Bankruptcy Reform and the Financial Crisis

The recent financial crisis has generated a sharp shift in public discourse about, and regulatory interest in, the federal bankruptcy system and financially distressed families. Once, the news media were disproportionately fascinated by the fallen executive with a house in Florida that his creditors could not touch. Today, the featured debtor is more likely to be the low-income homeowner whose mistake was answering the door when a dishonest mortgage broker came calling. Just a few short years ago, lawmakers overwhelmingly supported a giant reform bill, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), (1) based partly on the notion that bankruptcy judges had too much discretion and bankruptcy professionals were not to be trusted. (2) BAPCPA was well understood to increase the cost and decrease the effectiveness of bankruptcy relief for filets, with little attention to how this might affect the stability of their homeownership. Now, a new bankruptcy reform bill is touted as granting bankruptcy judges more flexibility to stabilize mortgages and communities. (3) With North Carolina Representative Brad Miller helping to take the lead, the legislation expands bankruptcy relief for debtors with the express intent to advance housing and economic policy goals through mortgagor protection. (4) Prior to the current financial crisis, housing policy experts did not publicly reckon with the role of bankruptcy law in managing mortgage delinquency, let alone the limits of bankruptcy law to accomplish those goals. Regardless of their awareness, the existing bankruptcy system has long served as a national anti-deficiency law for debtors who part with their homes for less than the amount of their mortgage debt. Through Chapter 13 of the Bankruptcy Code, in which debtors participate in a supervised repayment plan, bankruptcy has allowed homeowners to reinstate their mortgages in installment payments over the objections of their mortgage holders, although statistics are scarce on actual home retention. But beyond this reversal of acceleration clauses, home mortgages usually cannot be restructured in bankruptcy without consent of the mortgage holder--whoever that may be these days. Consequently, unlike other secured debts, this precludes imposing reductions in interest rate or principal on a mortgage holder. (5) As lawmakers and housing policy experts seek to limit the social costs of widespread foreclosure, they see that a temporary relaxation of this special insulation of home mortgages could prevent poorly underwritten mortgages from wreaking even more havoc in communities and housing markets. In other words, if bankruptcy law permitted a repayment plan to reduce the interest rate on a subprime mortgage, perhaps a borrower in default could keep her home and her neighbors would not see further declines in their property values. (6) If bankruptcy law reduced the mortgage debt to the value of the collateral, perhaps the borrower could see the potential upside in the future and have less of incentive to abandon the home. (7)