender.
For most of the rest of us, if we do end up declaring bankruptcy, the same option doesn't exist. In effect, a home owner would be able to stay in the house, and the bank would write down the value of the loan to reflect the "new reality". This is already how it works forcredit cards. And the idea seems to be getting a lot of traction from some members of Congress.
On the positive side, this would allow many that would otherwise face foreclosure to stay in their homes. Instead of being at the mercy of the banks, judges would be to to quickly and efficiently change the terms of a loan unilaterally. Right now, home owners might wait for months to be told no... or worse, might have to produce some arcane piece of paper and join the line again to wait months to hear the next hurdle.
But there is a giant negative... And it seems like a lot of the people that are proposing this as a solution to ease the foreclosure crisis are ignoring this completely. The effect of risk on interest rates. With increased risk come increased cost. And we aren't talking about pennies here, either. Take a look at a few different types of loan products and the costs associated with each of them.
- Regular owner/occupant mortgage. 5.188% $1100/mo. Payment
- Commercial Property 30yr. mortgage. 7.62% $1415/mo. Payment
- Credit Card Rate highest risk. 12.65% $2160/mo. Payment
In the case of a traditional mortgage, the bank can be reasonably assured that they have a shot at getting the money back that they loaned out. They certainly have risk... especially now... but it is low by comparison. They either get paid in full, take back the property, choose to lower the principal on the loan or choose to alter the terms.
With the commercial property mortgage, there is a higher risk for the lender. If the borrower were to have a financial problem landing them in some sort of restructuring, they could have the value of the loan modified, the terms altered or they could end up taking back the property. But, instead of choosing to do it because it is a good business decision, they can be forced.
Credit cards are unsecured. In the case of a bankruptcy, the balance can be dramatically altered, or even wiped out. The risk is very high. So, despite the fact that the banks are borrowing the money at a very low rate, they have to jack it up in order to cover the default risk of the borrowers.
Give me the "Executive Summary"
In a nutshell, if "cram-down" provisions were placed into the bankruptcy code, the interest rates would have to rise in order to cover the increased risk. Also, remember that most investor loans require 20% down because mortgage insurance companies don't like them at all.
So, not only would rates go up, but down payment requirements would also go up.
Do you think either of those things would help the real estate market? Prices would drop a LOT more than they would otherwise. A lot more borrowers would be in precarious financial situations. The government would end up fueling the very thing they are trying to stop.
But worse, think of the people that have NOT made mistakes... the ones that haven't even bought yet. They would be penalized MASSIVELY for the irresponsible acts of those that bought homes they couldn't afford. That $315/mo over 30 years is more than $113,000!
Lane - I have some mixed feelings about this, but, am tilted against it. I would prefer to see modified payment plans or loan restructuring. On the other hand, certain members of congress want to make sure that it not only isn't made harder for low income people to buy but to even expand the programs and make it easier.
I'm waiting to see how the latest proposal is designed to work. It seems that it could be the solution that many homeowners need to be able to stay put and perhaps stop the "walk away" mentality. I had two calls this week from homeowners who are bleeding due to the lower value of their homes, they put 20% down and still the value of their homes are 100K less than what they owe. Hopefully this new plan will keep them where they want to be but I'm still not convinced.
Lane - a form of this subject was debated extensively during our last state directors meeting around the subject of 'short closures'. The idea was to incent banks to be more responsive to short-sales and if they didn't respond or wouldn't work with a legitimate short-sale offer, the next step would be to force them (cram-down) to take a deed-in-lieu and short out any junior liens. We decided not to pursue it as a legislative effort precisely because of the negative impact to interest rates and the complete elimination of any secondary loan market. If you've got a good chance of being crammed out, what's the incentive to lend in the first place and how much are you going to charge for that. It'll be an interesting process to watch.
Mike - My feelings are only mixed in that I know that some would benefit from cram-downs... but it would damage way too many more.
Cindy - "Helping" people this way has too many casualties. Think of the ramifications. They might find that after their loan is crammed down, they are upside-down again because of the slide in valued from being able to cram-down. I don't mind if the banks choose to do it... and I think there are many cases where it is a better financial move for them to do so, but doing it by force will only damage the whole real estate arena.
Gene - Exactly the point!
Lane,
Thanks for the good explanation. To answer your question, very bad idea. :)
Steve
Steve - I think so...