Mortgage Cram-Downs by Bankruptcy Judges Are Taking Place: DBRS
By: Carrie Bay
NOTE: Article has been updated to include jurisdictions where DBRS says most primary mortgage cram-downs are taking place: California, Texas, and Louisiana.
The research firm and ratings agency DBRS has learned from various servicers that although Congress never authorized bankruptcy judges to modify mortgages on primary residences, these “cram-downs,” as they have been termed, are currently being performed in some courts.
“The amount of the cram-down varies by state, property value, and borrower situation but usually includes a reduction in the principal amount of the loan to fair market value,” DBRS said in a report released Monday.
Kathleen Tillwitz is an SVP in DBRS’ structured finance group. She says the “small number” of cases that have been uncovered involving cram-downs of first mortgages have been concentrated in California, Texas, and Louisiana.
The bankruptcy cram-down was part of the original language of the Helping Families Save Their Homes Act of 2009 and would have amended the federal bankruptcy law governing a Chapter 13 debtor to allow judges to alter the terms of mortgages on primary residences.
However, that provision was dropped in the Senate and was not included in the version that was eventually signed into law on May 20, 2009.
Historically, bankruptcy judges could only modify the terms of mortgages on investment properties and vacation homes but not on primary residences, DBRS explained in its report.
The proposed provision in the 2009 legislation would have allowed a bankruptcy judge to reduce the principal amount to the fair market value of the property; reduce
the interest rate; extend the term of the mortgage up to 40 years; prohibit, reduce, or delay the adjustment of an adjustable-rate mortgage (ARM); and waive prepayment penalties.
DBRS says the cram-down provision drew extensive criticism because it would have allowed borrowers to abdicate their contractual obligation to repay the full amount of their loan. Additionally, many argued that allowing cram-downs would have made it more costly for other individuals to purchase a home because lenders would have had to increase interest rates and down payments to supplement the loss from the loan modification, the research firm explained.
The use of the controversial bankruptcy cram-down has been voted down in Congress several times, but DBRS says that hasn’t stopped some judges from putting them into practice.
The news has the residential mortgage-backed securities (RMBS) market worrying about an increase in AAA downgrades and bankruptcy filings, according to DBRS.
Many transactions have a bankruptcy carve out that places a limit on the maximum amount of losses that will be absorbed by the subordinate tranches from bankruptcy filings, the ratings agency explained, adding that any bankruptcy losses exceeding this limit may be allocated on a pro rata basis, which can lead to losses on the senior most tranches.
Furthermore, when a bankruptcy judge reduces the principal amount of the loan to the fair market value of the property, the amount of the write-down becomes an unsecured debt that will be paid pro rata along with any other unsecured claims that the borrower has, such as credit cards, DBRS says.
As a result, the unsecured portion of the mortgage debt (or the cram-down amount) will likely result in immediate losses to RMBS pools, which may cause subordinate classes to be written down faster, according to DBRS.
The analysts at DBRS say that once it becomes more widely known that bankruptcy judges are utilizing cram-downs on first mortgages in certain situations, they believe the practice will become more prevalent in the industry.
As a result, DBRS expects to see an increase in personal bankruptcies in 2011 as well as judges becoming more aggressive in the use of first-mortgage debt forgiveness.
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