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Cleveland Fed Paper Suggests Bankruptcy Cramdowns Would Do Little Harm to Banks

September 29, 2010

As Moreno Valley personal bankruptcy lawyers, we followed last year's debate on cramdowns in Chapter 13 bankruptcies with interest. If Congress had passed the law it had been considering, bankruptcy judges would have been permitted to "cram down" the value of a first home mortgage to the current market value of the home, allowing the remaining value of the loan to become an unsecured debt with a lesser priority, just like credit card debt. But Congress failed to pass the cramdown legislation because of an outcry from the financial industry, which said cramdowns would drive up interest rates and make home loans harder to get. On Sept. 19, the Los Angeles Times ran a syndicated column about a Cleveland Fed paper that took a closer look at those claims.

The August paper from the Cleveland Fed -- a regional division of the Federal Reserve Bank -- examined the idea by analogy to a similar reform enacted in farm bankruptcies. Farmers saw a lending crisis in the early 1980s similar to the one affecting homeowners today. In response, Congress created Chapter 12 bankruptcies, which were aimed at family farms. The new Chapter 12 bankruptcies gave judges the ability to perform cramdowns, then called stripdowns, on farmers' homes.

The authors, Thomas Fitzpatrick IV and James Thomson, wrote that "Stripdowns were permitted for farmers because voluntary modification efforts, even when subsidized by the government, did not lead agricultural lenders to negotiate loan modifications. At the time, opponents of stripdowns made the same arguments people are raising today: Allowing stripdowns would flood bankruptcy courts, permit abuse by borrowers who could afford to pay their loans, and reduce the availability of credit, among other things."

However, the paper found, any negative result of Chapter 12 was actually small. A 1989 survey found a small increase in interest rates offered to farmers, which the authors said could just as easily have been a result of the economic environment of the time. Later economic studies found that Chapter 12's main effect had been preventive: it gave lenders an incentive to perform private loan modifications, in order to avoid a stripdown they could not control. In the year Chapter 12 was enacted, they said, the government predicted 30,000 Chapter 12 filings, but only 8,500 were filed within the first two years.

Our Placentia individual bankruptcy attorneys have long believed that cramdowns would not do as much harm as the financial industry claims. As things currently stand, cramdowns are allowed for second homes, car loans and other secured debts in consumer bankruptcies, as well as for certain types of business bankruptcies. Lending is not tighter for these types of loans than it is elsewhere in the economy, and while it's hard to directly compare mortgages to auto loans, we do not believe standards on auto loans are significantly tighter. The Cleveland Fed paper just adds more information based on experience to this common-sense evidence. It also shows that allowing Chapter 13 cramdowns would have benefits even for people not in bankruptcy, because it would give lenders an incentive to modify loans before a judge can modify them.

At Howard Law PC, we help individuals and couples explore declaring bankruptcy as a way to deal with their overwhelming debts. We encourage potential clients to come to us as soon as they realize they can't pay off their debts. In our experience as Rancho Santa Margarita consumer bankruptcy lawyers, many clients put off bankruptcy because they feel it has a stigma attached. Unfortunately, these clients are simply delaying the inevitable, prolonging their stress needlessly and sometimes draining assets that would be protected in a bankruptcy. What's more, more and more Californians are choosing bankruptcy as a responsible way to regain control over their finances. With each new client, we crunch the numbers to determine whether bankruptcy is their best choice, and which type will best help them get a fresh start.

Howard Law offers free, confidential case evaluations. You can speak to us about your case with confidence that we will never share your information or require further payment or other obligations. To set up an appointment or learn more, call us today at 1-800-872-5925 or send us a message online.