Late last year, government responses to the subprime mortgage crisis proliferated but most attention focused on those measures that could be, and in some cases were, rapidly implemented — measures like the Treasury Department’s urging holders of certain subprime adjustable rate mortgages (ARMs) to freeze interest rates temporarily or the Federal Reserve’s proposed tightening of lending requirements. 1 Less attention was paid to certain legislative proposals moving more slowly through Congress, but attention is likely to turn to these proposals this year, with the threat of increased residential foreclosures as ARMs adjust upwards in 2008.2
Among the various measures currently pending before Congress are three bills3 that would change chapter 13 of the Bankruptcy Code4 to allow an individual debtor facing foreclosure to file a reorganization plan5 to modify the provisions of his or her primary home mortgage — a change that aims to preserve home ownership, but could have a profound effect on the secondary market for mortgages and mortgage-backed securities.6
At issue is Bankruptcy Code §1322(b)(2)7 which generally prohibits an individual debtor from modifying the mortgage on his or her principal residence,8 although among other exceptions, mortgage modifications are currently allowed with respect to mortgage loans for second homes, vacation homes, and single family homes purchased for investment or rental purposes.9 The proposed changes have split the financial community, with some bankruptcy professionals, economists, and certain lenders supporting the changes,10 while many lender groups remain opposed.11
Putting aside the business and public policy arguments for and against modifying this provision of chapter 13, it is useful to look at the current state of the law as well as at the specific changes proposed by, and the differences among, the three approaches being considered by Congress to determine the extent to which any changes would affect the marketplace.
Chapter 13 allows a debtor to restructure his or her debts and satisfy them over a three to five year period. Although under existing law, a chapter 13 debtor may propose to cure a default on primary home mortgage debt having a maturity date that extends beyond the term of the plan and then continue to make regular payments on such debt,12 chapter 13 generally prohibits a debtor from modifying monthly payments or the interest rate on a primary home mortgage through his or her plan of reorganization.13 The plan must provide for full payment of all arrearages, penalties, and accrued interest in order to prevent foreclosure.14 Chapter 13 also prevents debtors from “lien stripping”, i.e., writing down the value of the primary mortgage debt to the current market value of the creditor’s collateral.15
Senators Durbin and Specter have introduced competing bills in the Senate, while the House Judiciary Committee has approved a bill that is expected to be considered by the full House of Representatives later this year. As further described below, each of the proposed bills pending before Congress addresses these issues in one way or another. The proposals also variously establish methods of extending the repayment period of the mortgage and modifying the interest rate, among other things.16 The three measures would address the primary issues at hand as follows:
Certain Primary Mortgage Loans Eligible for Modification
Although all three bills would now permit primary mortgages to be modified, each one is restricted in its application by the income of the debtor or characteristics of the mortgage loan. The Durbin Bill would allow a debtor to modify an allowed claim secured by his or her primary home mortgage if, after deducting certain expenses permitted under the Code (such as payments to support an elderly or chronically ill family member, child support payments, and the like), the debtor has insufficient current monthly income to cure an outstanding default and maintain payments during the pendency of his or her bankruptcy case.17
The Specter Bill would permit modification only if the combined current monthly income of the debtor and his or her spouse, when multiplied by 12, were less than 150% of the applicable state median income (as determined according to the formula set forth in the statute). In addition, the Specter Bill would limit these modifications to mortgages originated prior to September 26, 2007.
The House Bill would allow modification only of “subprime mortgages” (those senior and subordinate loans having an annual percentage rate (APR) exceeding the sum of three to five percent on a senior or subordinate mortgage, respectively, plus the yield on U.S. Treasuries with comparable maturities) and “nontraditional mortgages” (including interestonly and adjustable rate mortgages that can lead to negative amortization but excluding subordinate home equity lines and reverse mortgages) made from January 1, 2000 through the legislation’s effective date that are the subject of an outstanding foreclosure notice. Like the Durbin Bill, the House measure would permit primary mortgage modification only by a debtor whose current monthly income (less permitted exclusions) is insufficient to cure outstanding defaults and maintain all payments while his or her case is pending.
