‘Cram downs’ are the carrot and the stick

Judicial modification, also known as “cram down” in bankruptcy circles, would give judges the power to reduce a mortgage loan balance on a primary residence of a consumer that files for bankruptcy. Under the current bankruptcy laws this tool is not available to federal judges in bankruptcy. Currently, bankruptcy judges can reduce or wipe out other types of debt for consumers but not mortgage debt on a primary residence. To receive judicial mortgage modification in bankruptcy, homeowners would have to first seek relief from their lender or loan servicing company.

Legislation that would amend the U.S. Bankruptcy Code to give judges modification power is under consideration by the House of Representatives.

With this cram down tool, bankruptcy judges could also extend the term of the loan and reduce the interest rate. This would be available only on mortgages that can be purchased by government-backed mortgage giants Fannie Mae and Freddie Mac, according to the Obama plan. So, what does this mean? The plan to allow cram downs in a bankruptcy context is of consequence even to those borrowers that do not file for bankruptcy. What the plan does for borrowers is give the lenders a strong incentive towards modification or some other form of loss mitigation prior to a borrower filing for bankruptcy.

For the larger economy, this may mean fewer foreclosures. Keeping more people in their homes reduces the amount of inventory available. Fewer foreclosures also means that there will be fewer blighted neighborhoods and maybe that will help to stabilize property values. Much of the problem in the housing crisis is the fact that property values have plummeted and market value is so elusive. For those with good credit who want to refinance, to take advantage of low interest rates, they are not able to do so because their property value has sunk and they are underwater.

Principal reductions in the form of true modifications can help stem the declining property prices and keep borrowers in their homes. By “true” modification, I mean just that, principal reductions as part of a modification. A borrower that obtains a modification in the form of half their monthly payment for fives years with the arrearage tacked on to the principal of the loan will just need another loss mitigation solution in five years. Many borrowers would rather keep their home and pay an amount that adequately reflects the property value for the next 30 years.

Cynthia A. Riddell, an attorney whose practice primarily focuses on real estate foreclosure, short sale and bankruptcy issues, can be reached at (941) 366-1300.