Mortgages and Moral Hazards

By Mike Appleton, Guest Blogger

In 1984 Leonard and Harriet Nobelman purchased a condominium with the assistance of an adjustable rate mortgage loan from American Savings Bank.  Six years later, the Nobelmans encountered financial difficulties and filed Chapter 13 proceedings in bankruptcy court.  At the time of their filing, their mortgage balance, including accrued interest and late fees, was $71,335.00 and the fair market value of their home was only $23,500.00.  Accordingly, the Nobelmans proposed a reorganization plan which treated the difference between the mortgage balance and the fair market value, a total of $47,835.00, as unsecured debt.

Under bankruptcy law, the reclassification of indebtedness exceeding the value of the collateral from secured to unsecured status is known as a “cramdown.”  This is a commonly used device that effectively “strips” the lien of a security interest down to the collateral’s value.  It enables a debtor to retain property while insuring that the secured creditor will recover at least as much as it would realize from a foreclosure sale of the property.

The problem is that as a practical matter, unsecured creditors, whether in reorganization or straight liquidating bankruptcies, seldom receive any of the amounts owed to them.  So American Savings Bank, staring at the potential loss of more than half of the mortgage principal, filed an objection to the Nobelmans’ plan.  The ensuing litigation odyssey required three years and produced a Supreme Court decision that has particular significance in the current housing crisis.

The Court ruled that the Nobelmans could not cram down their mortgage with American Savings Bank.  Why?  Because, said the Court, when Congress reformed the bankruptcy laws in 1978, it eliminated the availability of cramdown for mortgages encumbering a debtor’s home.  More specifically, Section 1332(b)2 permits the modification of any secured debt “other than a claim secured only by a security interest in real property that is the debtor’s principal residence.”  Had the Nobelmans’ condominium been held as an investment or used as a vacation home, the cramdown provisions could have been applied and their plan would have been approved.  Nobelman v. American Savings Bank, 508 U.S. 324 (1993).

The change in the law was a result of intense lobbying by groups such as the Mortgage Bankers Association.  The industry argued that it was entitled to special protection in view of the fact that lenders were providing a “valuable social service” for people desirous of purchasing a home and that the risk of modification in bankruptcy would adversely impact the mortgage market and make home ownership more difficult.  How the “valuable social service” attending the approval of a home mortgage is distinguishable from the “valuable social service” rendered when the loan is secured by an office building or strip mall has never been satisfactorily explained.

The impact of the Nobelman  decision has been significant.  Prior to 1978, home mortgages were frequently modified in bankruptcy.  Even after the passage of the 1978 act, many courts interpreted the statutory amendments to still permit cramdowns of such mortgages.  There have been attempts to restore the pre-1978 cramdown rules, but they have been met with strong opposition, and that opposition is frequently couched in distinctly moral terms.  During Congressional debate in March of 2009 over the proposed Helping Families Save Their Homes Act, for example, Rep. Michele Bachmann advanced a form of sacred covenant argument.  “Of the foundational policies of American exceptionalism,” she said, “the concepts that have inspired our great Nation are the sanctity of contracts and upholding the rule of law.”  Rep. Louis Gohmert added that permitting home mortgage modification by bankruptcy judges was “rewarding greed and improper conduct” and warned it would enable bankruptcy judges to modify mortgages on a “whim.”  The only thing missing from the debate was a request for publication of the Collected Sermons of Cotton Mather in the Congressional Record.  In April of that year, a Republican filibuster killed the bill.

A version of these arguments was repeated again two weeks ago by Edward DeMarco, who is apparently destined to remain acting director of the Federal Housing Finance Agency as long as Pres. Obama remains in the White House, and who once again declared his opposition to Administration proposals to permit refinancing of home loans by Fannie Mae and Freddie Mac, citing a vaguely defined “moral hazard” that would follow pursuit of such a policy.

The appeal to American exceptionalism and the neo-Calvinist assault on the good faith of the average homeowner is both absurd and insulting.  There is certainly no evidence that would suggest that homeowners treat their contractual responsibilities with less regard than do commercial businesses.  And the “sanctity of contract” argument has neither discouraged the political resolve to eliminate public employee union contracts nor dissuaded the Bain Capitals in the land from bankrupting companies and walking away from pension obligations.

