Bankruptcy Code Changes Could Help Avoid Foreclosures

by Amy Lillard

Could over 600,000 foreclosures be prevented over the next two years with a simple change to the bankruptcy code?

That's the stand of the Center for Responsible Lending (CRL), who has proposed changes to regulations for Chapter 13 bankruptcies in a recently introduced House bill. The CRL calls it a tweak, and says the effect could be significant for homeowners and mortgage-backed securities markets.

"Under current law, subprime homeowners have two choices," said Eric Stein, senior vice president for CRL, in written testimony before a House Judiciary subcommittee last week. "They can get a loan modification, or they can lose their home through foreclosure. Bankruptcy – the traditional option of last resort– is virtually useless, because current law prevents bankruptcy courts from assisting with the very debt that is causing the problem today – the mortgage on the family home."

The CRL proposal aims to retool the current regulations, which establish a repayment plan instead of wiping out debt. Judges can't reduce mortgage debt owned on a person’s primary residence.

The House bill proposes that the bankruptcy judge for Chapter 13 bankruptcies would have the option of reducing what the homeowner owes lenders, perhaps reducing the principal to match the home's current market value and reduce the loan's interest rate. The rest of the original principal would become lower priority for repayment as an unsecured debt.

"If bankruptcy law is like a life preserver, we're reserving it for the strongest swimmers while hundreds of thousands of families drown," said Stein. "Changing the bankruptcy code to allow the courts to modify loans on primary residences could help 600,000 families facing subprime exploding ARMs stay in their homes. This change will also save American families not facing foreclosure $72.5 billion in wealth by avoiding these foreclosures."

CRL says that this change to the bankruptcy code would not necessarily increase bankruptcy filings, and in fact deter them. If lenders and investors know the new protections, they might be more willing to modify borrowers’ terms. Additionally, lenders will get paid more than they would for a foreclosure, making it a more attractive option.

Preventing foreclosure can also preserve home values in the neighborhood, a big perk for lenders and communities.

Homeowners who take advantage of this new provision will experience damaged credit, and a bankruptcy judge will closely monitor their finances. But this reality could be a better option than the threat of foreclosure.