GM bondholders have a problem. While the company gasps and groans in the marketplace, bondholders don’t want the company to go bankrupt.
In a bankruptcy court bondholders are simply unsecured creditors, and not creditors with a first shot at GM’s assets and income. Instead of the 50 cents on the dollar or 30 cents on the dollar that bondholders might get in negotiations with GM, in a bankruptcy court they might get 10 cents on the dollar — or maybe nothing.
In a GM bankruptcy you can bet that a number of people will be paid before the bondholders, including:
- Essential vendors — the suppliers needed to keep the company going.
- Uncle Sam — the source of bailout funds worth billions of dollars.
- Unions — pension and healthcare claims are worth billions.
- Secured creditors.
Once the main creditors are paid then whatever is left over can be used to satisfy the claims of unsecured creditors such as bondholders. By the time the process ends bondholders might get little more than a used Camaro bumper and a can of touch-up paint.
I bring up the GM situation because GM bondholders and mortgage lenders are much alike. Both make term loans. Both receive a stipulated amount of interest. Both are entitled to the full return of their principal.
Unlike bondholders, however, mortgage lenders have two advantages. First, they are secured creditors, meaning that if a homeowner doesn’t pay the property can be sold to satisfy the lender’s claim. Second, since 1993, as a result of the Supreme Court’s Nobleman decision, if a homeowner declares bankruptcy a judge has no right to modify the mortgage.
The House has now passed H.R. 1106: The Helping Families Save Their Homes Act of 2009. If this bill ultimately becomes law it would largely reverse the Nobleman decision and allow bankruptcy judges to modify mortgages on prime residences.
In basic terms, the key elements of the House bill look like this:
Prime Residence. The benefits of the bill apply only to borrowers who want to modify loans for a prime residence. This sounds very fair until you realize that judges already have the authority to modify loans on vacation homes.
Waiting Period. Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, those seeking bankruptcy must first obtain 180 days of credit counseling. The bill removes that requirement for those who have received a foreclosure notice.
This is an important provision because in many states it’s possible to be foreclosed in less than six months, meaning there’s no opportunity to even file for bankruptcy court before losing a home.
Modification. Judges may modify loans under certain conditions by extending the loan term to as long as 40 years, reducing the interest rate, and converting the loan from adjustable-rate financing to fixed-rate debt.
Equity. After a bankruptcy a lender may have a claim against the home’s equity for as long as five years. This means that if values rise and a home is sold after a bankruptcy, a lender may be able to claim some of the higher value to make up for losses on its loan.
Safe Harbor. The legislation provides a “safe harbor” for mortgage servicers, meaning that if a “servicer” — the party unusually in contact with a borrower on behalf of a loan owner — helps to modify a loan it cannot be sued by the mortgage investor.
Contact. To qualify for assistance the borrower must contact the lender seeking a loan modification 30 days before filing for bankruptcy. This provision is certainly better than the 180-day counseling requirement, however it also raises two problems. First, for borrowers who are 60 and 90 days late on their mortgage, it effectively means that bankruptcy protection may not be available. Second, since the borrower must prove they attempted to get a modification they should send letters to lenders by certified mail with a return receipt to document the date of their request.
Qualified Modification. Borrowers must consider any loan modification plan which meets the standards of the just-announced Obama foreclosure prevention program. In other words, if the lender can reduce the borrower’s monthly housing costs to 38 percent of his or her gross income, then the government will subsidize the loan so that the borrower is paying only 31 percent of his income for housing expenses. While such a modification would greatly help many borrowers, it will not work for those who are now unemployed, and unemployment is a growing problem.
In essence, the bill would give judges the right to modify home loans but only after other steps had been taken to first try to work something out directly between lenders and borrowers.
The Next Step
The House bill will now be considered by the Senate and, if passed there, by a conference committee. It’s possible that substantial changes will be made to the bill. Some of the ideas floating around Washington include provisions that would limit relief to subprime borrowers and allow modifications only for loans with negative amortization and for mortgages which did not meet reasonable underwriting standards.
“The bankruptcy debate reflects a battle between borrowers and lenders that’s been going on since biblical times,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the nation’s leading online marketplace for foreclosure listings and data. “What are the claims of lenders when things go wrong? When are loan terms fair and when are they unfair? These are really the questions everyone is trying to answer.”
Indeed, lurking in the background of today’s debate are two other issues which may receive more attention as foreclosure levels increase.
First, there’s some sense that the lending community might actually welcome help from bankruptcy courts despite vehement public opposition to what lenders call cramdowns. The reasons? Bankruptcy judges have long experience valuing assets and the bankruptcy system gives lenders a way to examine loans individually.
Second, bankruptcy judges have always been able to modify loans on second homes, boats, cars and planes — all forms of secured financing which are exactly like home mortgages. Also, just like home mortgages, auto loans, mortgages on second homes and similar forms of financing can be used to create securities for investors worldwide. Consumer advocates — and probably a few GM bondholders — want to know why home mortgage lenders should be given special privileges in America’s bankruptcy courts, privileges denied to various lenders with otherwise equal standing and status.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.