Sterling Professor Alan Schwartz of Yale holds a joint professorship in law and management, which may explain why the New York Times gives him an opportunity to take his best shot at bankruptcy cramdown. He offers three reasons it won’t work: there are too many cases and too few judges, debtors can’t win, and economic uncertainty will increase. Let’s see how Yale theorizing stacks up against practical reality.
When a family comes to see a bankruptcy lawyer, the most important thing is the budget. The lawyer and the family calculate the current income and monthly payments. The family works out how much they can pay to creditors, assuming they can cut their payments to unsecured creditors, but the mortgage payment remains the same. If they cannot pay their regular monthly expenses after those cuts, their alternative is liquidation in Chapter 11.
If cramdown were available, they could try again with a lowered house payment. The goal would be to set up a house payment that would allow minimal payments to unsecured creditors, and make it possible for them to keep their house. Once they see how much is available to pay for housing within the budget, the lawyer and the family estimate the current value of the house. If it looks low enough, they can proceed.
The first step is to get an appraisal. In my community, this might cost $250-300. The next step is to contact the lender and make an offer. In almost all cases, the contact is with a servicing company. It doesn’t have any authority, and after a 15 day waiting period required by the draft statute, H.R. 200, (link not possible) the family files a Chapter 13. They propose a formal Plan, which states the amount they will pay on each class of debt, including the house payment. If no one objects, the Plan is confirmed, and the new payments go into effect.
Suppose the servicer objects. The only grounds will be that the Debtor can’t make the payments, the price for the house is too low, or that the interest rate should be higher. If the servicer thinks the price should be higher, it gets a lawyer and its own appraiser, and files an objection to Court approval of the Plan, which is called confirmation. The Court hears the evidence from the appraisers and maybe the Debtor, which will take an hour or two. Then the Court decides. If the Debtor can make the payments at the Court’s price, with or without other modifications, the plan is confirmed; otherwise the Debtor is out of luck. Either way, it’s over. The house may be foreclosed, or it may stay with the Debtor, but that house has a value.
After a few cases, all the lawyers in the community have a pretty good idea about how the court thinks, and there will be fewer hearings. Instead, the parties will negotiate a value reasonably satisfactory to each. The Court is required to rule on whether the Debtor can actually make the payments under the Plan, which increases the certainty of payment, a value to the noteholder.
Schwartz thinks the Debtor is at a financial disadvantage. That would be true if appraising houses were complicated or expensive. It isn’t. It’s a normal process, and would be done when the house sold privately. And judges aren’t going to let this turn into a ludicrous Coleman/Franken battle.
Schwartz thinks that this process increases economic uncertainty, on the ground that the appraisal process is arbitrary, and, he says, influenced by the personal feelings of judges. He ignores the fact that Bankruptcy Judges are required by law to value real property by the Bankruptcy Code. This includes single asset commercial real estate, like apartment complexes or office buildings, where fees run $10,000 plus more for court time. Everyone realizes this process is somewhat arbitrary, but most of the time parties prefer the certainty of a decision to the alternative of foreclosure and eventual sale.
Schwartz complains that price setting is difficult today, because there aren’t enough buyers with cash and financing. The cramdown solves that problem directly: the buyer is the Debtor, and the current lender provides the financing.
Ellen Tauscher (D-Banksters) thinks this should only be available for subprime loans. Did I mention interest rates in this analysis? No. The interest rate on the original loan, which is how you know the loan was subprime, is utterly irrelevant. The twin problems are that the house isn’t worth what’s owed on it, and the Debtor can’t make the payments. The first means that it’s pointless to keep paying. The second means the house is headed to foreclosure in a market where there are no buyers. Subprime or prime, these problems won’t change.
Tauscher is putty in the hands of lobbyists from the Money Branch of Government. She’s just another corporatist democrat serving her financial betters. Anybody got an explanation for Sterling Professor Alan Schwartz of Yale University? I wonder if his view is affected by the fact that the Yale Endowment dropped 25% last year, no doubt in part because of toxic waste.