Almost 30 years have passed since the Bankruptcy Reform Act of 1978, a time when mortgages typically had a fixed-rate and unchanging monthly costs. Back then — and until 2005 — if you ran into financial trouble bankruptcy provided a way out and a fresh start.
But in 2005 declaring bankruptcy — something that was never simple, easy or pleasant to begin with — became far tougher. Under the Bankruptcy Abuse Prevention and Consumer Protection Act creditors suddenly had new protections — and borrowers didn’t.
What changed? Effective October 17, 2005 most student loans can no longer be discharged. If your income exceeds the state medium you can be forced to file under Chapter 13 (a repayment program) and not Chapter 7 (a discharge and forgiveness plan). Credit debt is not forgiven if you spend at least $500 in the 60 days prior to seeking bankruptcy protection — say a cash advance to pay off a looming mortgage payment.
Perhaps most importantly for mortgage borrowers, the 2005 legislation says homeowners must obtain credit counseling and develop a budget analysis in the 180-day period before filing for bankruptcy.
If you put all the changes together the results are predictable: Bankruptcy filings should fall and that’s exactly what happened. According to court filings there were 1,597,462 bankruptcies in 2004 and 2,078,415 bankruptcies in 2005. As for 2006, bankruptcies declined 70 percent to 617,660 cases.
The falling number of bankruptcies and the rising numbers of foreclosures are related. In basic terms, under the old bankruptcy rules it was often possible to delay a foreclosure action by stalling the creditor in court and using that time to sell or refinance the property.
Curiously though, the 1978 legislation had an unusual mortgage-related requirement. It provided that while a bankruptcy court could modify and adjust various debts, including the mortgage on a vacation home, it could not modify the mortgage on a prime residence. A literal interpretation of this language was upheld in 1993 by the Supreme Count in its Nobleman decision.
“The practical effect of the current bankruptcy law is that borrowers stuck in unaffordable home loans must cure their defaults and, in addition, make monthly payments on the loans according to their terms or lose their homes. No other creditor in personal bankruptcy or business bankruptcy can leave a borrower in such a position,” says a study produced jointly by the National Consumer Law Center, National Association of Consumer Bankruptcy Attorneys, Consumer Federation of America, National Association of Consumer Advocates and the Center for Responsible Lending.
Under the 2005 legislation borrowers cannot get into a bankruptcy court until they’ve satisfied credit counseling requirements. Unfortunately, in many jurisdictions foreclosures can be accomplished in far less than 180 days, meaning that the property can be lost before a borrower is even allowed to file a bankruptcy claim.
“What we need today are bankruptcy laws which assure that creditors are protected from the easy loss of their investments,” says Jim Saccacio, chairman and chief executive officer of RealtyTrac, the leading online marketplace for foreclosure properties. “At the same time, we need to end the imbalances found in current bankruptcy rules. The mortgage products which existed in 1978 have been supplanted with new and complex mortgage instruments, so the rules which worked in the past need to be reconsidered in the light of fresh circumstances.”
Such change may well be underway. In the House, a Judiciary subcommittee has approved HR 3609, a bill introduced by Rep. Brad Miller (D-NC) and Rep. Linda Sánchez (D-CA) that would end the credit counseling requirement and also allow bankruptcy courts to modify mortgage debts on prime residences.
In the Senate, S.2136, introduced by Sen. Dick Durban (D-IL), would eliminate the credit counseling requirement and allow bankruptcy judges to modify mortgage obligations, just like the House proposal. The Durbin bill would also:
Give debtors up to 30 years, less the time the mortgage has been outstanding, to pay-off long-term real estate debt.
Allow a bankruptcy judge to convert a mortgage into fixed-rate financing “in an amount equal to the most recently published annual yield on conventional mortgages published by the Board of Governors of the Federal Reserve System, as of the applicable time set forth in the rules of the Board, plus a reasonable premium for risk.” In essence, a bankruptcy judge could modify a predatory loan or an exploding ARM.
- Combat excessive fees charged to debtors in bankruptcy.
- Maintain debtors’ legal claims against predatory lenders while in bankruptcy.
- Allow bankruptcy judges to rule on core issues rather than defer to arbitration.
- Allow property owners over age 55 to have at least a $75,000 homestead allowance, a larger allowance than is now available in many states.
- Reinforce consumer protection claims even when a borrower goes bankrupt.
If the bankruptcy reform bills had been proposed a year ago their chance of passage would have been zero. But with the number of foreclosures growing nationwide, with homes losing value in many local markets and with the presidential race now underway, bankruptcy reform has a real shot at passing.
Columnist Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 100 newspapers.