Moreover, the various proposals for mortgage modification and partial principal forgiveness are not without historical precedent.  In 1933, Pres. Franklin Roosevelt created the Home Owners Loan Corporation in response to the surge in home foreclosures.  Over the next several years the HOLC purchased mortgages from lenders in exchange for government bonds.  Hundreds of thousands of these loans were thereafter refinanced for longer terms at fixed interest rates and, in many instances, with principal reductions to 80% of appraised values.  By the time the HOLC had completed selling off the loans and ceasing operations in 1951, it had actually made a small profit.

Few people will remember the HOLC, but many will recall the Farm Aid concerts begun in 1985 in response to a farm foreclosure crisis in the Midwest and Great Plains states.  Record profits from agricultural exports during the 1970s generated demand for more farm land, leading in turn to higher land prices.  In Iowa alone, the price per acre of farm land quadrupled between 1970 and 1982.  Farmers accumulated significant debt to finance expansion and banks, eager to cash in on the boom, made huge loans largely in reliance on anticipated increases in land values.  Sound familiar?  When demand for farm products slackened beginning in the late 1970s, farm revenues became insufficient to service debt and land prices plummeted.  The efforts of Willie Nelson, John Mellencamp, Neil Young and others brought pressure to bear on Congress, and in 1986 a new Chapter 12 became part of the bankruptcy code.  Designed specifically for family farmers, it permitted the stripdown of secured debt, including debt encumbering a farmer’s residence.  Chapter 12 became a permanent part of the bankruptcy code in 2005.  The legislation did not produce the flood of farm bankruptcies predicted by its critics nor appreciably hamper the ability of farmers to obtain credit.

The claim that underwater homeowners are “undeserving” of assistance or that providing that assistance will encourage irresponsible behavior is not a conclusion from evidence, but a moral judgment predicated upon a cynical view of human nature.  And the myth of “sanctity of contract” no more justifies legislative inaction than the myth of “voter fraud” justifies voter suppression laws.  As Justice Holmes once observed, “Nowhere is the confusion between legal and moral ideas more manifest than in the law of contract. . . . The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it-and nothing more.”  Holmes, The Path of the Law10 Harvard L. Rev. 457, 462 (1897).   Of course the duties imposed by a contract are to be taken seriously, but being overtaken by events over which one has no control is an increasingly common fact of life.  Under such circumstances, the inability to continue meeting the payment terms in one’s home mortgage is not a mortal sin or cause for moral censure.  It is instead an example of precisely the sort of difficulty for which bankruptcy laws were intended to provide relief.

A mortgage is not a sacred instrument and the housing crisis is not a moral dilemma, but an economic problem requiring economic solutions. There is no rational basis for compelling homeowners to adhere to a set of rules applicable to no one else.  Mr. DeMarco and members of Congress need to climb down from their moral high horses and recognize that the needs of distressed homeowners are at least as important as the needs of holders of mortgage securities.

34 thoughts on “Mortgages and Moral Hazards”

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  2. @Malisha: That is more explicit, and a case of stolen identity.

    The majority of the fraud was conducted by banks to investors, by willfully misleading the investors into thinking they were buying loans to well-vetted borrowers with the ability to pay, so the default rates would be in the very low single digit percentages.

    The investors bought into that fraud because for decades banks had a good track record of turning down loans if the property was valued too highly, or the borrower’s income was too unreliable. But that was when the banks serviced the loans themselves, and had a strong financial interest in only making good loans that would be repaid, or at least covered by the collateral.

    That is why banks used to demand money down; because they figured if if you put 10% down on a fairly-valued house, and they loaned you the other 90%, then there was a good chance if you defaulted they could at least recover their loan value by repossession and resale.

    All that common sense went out the window in 1999 when they no longer had to worry about servicing their own loans. Default became somebody else’s problem, and being careful just meant less profit.

  3. I witnessed a little mortgage fraud in California in 2010. It was apparently quite simple; a little fraud goes a long way, apparently, over and over and over and over. A mortgage broker sells a bunch of mortgages. Let’s say one out of 6 of them is a deliberate fraud meant to go right into default before the first payment is due. She personally arranged to have her elderly relative or some other elderly person she zeroed in on buy a house SHE owned, with a high mortgage, although the woman had NO MONEY and lived on SSI. Then she bundled the mortgage with half a dozen real mortgages, sold them to a bank, which sold them to another bank, blah blah, and when the default occurred, who cared? Since she had a fraudulent signature and fraudulent notary seal on the original papers, the old people never even knew they “bought” a house or lost it or had ruined credit; probably some of them never even spoke English. Incredible and bizarre. More than one person reported her scam and we all heard the same thing: THERE WAS SO MUCH FRAUD GOING ON THAT NOBODY HAD TIME TO BUST HER.

