It is gaining popularity among some in the political class. The idea is being floated to change the law and allow “cram-downs” on owner/occupant loans.
Cram-down: Basically, on many commercial (investment property) loans, a bankruptcy judge can alter the terms of the loan during a bankruptcy proceeding. Let’s say that the property has deflated in value and won’t support the payment it once did, the judge could lower the balance of the loan to allow the owner’s payment to cover servicing the new lower debt. In effect, the new value is crammed-down the throat of the mortgage lender.
For most of the rest of us, if we do end up declaring bankruptcy, the same option doesn’t exist. In effect, a home owner would be able to stay in the house, and the bank would write down the value of the loan to reflect the “new reality”. This is already how it works forcredit cards. And the idea seems to be getting a lot of traction from some members of Congress.
On the positive side, this would allow many that would otherwise face foreclosure to stay in their homes. Instead of being at the mercy of the banks, judges would be to to quickly and efficiently change the terms of a loan unilaterally. Right now, home owners might wait for months to be told no… or worse, might have to produce some arcane piece of paper and join the line again to wait months to hear the next hurdle.
But there is a giant negative… And it seems like a lot of the people that are proposing this as a solution to ease the foreclosure crisis are ignoring this completely. The effect of risk on interest rates. With increased risk come increased cost. And we aren’t talking about pennies here, either. Take a look at a few different types of loan products and the costs associated with each of them.
- Regular owner/occupant mortgage. 5.188% $1100/mo. Payment
- Commercial Property 30yr. mortgage. 7.62% $1415/mo. Payment
- Credit Card Rate highest risk. 12.65% $2160/mo. Payment
In the case of a traditional mortgage, the bank can be reasonably assured that they have a shot at getting the money back that they loaned out. They certainly have risk… especially now… but it is low by comparison. They either get paid in full, take back the property, choose to lower the principal on the loan or choose to alter the terms.
With the commercial property mortgage, there is a higher risk for the lender. If the borrower were to have a financial problem landing them in some sort of restructuring, they could have the value of the loan modified, the terms altered or they could end up taking back the property. But, instead of choosing to do it because it is a good business decision, they can be forced.
Credit cards are unsecured. In the case of a bankruptcy, the balance can be dramatically altered, or even wiped out. The risk is very high. So, despite the fact that the banks are borrowing the money at a very low rate, they have to jack it up in order to cover the default risk of the borrowers.
Give me the “Executive Summary”
In a nutshell, if “cram-down” provisions were placed into the bankruptcy code, the interest rates would have to rise in order to cover the increased risk. Also, remember that most investor loans require 20% down because mortgage insurance companies don’t like them at all.
So, not only would rates go up, but down payment requirements would also go up.
Do you think either of those things would help the real estate market? Prices would drop a LOT more than they would otherwise. A lot more borrowers would be in precarious financial situations. The government would end up fueling the very thing they are trying to stop.
But worse, think of the people that have NOT made mistakes… the ones that haven’t even bought yet. They would be penalized MASSIVELY for the irresponsible acts of those that bought homes they couldn’t afford. That $315/mo over 30 years is more than $113,000!
also authored by Lane Bailey