Bankruptcy judges may get to modify mortgages
By Marcie Geffner • Bankrate.com

Federal bankruptcy courts currently offer only scant relief to homeowners who can't afford to pay their mortgages. That could change, if supporters of legislation that would allow bankruptcy judges to modify mortgages can muster enough votes in Congress to override a threatened presidential veto.

Giving bankruptcy courts the authority to modify home loans would be a palatable way to accommodate both borrowers and lenders, says Jack Williams, a bankruptcy professor at Georgia State University College of Law. Borrowers would "get to keep a major asset with significant upside potential" and avoid the emotional wound of losing their homes, while lenders would be placed in "a position based on the fair market value of the property," which would be better than a foreclosure, Williams says.

Currently, bankruptcy affords "very limited protection to a (homeowner) who has a financial problem with a home mortgage company," Williams says. Filing Chapter 13 bankruptcy, which is characterized by a debt repayment plan, can spread out prior delinquent payments over a number of months or years in the future; however, no bankruptcy proceeding can modify the terms of an existing home loan on a principal residence.

That prohibition is an "anomaly," Williams says, because bankruptcy courts can modify the terms of virtually all other types of debts, including home loans secured by second/vacation homes or investment properties. Only the principal residence is excluded from bankruptcy judges' authority.

Subprime mortgage crisis triggers new look at bankruptcy
The exception for residential mortgages dates back to 1978, when the bankruptcy code was written, says Williams, who is also a scholar-in-residence at the American Bankruptcy Institute, or ABI, a nonpartisan organization that researches issues related to insolvency. That exception makes home loan lenders a favored class of creditors and originally was intended to encourage mortgage lending.

Thirty years later, after rapid and radical innovation in home loans and mortgage lending, that purpose may no longer make sense as good public policy, says Susanne M. Robicsek, a bankruptcy attorney in Charlotte, N.C.

"Historically, the argument was that they didn't want to discourage banks from making loans to consumers. The types of loans have changed immensely, and we now find ourselves in a new lending environment that has led to a crisis that can't be solved," she says.

That crisis has consisted of a spike in delinquent payments and defaults on home loans and a rise in bank foreclosures on residential properties, especially in such states as California and Florida. The crisis has led to finger-pointing at several causes and culprits.

Mortgage crisis culprits:

• Greedy, foolish and unsophisticated borrowers. • Inflated home valuations and appraisals. • Aggressive and unethical mortgage brokers. • Misguided and fraudulent lending practices. • Faulty home loan products. • Lax, inadequate or absent regulatory oversight.

Judicial power would be limited
The bankruptcy bills that have been introduced in Congress would place limits on who would be eligible for home loan modifications, according to a briefing paper published by the Center for Responsible Lending, a nonprofit research organization in Durham, N.C. As written, the legislation would contain several restrictions.

Restrictions in legislation

Relief would be limited to homeowners who: • Didn't earn enough income to afford their mortgage payments. • Had a subprime or nontraditional loan such as an interest-only or payment-option adjustable-rate mortgage. • Faced imminent foreclosure.   Bankruptcy judges would be required to: • Set commercially reasonable interest rates on modified mortgages. • Not reduce loan balances to less than the market value of the property.   The time frame for relief would be restricted to: • Loans that were originated on or after Jan. 1, 2000. • A seven-year period, after which the law would sunset, unless it was extended.