The Real Message of the Massachusetts Senate Election

Everyone is trying to figure out the meaning behind Republican Scott Brown’s mind-numbing 5-point victory to fill Teddy Kennedy’s seat in the U.S. Senate. Most people think it has something to do with the health care legislation, and I would agree with that. I think people don’t believe that government can actually keep health care costs down. But I think the real issue is that people are so upset the health care bill has taken up almost a year of legislative work, when the big issue is the economy and legislative action on the economy has been either non-existent or completely ineffectual. Instead of wasting all this time on health care, why don’t you put your heads together to come up with some economic reforms, voters are saying.

I think Congress thought they had done something like that with the stimulus and loan modification program passed early in the year. But neither of those programs have done anything to put a dent in the economic situation. The stimulus is a pork-laden and bureacratically-entangled mess, which is incredibly inefficient at getting money back into the economy. And the loan modification program has proven a collosal failure. Only a small percentage of the estimated loan modifications have taken place. President Obama indicated he wanted to use a carrot and stick approach to loan modifications. Well, Mr. President, we have tried the carrot and it has not worked. Its time for the stick.

It is time to look again at legislation allowing modification of home loans in Chapter 13 bankruptcy. You can modify car loans, boat loans, rental loans, farm loans, and just about any other kind of loans. But you can’t modify a loan on the principal residence of the debtor. It is time to remove that favored treatment to let people keep their houses. This will stave off the next foreclosure wave that everyone is so nervously talking about, and the deleterious effect on home prices from the shadow inventory of foreclosed homes banks are holding, and allow the market to stabilize.

As I have discussed in numerous posts (see, e.g., one, two, and three), dealing with this problem in bankruptcy is the best place to do it for the following reasons:

1. Bankruptcy is a last resort. Nobody wants to file bankruptcy. So only those who are most desparate for the relief will file, thus limiting the number of people taking advantage of this relief.
2. Bankruptcy provides a built-in mechanism to determine if people should be eligible for the relief of modifying the loan. There is no better mechanism out there for determining what people should qualify for a modified loan.
3. All of these modifications would be supervised by the bankruptcy court. The bankruptcy court is pre-equipped with the knowledge and resources to properly vet requests to modify loans. The bankruptcy court does it all the time in contexts other than home loans. (And in Chapter 12, it even supervises modification of home loans.)
4. A Chapter 13 plan takes a lot of doing to finish. Debtors would have to comply with every provision and make every payment on time for 5 years to get the relief of a modified loan. Anything else would result in dismissal of the case and vitiation of the relief requested.
5. Almost all of the mortgages in this country are held in trusts. Each of these trusts has a whole panoply of parties responsible for various aspects of the mortgage, many of which have conflicting interests. Often, the various parties to the trust don’t want to act for fear of being sued or don’t want to act in a way that is in the interest of the investors because that is against that parties’ interest. By allowing mortgages to be modified in Chapter 13, these sticky conflicts are avoided and the Bankruptcy Code can accomplish what it was intended to do: give the debtor a fresh start and treat all creditors fairly.
6. These trusts are known as REMIC trusts and are given special tax treatment. That tax treatment can be threatened if too many of the mortgages are modified.

And the best part about this solution is that it should be inherently palatable to both sides of the aisle. It is inherently free-market because it removes special protections for certain types of loans and would result in little, if any, increased government expenditure or regulation. It is also inherently populist, because it helps the little guy by giving him the same rights to modify a loan in a small bankruptcy that a big corporation has in Chapter 11. It is time to allow home loan modification in Chapter 13 bankruptcy.

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