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 Law, 10 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.