There seems to be a lot of momentum toward bankruptcy cram-downs as a way to reduce foreclosures.

Cram-downs are a bit of a policy of last resort but nothing else seems to be working so cram-down policies have risen to the top of the banking crisis discussion lately.

  • Cram-downs would reduce foreclosures. (Good)
  • Approving cram-downs would cause a bankruptcy stampede. (Bad)
  • Cram-downs would force banks to take losses sooner rather than later. (Bad… I think)
  • Cram-downs, if permanent, could prevent the non-governmental mortgage lending industry from ever rebounding after home prices bottom out. (Bad)

If you are unfamiliar with the term, here’s how the Journal describes the process:

In a cram-down, a judge modifies a loan, often reducing principal so a borrower can afford it. Lenders hate it because they have to absorb the loss. Bankruptcy judges currently have the ability to modify certain personal loans and even mortgages on vacation homes, but they can not cram-down mortgages on primary residences.

President-elect Obama indicated his inclination to bankruptcy reform to allow cram-downs during his campaign, and two main Congressional players — Barney Frank and Christoper Dodd — have made no secret of their affinity for the program. Given that sort of backing and the Democratic majority, I think you can call it a done deal.

There are only a few problems with the idea.

Think about how the courts are going to handle this. There will be a tidal wave of BKs. No way on earth that they can handle the crunch of say ten or twenty million petitioners. As the cases wind their way through the system, the payments will likely be stayed and a lot of people will live mortgage payment free while the owners of the mortgages, many of whom we have already bailed out, will get hammered.

And here is the downside.

And of course, no investor in his right mind is going to invest in any American mortgage security again without a substantial risk premium. So unless we want to see mortgage rates in the neighborhood of credit card rates, the government is going to have to subsidize the business from here to Kingdom come. Which one of those options do you think is going to come about?

Moral Hazard

Cram-downs could have an “unfairness” effect that could undermine faith in the entire economic system. Your irresponsible, formerly-bankrupt neighbor now pays less for his mortgage every month than you, and later when you both sell your homes, he makes money while you lose money.

In the current “foreclose-not-forgive” system, the irresponsible neighbor is at least shamed by being forced to move out which encourages responsible behavior among the remaining neighbors.

The Best Way to Write-Down a Mortgage?

However, when it comes to lenders forgiving mortgage debt (reducing the mortgage loan balance), there is a “fairness” advantage of doing it within the court bankruptcy process. You know the bankruptcy rules were applied uniformly by the courts in a well established process, and with a bankruptcy, you know the homeowner was wiped out financially.

If a bank forgives debt within a foreclosure process, on the other hand, it opens up a can of worms which is why lenders haven’t done it much.

For example, homeowners who are underwater but who are able to pay the mortgage (and who have plenty of other financial assets) would simply stop paying the mortgage if they thought the bank might forgive a large portion of their mortgage debt. If, however, the homeowner knows the bank will kick them out if they stop making mortgage payments, the homeowner is more likely to make the mortgage payments even if he is underwater.