Modification of Interest Rate
There are two basic differences among the proposals with respect to how interest rates could be reset for modified mortgages. Under the Durbin Bill in the Senate and the revised House Bill, the bankruptcy court would determine interest rates for modified mortgages, setting a fixed APR at the most recent annual yield published by the Federal Reserve for conventional mortgages plus a “reasonable” risk premium.18
Under the Specter proposal, the chapter 13 plan applicable to a mortgage eligible for modification could propose to prohibit or delay adjustments to the interest rate applicable to an adjustable rate mortgage (with respect to a rate adjusting after the filing date of the plan), or even to void any adjustment that occurred within two years prior to the filing of the plan.19
Extension of Maturity Date/ Mortgage Payments Beyond Term of Reorganization Plan
While the Specter Bill would not allow any extension of the term of the mortgage, the Durbin Bill would allow an eligible debtor to repay his or her modified mortgage for a period of up to 30 years from the date of the order for relief (which period would be reduced by the amount of time elapsed since origination of the loan). The House Bill also would allow an extension to 30 years from the date of the order for relief.
Chapter 13 reorganization plans generally are limited to three to five year’s duration.20 All of the proposed bills would allow payments of modified mortgages beyond the term of the plan, although each handles the timing of discharge differently. The House Bill expressly permits the plan to extend mortgage repayment for a period that is the longer of 30 years (less any portion of the term that has already transpired) or the remaining term of the loan beginning on the date of the order for relief. The House Bill also states that the holder of a modified mortgage claim shall retain its lien until the later of payment of the claim or after the debtor is discharged and excepts from discharge the modified portion of the mortgage claim. The Durbin and Specter Bills lack clarity on these issues.21
The House Bill specifically authorizes lien stripping. The Specter Bill would not allow lien stripping unless the debtor and the mortgage holder agree to it in writing. The Durbin Bill does not expressly authorize (or prohibit) lien stripping.
Elimination of Undisclosed Post-Petition Fees
Mortgage loan agreements generally allow lenders to accrue fees, costs and expenses during a bankruptcy case, including attorneys’ fees, appraisal fees and late payments. Allegedly, these accruals are often hidden from debtors and courts during the three to five years of a chapter 13 plan, with charges presented to debtors after the completion of known payments under the plan. The Durbin and the House measures would require that in order to add accrued fees, costs and charges to its secured claim, the mortgage lender must provide notice to the court within certain time limits and the expenses must be “lawful” and “reasonable” fees to which the lender is entitled under the mortgage agreement. In addition, the House Bill states that the secured creditor’s claim must be oversecured (i.e., the value of its collateral must exceed the amount of its claim) in order for it to be entitled to such fees, costs and expenses. Failure to provide this notice would be deemed a waiver of such fees, costs and expenses, and any attempt to collect them would be deemed a violation of the automatic stay or order granting discharge, as applicable. The Specter Bill does not expressly address this issue, although it does permit interest, late fees and other fees to be voided as fraudulent transfers22 if the court finds that there was a “material failure to disclose” their material terms.
Treatment of Prepayment Penalties
All of the proposed legislation would allow the debtor’s plan to waive prepayment penalties. Each of the Durbin Bill and the House Bill expressly states that a plan may provide for waiver of early repayment or prepayment penalties on a claim secured by a primary home mortgage. In the case of the Specter Bill, such removal would exist only in cases where the debtor is eligible to modify his or her mortgage claim.
Recovery of Pre-Petition Interest as Fraudulent Transfer; Disallowance of Entire Mortgage Claim
Each of the Specter and House measures would amend section 548(a) of the Bankruptcy Code, which addresses actual fraud, to allow the bankruptcy court to avoid payments of interest pre-petition if they resulted from a “substantial failure to disclose material terms regarding interest.” The look-back period for fraudulent transfers is two years from the filing date.23
The Durbin Bill goes even farther. It would disallow the mortgage claim in its entirety and subject the claim to any remedy for damages or rescission, even after entry of a foreclosure judgment, if the mortgagee was found to have violated the Truth in Lending Act or other state or federal consumer protection laws in effect when the violation took place.
Despite the recent “compromise” in the House, questions remain about whether any of these provisions will become law in 2008. Nonetheless, the industry continues to watch these legislative developments with interest in order to monitor the extent to which the terms of mortgages subject to outstanding securitizations may be modified, and thereby evaluate the legislation’s potential impact on future markets.