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Economists Suggest Chapter 13 Should Allow "Cramdowns"

The housing market across the country has been on a roller coaster ride over the past decade. A housing boom was followed by a housing bust. Moreover, foreclosures have skyrocketed. The government has attempted over the past few years to stimulate the economy and housing market in an effort to stabilize the economy. Included within the stimulus efforts are incentive programs to increase loan modifications to help distressed homeowners halt home foreclosures.

Two research economists with the Federal Reserve Bank in Cleveland recently wrote a commentary suggesting the government modify bankruptcy law to allow for a "stripdown" or "cramdown" of a first mortgage. The economists use the farm crisis in the 1980s and the advent of chapter 12 bankruptcy-related to farmers-as the backdrop for their commentary.

Many homeowners have become "underwater on their mortgage, where the principle value of the loan exceeds the market value. A "cramdown" essentially would allow the bankruptcy court to rewrite a mortgage to reflect the current market value of a home. The current market value of the home would remain secured under the mortgage. The excess principle owed on the mortgage over the market value would become unsecured debt.

The Federal Reserve economists suggest allowing for cramdowns under the chapter 13 bankruptcy code. Opponents argue that cramdowns would lead to higher interest rates. Opponents also say that cramdowns would lead to a large spike in chapter 13 filings if the law were modified.

The economists say similar arguments were raised during the farm crisis in the 1980s. Congress created chapter 12, a provision available for family farmers. The economists admit that some differences exist, such as the current practice of securitizing and reselling mortgages that did not exist during the farm crisis to the extent it exists today. The economists, however, say that the fears of increased filings and interest rates did not surface as expected in the 1980s.

The economists say in the commentary that the authority in bankruptcy proceedings to cramdown a farm loan in the 1980s led to greater negotiation in modifying mortgages. Filings did not increase to the levels opponents had suggested. The availability of farm credit did not have an economically significant adverse impact upon family farms.

The economists say that the housing market remains distressed despite government efforts to stem the tide of foreclosures that have gripped the country. They say that, although the economic climate now is different than the farm crisis, the 1980s can act as a guide to amending the bankruptcy code to better serve economic recovery.

Source: Federal Reserve Bank of Cleveland, "Stripdowns and bankruptcy: Lessons from Agricultural Bankruptcy Reform," 3 Aug 2010

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