Why are businesses allowed to retructure loans in bankruptcy and homeowners are not?

Any business going into Chapter 11 bankruptcy reorganization can restructure and reamortize loans whose conditions they find onerous or can no longer meet. But an individual homeowner going through Chapter 13 bankruptcy cannot restructure his mortgage loan. Why not?

As the bankruptcy Judge wrote in the Washington Post

Homeowners are the only ones who cannot modify the terms of their secured debts in bankruptcy. Corporate America flocks to bankruptcy courts to do precisely this -- to restructure and reamortize loans whose conditions they find onerous or can no longer meet. Airlines are still flying and auto parts makers still operating because they have used this powerful tool of the bankruptcy process. Lehman Brothers will surely invoke it. But when the bankruptcy code was adopted in 1979, the mortgage industry persuaded Congress that its market was so tightly regulated and conservatively run that it should be exempted from the general bankruptcy rules permitting modification. [Snip]

For more than a year, a number of legislators, academics and judges have advocated removing this ban on home mortgage modification to help stem the increasing number of foreclosures. I have twice participated in briefing sessions organized by the House Judiciary Committee, where I was lectured by lobbyists for the mortgage industry about the sanctity of contracts. I have listened to their high-priced lawyers make fallacious constitutional arguments based on discredited cases from the 1930s. (This is, incidentally, an industry that is not particularly concerned about its own contractual obligations as it tries, through various Treasury-aided programs, to stay afloat.)

The current prohibition on bankruptcy judges in Chapter 13 reorganization cases for individuals might make sense if the homes could be resold at market values that were as high as the mortgage values, or if the mortgage itself were not a subprime mortgage designed to automatically increase to levels the mortgage buyer was never going to be able to afford. But the current market in many parts of America has to drop 40% to 50% so that the average home can be afforded by the average homebuyer. And a great many home buyers and individuals who refinanced to pay for home repairs were shifted into adjustable Rate Mortgages (ARMs) they were never going to be able to afford, but which provide the mortgage seller a much larger commission.

Personal note: My next door neighbor was sold an ARM which reset a year and a half ago. Her mortgage payment jumped from $650 a month to over $1100 a month. The out-of-state mortgage owner refused to work with her on the payments. She lost the house to foreclosure. She had purchased it for $58,000 and it sold in foreclosure for $38,000. Who won? The mortgage broker who was long gone.

The average cost of foreclosure is 25% of the total value of the home. This goes to pay for the foreclosure process. The mortgage holder loses this just as the homeowner does. Foreclosure is a very expensive process.

The mortgage-holder has a mortgage on their books at a price that is much higher than the home can be sold for. But if it goes through foreclosure, an additional 25% of the current value is taken away from the mortgage holder. A bankruptcy judge could save this cost by restructuring the mortgage. The homeowner would get a mortgage at a price that reflects realistic current market values and the mortgage holder would avoid the additional 25% cost imposed by the foreclosure process.

Unfortunately, the mortgage broker still gets off scot free with his ill-gotten commissions.

It simply is not reasonable any more to think that mortgage industry's market is so tightly regulated and conservatively run that it should be exempted from the general bankruptcy rules permitting modification. Too many homeowners - AND their mortgage holders are being forced into foreclosure and bankruptcy in the current economy to continue this stupid provision of the bankruptcy code. "Tightly regulated and conservatively run?" That's a fiction left over from the days before financial deregulation with its subprime and ARM mortgages along with liar loans are bundled into massive Mortgage-backed Securities in which the investor does not have the time or money to deal with reconstructing an individual mortgage contract.

The banks are fighting against the change in the bankruptcy law because it will force them to write down mortgages that are part of their assets. This is especially threatening to them because the large banks are already having to write down so may losses from their assets. But when those mortgage assets go through foreclosure, the same write-down will be required - except that the foreclosure process will cost an additional 25% of the value of the home.

The only reasonable and cost-efficient solution is to give bankruptcy judges the power to restructure mortgages. Judge Leonard is correct. The proposed change in the bankruptcy law is a win-win solution to a problem that should not be allowed to continue.