Bankruptcy cram-downs have increasingly become a concern for the ABS market over the past few weeks in light of Citigroup's decision to back a revised bill amending the bankruptcy code. The legislation also carries the support of the new Democratic administration.
But measures to stem the tide of foreclosures might come with accompanying side effects for the broader credit markets.
The mortgage banking industry has spoken out against cram-down proposals since the housing crisis began. Lenders have cautioned that allowing bankruptcy judges to reduce mortgage balances would compromise the collateral underlying these loans and might induce more write-downs and even tighter credit conditions going forward.
A lot hinges on the degree of moral hazard that might result - such a bill could force consumers into a bankruptcy-type situation to take advantage of the legislation.
Borrowers who are not facing foreclosure could decide to file for bankruptcy because their loans are larger than the value of their homes. For instance, a 120% current combined LTV on a $200,000 mortgage represents a $40,000 incentive, according to data from Barclays Capital.
The potential for the dissolution of mortgage debt in bankruptcy might cause even more pricing discrepancy for MBS.
Furthermore, losses from bankruptcy cram-downs could be significantly larger than servicer-driven modifications.
Traditionally, "servicers have screened loan modification applications with an eye toward maximizing value to the trust," said Glenn Boyd, head of U.S. ABS strategy at Barclays. Borrowers who are not good risk prospects would not be modified and would go into foreclosure. However, in a cram-down situation, bankruptcy judges will not seek to maximize value to the trust, and losses will be greater on many of these loans that go into bankruptcy, Boyd said.
While a cram-down would not likely be any larger than what lenders were going to lose in a foreclosure, said Lou Barnes, a mortgage banker at Boulder West Financial Services, a very high portion of loans will still go into foreclosure, he said. "In both cases the lender loses."
Indeed, writing down a loan amount to the current value of a home won't necessarily keep people in houses. "You could cram down the loan balance to the current value, recast the loan and lower the interest rate, and you would still have a cheaper home for rent down the street," Barnes said, pointing to the widening gap between a purchased home's value and rental values. "With no immediate appreciation and no equity in the home, what is to stop them from walking away?" he said.
Borrowers might redefault at high rates, which could keep foreclosures too high to stimulate a housing recovery - eliminating the only potential positive for trust holders, Boyd said.
Higher Borrower Cost
The Mortgage Bankers Association (MBA) has devoted a section of its Web site to the cause, under the header Stop the Bankruptcy Cram-Down Resource Center. Among the MBA's main concerns is the possibility that mortgage rates could increase in cost by 150 basis points. Lenders will also need to require higher down payments and charge higher costs at closing, the MBA said.
If the legislation permitting cram-downs is passed, monthly mortgage payments are expected to rise across the country. Hawaii, where the average loan amount is approximately $339,235, could see mortgage rates increase $338 per month, according to the MBA. California, where the average loan amount is $331,926, could see monthly payments jump $331, and New York, where the average loan is $249,944, could see a rise of $249 per month.
A Lose-Lose for Credit Cards
Increased filings would also have a negative impact on other consumer asset classes. Credit card receivables, in particular, might face higher credit card charge-offs. And recoveries on charged-off loans would also decline since credit card debt would be pari passu with unsecured mortgage debt. Charge-offs could increase by 2% or more, Boyd said.
There are also issues within the securitization structures that will need to be worked out, although they may not necessarily be an impediment, said Joel Telpner, partner at Mayer Brown. Servicers are still operating on documentation that doesn't allow for outstanding mortgage loans in securitized pools to be renegotiated or restructured, he said.
Sheep in Wolf's Clothing?
However, the bill may be "a necessary evil," JPMorgan Securities analysts said, and others agreed. Allowing bankruptcy cram-downs would force servicers to use principal forgiveness with loan modifications. "In the long run, cram-downs can help stabilize home prices through reducing distressed sales," the analysts said.
Indeed, while redefaults remain high - a generic 25% payment reduction results in a 50% redefault rate - a 25% balance reduction, which is the type of modification a cram-down would accomplish, makes for a lower 30% redefault rate, according to Merrill Lynch data.
This may ultimately be a better alternative for bond holders as compared with the growing number of defaults and foreclosures, which is where the trend line is going, Telpner said. He pointed out that these modifications could stabilize assets in the pool even if investors are getting paid less on the dollar. "For some ABS pools, cram-downs may provide greater recovery because they serve as an alternative to writing off an increasingly large portion of the pool," he said.
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