Bankruptcy Courts Do Not Allow For Loan Modifications

Bankruptcy Courts cannot perform Loan Modifications

I watched a middle-aged widow lose her home recently. Her story was familiar. She owned her simple brick residence outright until four years ago, when a mortgage broker stopped by and offered her a loan too good to be true. In exchange for taking on a modest monthly payment, she could make some needed repairs and consolidate other debts.

More sophisticated than many borrowers, she realized she was getting an adjustable-rate mortgage. But what she didn't realize was that, it is the biggest "bait-and-switch" ever pulled by an entire industry. Her rate was adjusted periodically, ever upward. When it hit 14 percent, her social worker's salary could no longer cover the payments.

I watched this story unfold in court, from my seat in a bankruptcy judge's chair. While a Chapter 13 filing temporarily stopped the foreclosure on this woman's home, it did little more than buy a few months' time.

Under existing law, bankruptcy courts cannot modify the terms of home mortgages. To keep her home, this debtor needed to demonstrate sufficient income not only to make her ongoing payments, but also to cover the payments she had defaulted on.

Homeowners are the only ones who cannot modify the terms of their secured debts in bankruptcy. Corporate America flocks to bankruptcy courts to do precisely this – to restructure and reamortize loans whose conditions they find onerous or can no longer meet. Airlines are still flying and auto-parts makers still operating, because they have used this powerful tool of the bankruptcy process.

For more than a year, a number of legislators, academics, and judges have advocated removing this ban on loan modifications, to help curb the increasing number of foreclosures.

Obviously, it would be better for the homeowner and the community in which she lives; if instead of another abandoned house tied up in foreclosure, her residence would be owned by a taxpaying citizen like her. Lenders are not going to get their interest return, but instead of the total recovery, limited to the proceeds from a foreclosure sale in a depressed market; any deficiency owed by the homeowner will be discharged as part of her bankruptcy. No one has been able to explain to me, why it is not better for mortgage holders to get a fair return of principal, though at a lower interest rate, than to take a lump sum through foreclosure that is probably much less than the value of the note.

There is a simple answer to the assertion that such a process would be abused: Chapter 13 is no walk in the park. It requires public disclosure of every aspect of your life, examinations under oath by a trustee and creditors, allowing creditors to haul you into court on any objection, and relinquishment of control of your financial life for up to five years. If you falter, your case will be dismissed and you will lose the entire benefit of the bankruptcy law, including having your original contract terms reinstated. That is precisely why allowing loan modifications is such a good approach. It would separate those homeowners who desperately need to stay in their homes and have sufficient incomes to make reasonable payments; from those investors who bet on lax regulation, easy credit, and an appreciating market in buying residential properties. Those in the latter category will have no use for this process, but for the first category, it could be a powerful step back to financial stability.

Written by Katherine M

(Summarized From: Let bankruptcy help fix bad Mortgages, By Rich Leonard Rich Leonard, Christian Science Monitor)