As we have discussed recently, here and here, the Federal Housing Finance Agency has asked for ideas about how to dispose of foreclosed properties in bulk. But there is no reason we shouldn’t take this request as also encompassing reducing foreclosed inventory by preventing foreclosures to begin with. FHFA has the power to implement either type of program for loans or properties controlled by Fannie or Freddie, the government-sponsored entities under FHFA conservatorship.
So let’s talk about the idea of Principal Pay Down (PPD) in chapter 13 bankruptcy as a foreclosure prevention strategy. FHFA could direct the GSEs to go along with chapter 13 plans that propose to pay down principal over five years, thus affecting a broad swath of home mortgages.
Here are the elements of PPD
(with thanks to Norma Hammes for the particulars):
- This plan restructures certain undersecured (underwater) mortgages in chapter 13 bankruptcy cases so the homeowner can pay down the loan principal and reduce negative equity and acquire equity faster than with the existing loan.
- This is accomplished by reducing the interest rate to 0% for five years, letting the borrower’s entire monthly loan payment go directly to the principal.
- During the five-year period, the borrower’s minimum monthly housing payment is calculated similar to a HAMP modification payment, at 31% of gross income.
- At the end of the initial five-year period, the remaining principal balance is amortized over 25 years at the Freddie Mac survey rate.
- The bankruptcy judge, with the assistance of the Chapter 13 Trustee, reviews the borrower’s budget to confirm the eligibility of the borrower and feasibility of the payments; and they oversee the implementation of the plan.
- There is no cramdown – the benefit to the borrower is achieved by actually paying down the loan.
- In exchange for this benefit, the borrower agrees to a general settlement of all claims against the lender and servicer and avoiding future title and loan litigation.
- The federal government and US taxpayers’ substantial liability on Fannie Mae and Freddie Mac (all GSE) owned and insured loans would be reduced by this plan.
- Private mortgage investors will benefit similarly.
- Everyone wins with this plan – even the borrower’s community and local government benefit from improved neighborhood stability.
Here is an example. Say the borrower has a $120,000 mortgage loan on a home worth $90,000. This borrower is $30,000 (25 percent) underwater and thus can’t refinance or sell and pay off the loan. Over five years in chapter 13, however, principal pay down could allow the debtor to pay down $1,000 a month or a total of $60,000 over 60 months, and end up with $30,000 in equity (rather than $30,000 underwater), assuming the home neither depreciated further nor appreciated in the meantime. PPD thus here gives a cushion for further depreciation, which is still occurring in the hardest hit parts of the country. In this example, the mortgage interest would have gotten paid $60,000 over five years, and the borrower would get credit for all of that toward the principal balance.
PPD is different from either principal write-down or shared-equity refinancing, discussed recently by Adam Levitin. With PPD, there is no write-down but rather a pay down, and all equity thus acquired would go to the borrower. This program would give many homeowners a stake in their properties by getting the mortgage balance below the value of the home, while also making their loans sustainable and helping to stabilize the housing market.
The compromise involved in PPD is that there is no write-down and that pay down occurs in chapter 13 bankruptcy, something borrowers are not going to do just to get a break on their mortgages if they can afford to pay them. Chapter 13 involves court supervision for the length of the plan and is an arduous road for debtors. PPD in chapter 13 thus addresses the moral hazard argument, that giving breaks on mortgages will draw those who don’t need them. If anything, PPD may be too tough a program. Both PPD in chapter 13 and equity-sharing refinancing outside bankruptcy could both be implemented by FHFA at the same time to increase foreclosure prevention to a meaningful level and experiment with alternatives to see which ones prove most attractive and effective.
Full disclosure: As noted in my bio, I am a member of the board of the National Association of Consumer Bankruptcy Attorneys, which supports PPD.
