Bankruptcy Mortgage Adjustments

Very interesting development late in the day that I would have thought would have been bearish but stocks sort of moved up on it. There seemed to be some momentum gained in the effort to allow bankruptcy judges to alter mortgages in a effort to prevent more housing foreclosures. What does this mean? This article summarizes it.

http://www.cnbc.com/id/28562958

Under the change, bankruptcy courts could alter the terms of mortgages, subject to certain conditions:

1) Only mortgages entered into prior to the date of enactment of the bill would be eligible for the treatment. All loans, and not just subprime, are eligible.

2) Borrowers have to show they made a “good faith” attempt to work with the lender before considering this bankruptcy provision. Bankruptcy cannot be the first option, and borrowers have to prove it wasn’t.

3) Bankruptcy judges can strip away a lender’s credit or rights if they violated the Truth in Lending Act or other state and federal laws.

Basically under 2005 bankruptcy reform law homeowners could only enter chapter 13 as opposed to chapter 7. This means they could only enter into repayment plans and the value of the mortgage would not come down to the new home price (assuming the home price had dropped below the mortgage) There is no ability to "cram down" the mortgage to the collateral value like there is in all other bankruptcy proceedings. The banks have been ardently against this and for good reason because it means that they could be told their mortgage which was an asset for say 300k is now a new mortgage for 200k (the actual value of the house). You must take an immediate 100k loss. It is interesting that this seems to me to be a total reversal of the governments strategy during this crises. Prolong and disguise. Here you will have things coming to the head quicker and be more obvious of the overall losses. Let me say I am completely for this. This is what we need but I do not think this helps the economy in the short run. I also think provision number 1 is ridiculous. If I understand this correctly it is not for new mortgages made after this law would be passed. One of the greatest benefits of this would be for lenders to make sure they are more informed about the loans they make and the appraisals they receive. If they can get the loan "crammed" down this would cause caution before making a bad loan.

From a financial market perspective I think this is very bearish for financials. The banking lobby group has been fighting this and had it defeated earlier in the year. Today with Citigroup breaking ranks others will most likely follow. The reason Citigroup would break ranks is beyond me except for the fact that the government is a large shareholder and lender at this point and will probably get bigger so Citigroup may not have had a choice (at least a real choice). The equity markets may have got this wrong but the debt markets didn't. Across the board the tranches of the ABX index took it on the head today.

http://www.markit.com/information/products/category/indices/abx.html

For those more interested on the process and how it works I highly recommend the late Tanta's piece from calculated risk. I pride myself on trying to figure out what is important and what is just noise. I may be wrong and it depends how it plays out and how it gets watered down but this may be very important.

http://www.calculatedriskblog.com/2007/10/just-say-yes-to-cram-downs.html