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In the September 2007 issue of the American Bankruptcy Institute Journal, Hank Hildebrand opines that one solution to the subprime mortgage crisis would be to remove the protection of Section 1322(b)(2) for residential mortgages and to allow subprime residential mortgages to be modified. (Hank Hildebrand is the chapter 13 Trustee for the Middle District of Tennessee and a nationally recognized expert on Chapter 13.) In my opinion, we should entirely remove the special protection for residential mortgages.
Mr. Hildebrand did not go into specifics regarding how his proposal would work, i.e., how subprime mortgages would be identified. He did, however, detail the compelling reasons why the residential mortgage exception should be removed.
It is estimated that the average mortgage lender loses more than $50,000 per foreclosed home. These losses are not simply limited to the lender or the investors in mortgage-backed securities. Loan servicers lose an income stream when a home is lost to foreclosure. Mortgage insurers are hit by increased claims, losses that will be passed on to other borrowers in the form of increased premiums. Cities lose tax revenue. Neighborhoods deteriorate as foreclosed homes stand vacant.
Currently, 11 U.S.C. Sec. 1322(b)(2) prohibits modification of a mortgage secured by the primary residence of the debtor. The basis for that special protection is that mortgage lenders were providing a valuable service and Congress did not want to scare mortgage lenders away from the home market. Now, however, there is little question as to whether mortgage lenders will stay in the single family residential market. In addition, at the time the residential exception in Sec. 1322(b)(2) was added, subprime mortgages were rare. For these reasons, Mr. Hildebrand argues (and I agree), the exception should be removed.
One of the first questions I ask my clients is whether they have an adjustable rate mortgage ("ARM"). Almost all of my clients do have an ARM loan. Many of them refinanced out of fixed rates into ARM's within the last three years. I often see the following scenario: "I refinanced 8 months ago. My interest rate is 7%. I have about a year and a half before it goes up. I don't know what it will be going up to." After reviewing the documents, I often have to tell a client that the interest rate will be going up to over 13% in a year and a half. Assuming a $300,000 mortgage, that is a difference between payments of $1,995/mo. and $3,318/mo.
My clients could pay $1,995/mo. But they won't be able to pay over $3,000/mo. My client will surrender the house. The lender will take it back at a huge loss. My client will get a rental for about $1,500/mo. Everyone loses.
If, on the other hand, Section 1322(b)(2) was changed, my client could decrease the interest rate on the loan. My client would be able to make the payment. The lender would keep the income stream. The profit would not be as high as the ARM would have provided, but my client was never going to be able to pay that and the lender won't suffer a $50,000-100,000 loss at a foreclosure sale, either.
Getting rid of the principal residence exception to 1322(b)(2) makes sense and could solve a lot of problems in the current mortgage market meltdown.
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