This report discusses the advantages and disadvantages of bankruptcy for troubled current homeowners and would-be future homeowners.

Data courtesy of the American Bankruptcy Institute

Homeowners have found it dramatically more difficult to pay their bills during this recession than in the past.  A few of the footprints on the path leading to the current homeownership trauma include:

• the Federal Reserve’s belated decision in August 2004 to put a squeeze on the availability of money (credit)  by increasing  short-term interest rates (the triggering event for this recession);
• the Wall Street bond market’s massive 2002 to 2006 expansion into the mortgage banking market, which erroneously allowed anyone to qualify for any type of mortgage loan (bringing on a financial crisis concurrent with the onset of this recession); and
• the constant lobbying effort by mortgage bankers to preempt homeowners’ need to adjust loan balances (cramdowns) during this recession. By 2005, their efforts caused Congress to bar bankruptcy judges from reducing a homeowner’s mortgage balance to match the reduced value of the home securing that mortgage.

In the absence of bankruptcy-ordered cramdowns, the relief available to homeowners in bankruptcy is limited. Nonetheless, bankruptcy is not without advantages for some underwater homeowners. The extent of these advantages is the subject of this report.

One immediate result of the current mortgage crisis and the accompanying recession, along with its loss of jobs, has been an unparallelled rise in the number of foreclosures in California. Another less dramatic issue, though still significant, is the corresponding rise in personal and corporate bankruptcies. For homeowners currently contemplating the prospect of foreclosure, a bankruptcy petition may appear to be a valid alternative of last-resort.  However, bankruptcies (as they are now managed, with cramdowns available to everyone but homeowners) do very little in the long term to avert foreclosure on homes that have no equity to preserve—in other words, California’s homes. Although it may give them pause, this does not make bankruptcy any less tempting for desperate homeowners. To them, bankruptcy is at least a useful way to buy time and gain some influence over lenders. Current and future owners, regardless of their propensity to default and be placed in foreclosure, should be aware of the influence that bankruptcy exerts on lenders under current real estate market conditions.

Try putting yourself into the shoes of a homeowner contemplating foreclosure and considering whether he can avoid his mortgage loans by entering bankruptcy. This individual must consider that household debt comes in two forms: secured debt and unsecured debt. In bankruptcy, secured debt, such as a mortgage loan, allows the lender to repossess the security in lieu of payment (in this case, by foreclosure on the home). Unsecured debt, such as credit card debt, has no such collateral, and can be avoided in Chapter 7 Bankruptcy, but not Chapter 13.

Two separate bankruptcy procedures exist, both governed by federal law. Chapter 7 Bankruptcy requires the insolvent homeowner in bankruptcy to repay his debt from whatever assets he possesses unless those assets are lower than state-allowed levels of assets and income. In Chapter 7 Bankruptcy, a home without equity will be counted among these assets, and foreclosed upon. Chapter 13 Bankruptcy, on the other hand, requires the homeowner to repay his delinquent debts over a longer period of time than contracted for, after deducting reasonable living expenses.  This Chapter 13 repayment plan may include the homesteaded sale of the owner’s home, if the home has any equity (a rare “real owner” situation, in California). Bankruptcy law no longer permits a homeowner’s mortgage to be reduced by a bankruptcy court (a cramdown). However, Chapter 7 Bankruptcy does void any deficiency obligations on recourse mortgage refinancing, just as it voids all unsecured debt whose value exceeds the amount of the homeowner’s nonexempt assets.

In addition to putting an immediate stop to lender collection efforts, the process of filing bankruptcy allows a homeowner to pay delinquent mortgage payments over a three-to-five year period. Troubled homeowners often choose to file Chapter 13 Bankruptcy in order to discharge their non-mortgage (unsecured) personal debts, and then use the newly freed funds to make future payments on their mortgage. Bankruptcy laws enforce California homesteads, which range from $75,000 for single homeowners without dependents to $175,000 for the aged or disabled.  For those homeowners with an equity in their home, this exemption acts as an incentive to file bankruptcy  where  unsecured debts can be avoided and cash can be freed up or available under the homestead, but has no effect on the priority or payment of an owner’s mortgage. The same process does adversely affect lenders who have obtained involuntary liens (judgment liens) against the homeowner’s title.

The most important aspect of bankruptcy, from the point of view of mortgage lenders, is the “automatic stay” provision. This provision of bankruptcy law also delivers the most direct and immediate results for troubled homeowners. Any owner who files bankruptcy immediately places an automatic stay on all collection efforts, including foreclosure sales. Lenders prefer to quickly move to a foreclosure sale, take title to the property or what proceeds they can and cut their losses, and are thus hamstrung by the automatic stay provision.  They are forced to wait until a bankruptcy court allows them to proceed. The stay provision increases the lender’s costs of dealing with a homeowner who does not maintain his mortgage payments while in bankruptcy.

On average, filing Chapter 7 bankruptcy extends the foreclosure process from six months to a year. Chapter 13 delays the foreclosure sale even longer, often drawing it out to a year and a half. Homeowners who file bankruptcy without the ability to make payments on their mortgage from their current income merely extend the time before the eventual foreclosure sale.  For the lender, the process increases his risk the home will be damaged or otherwise devalued before the sale takes place, increasing the lender’s eventual loss in this market. Lenders thus have a vested interest in government regulations that make it difficult for homeowners to obtain relief on their mortgages in bankruptcy, and they intend to keep their hard fought gain of a cramdown-free bankruptcy law intact.  They do not want the competition presented by a bankruptcy judge endowed with the power to reset the loan balance at exactly the amount the security for the loan is worth (which, of course, is all the lender can expect to get from foreclosure anyway).

When bankruptcy is unavoidable, lenders want to get out of bankruptcy court as quickly as possible.  Often they can be persuaded to agree to a short pay on a sale arranged by the homeowner in order to hasten the process and cut their losses. Bankruptcy can thus be an effective way for homeowners to force the lender’s hand, even if bankruptcy courts lack the essential cramdown authority.

So does filing bankruptcy, and thereby discharging unsecured debt and putting off a potential foreclosure sale, actually help homeowners pay their mortgages, or do the other costs of bankruptcy cancel out the benefits? Evidence is mixed, but homeowners and their attorneys certainly seem to believe it can. Troubled homeowners already make up the majority of those who file for Chapter 13 bankruptcy (studies in other states found that over 80% of filers owned homes with a loan to value ratio (LTV) over 90%). Of those homeowners, only about 33% successfully kept their homes. It is certain that bankruptcy does, at least on occasion, have a positive effect for those desperate homeowners who turn to it as a last resort, although it is also sure to have a negative effect, under the current recessionary market situation, for lenders.  And once the mess of bankruptcy has been sorted out, past bankruptcies will still interfere with the homeowner’s future ability to get an FHA-insured home loan, since the homeowner will be barred from such loans for a two year period (during which time he will be a creditworthy tenant for some landlord, if he has a job).

For a more comprehensive look at personal bankruptcy’s role in retaining or losing a home to foreclosure, see Residential Housing and Personal Bankruptcy, from the Philadelphia Federal Reserve.