  4. I have no problem with the sanctity of contracts: The mortgage lender agreed to use the home as security for the loan; thus the contract says if the borrower defaults on the mortgage, the lender gets the home to do with as they will. It is their own fault for loaning more than the property is worth. If the contract also says the borrower is responsible for the difference, then after the repossession, that owed difference is obviously not secured by any additional property; the conversion should be the automatic consequence of a stupid lender accepting collateral worth a third of the value of the money.

    The real moral hazard wasn’t with the borrower, it was with the original lender pursuing profit by approving loans it intended to bundle and flip, and since it was never going to be caught holding the bag on any defaults it did not bother to guard against them, and often willfully concealed the high probabilities of default by coaching borrowers on the “right” answers to questions. (Many such borrowers did not know a thing about mortgages or banking, and thought this was just helpful advice from an expert in navigating unknown territory, they did not realize they were aiding the commission of a fraud.)

  5. The banks that took the recent settlement in lieu of prosecution were supposed to help homeowners that were underwater by refinancing. It was a gentleman’s agreement as I understand it, no firm language ended up in the settlement. Well, it’s not happening. There is no help from any agency on the horizon. I don’t see that changing no matter who is in charge though I’d like to see a bunch of new faces just to test my instinct.

    The best investment a homeowner can make is the cost of a lawyer specializing in realty law to see if they have a ‘walk away’ provision in their loan contract. Then to use it the minute they can’t make a payment.

    The current delusion that there is some kind of help is just a delaying tactic to wring more money out of consumers that will eventually lose their homes. It’s a good investment for anyone that is planning to buy a home too; make sure there’s a ‘walk away’ in whatever housing loan one takes.

  6. Raf,

    Afghanistan, jobs, deficit, sequestration, taxes, contraception, gay marriage, healthcare, unions, public education, college loans, jobs, food stamps, military trials, veteran’s healthcare, Supreme Court appointments, fracking, drilling for oil, Iran, Israel, China trade, religious freedom, drought, farm relief, immigation, Dream Act, jobs, financial reform, consumer protection, Medicare “reform”, Medicaid expansion, climate change.

    Just where do you want to fit in the topic of DeMarco?

  7. Raf,

    I want DeMarco to go. Now give me a good battle plan that will be effective 90 days before this presidential election. Based on the difficulty of the past recess appointments, I’m dubious that getting an effective Director is accomplished easily and believe that Obama needs to be “armed” with reelection. And without his reelection, how much do you think will be accomplished before 1/20/13?

  8. Elaine,

    Thanks for the research on firing DeMarco. But I’m not sure I understand. He can move him to another position IF he names a director. As you state, that would have to be a recess appointment. My assessment of those appointments was that it wasn’t so damn easy. The Senate managed to stay in session once they knew what was planned and in the case of the Consumer Financial appointment, it was achieved in some 30 second window over Christmas or something.

    Anyway, isn’t it a pretty complex political battle and maybe not worth the price? What will be accomplished in the few months left of this admin? And that being the case, it smells to high heaven of being purely political. I’d opt for waiting until after the election. If Obama wins, then he has won the argument that DeMarco must go and the Republicans may find that Americans are not willing to put up with McConnell and Co. “Just Say No”. It would be a very bad start for them.

  9. uh oh…..there it is again….”Although it is not explicitly stated, you point out how the “Randian”, as Gene H puts it, elements actually want “socialist” application to their losses but “free market capitalism” to apply to the victim home owners.” (Dredd) that nasty double standard rearing its bugly head…

  10. I’m always highly suspicious of any man, woman, or group who dresses up their financial contractual agreements in Puritan garb.

    However, that being said, Obama and Geithner have done little beyond lip-service to help homeowners during the last 3 years. After-all, as best I can tell, less than 8 percent of the funds originally allocated in TARP for foreclosure relief has actually been spent.

    So why would Geithner send a letter to DeMarco now? In my opinion it is pure political posturing to hide a severely mishandled housing crisis. DeMarco could have been replaced months or years ago. He wasn’t. End of story.

    However, as November approaches, the incumbent needs to appear to be on the side of the victimized home owner rather than on the side of the flim-flam banker so Geithner writes his letter and DeMarco’s reaction becomes the distraction.

    It’s the old shell game … find the pea. Fraud on all sides.

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