With a record 1.5 million people expected to declare personal bankruptcy this year, it is clear that insolvency no longer carries the stigma it once did.
To be sure, bankruptcy is the debt-management option of last resort for some people. After all, the sudden loss of a job, a medical emergency or even a divorce can quickly wipe out a life’s savings.
But others who seek the court’s protection from creditors are nothing more than financially irresponsible over-spenders who use the federal bankruptcy laws the way most people take aspirin–again and again, and sometimes again.
And now, a commission established by Congress in 1994 to suggest improvements in the bankruptcy code is about to recommend that financially strapped homeowners who have borrowed more than their houses are worth should be allowed to walk away from a big part of what they owe.
Obviously, the idea doesn’t sit too well with most mortgage lenders, who maintain that it would disrupt the existing balance between debtors and their creditors.
But in a report to be delivered to Congress on Oct. 20, the National Consumer Bankruptcy Commission says that a mortgage exceeding the value of the underlying property when it was written is partially unsecured from its inception, and should be treated accordingly in the bankruptcy process.
All of this may be moot, however, because two key legislators have offered a proposal of their own–one which mortgage lenders intend to support–that would establish a “need-based” bankruptcy system.
The system envisioned by Reps. Bill McCollum (R-Fla.) and Rick Boucher (D-Va.) would encourage people to pay what they can by determining the amount of financial relief a debtor actually needs–no more and no less.
Under the current law, there are two kinds of personal bankruptcy:
– Chapter 7, known as a straight bankruptcy, involves the liquidation of all assets that are not exempt in your state.
– Chapter 13, also called a reorganization, allows you to keep certain property while you pay off what you owe over a three- to five-year period under a plan that the court finds acceptable.
Three out of every four people who choose bankruptcy opt for Chapter 13. And under that heading, a mortgage on a primary residence is treated as secured debt and cannot be modified. Therefore, it must be paid back in full.
But unsecured debt can be modified by the court. And though it is possible that the unsecured portion of what the borrower owes will be paid in full, in the majority of Chapter 13 cases, only about 20 percent is ever paid back.
In recent years, some homeowners have been borrowing far more than their homes are worth–sometimes 150 percent–to consolidate higher-interest credit-card debt, make improvements to their residences, start a business or finance their children’s education.
Lenders who make these kinds of high-ratio loans do so with the understanding that under the law, they will retain a full-security interest in the underlying property, regardless of how much is borrowed.
But the bankruptcy commission thinks differently. It says that high loan-to-value lenders are acting more like credit-card lenders who issue unsecured debt. And as a result, the commission will recommend that second-mortgage and home-equity loans should be subject to limited modification.
A coalition of lenders likens the commission’s plan to “cramdowns” in which a bankruptcy court forgives a portion of the borrower’s primary mortgage. The coalition says that all loans secured solely by residential real estate are protected from cramdowns under a 1993 Supreme Court decision.
But cramdowns–a euphemism for a distasteful ruling upon a creditor over his objection, as in “crammed down our throats”–usually occur because the house has lost value and is no longer worth as much as what is owed on it.
What the bankruptcy commission is talking about is unsecured lending at the outset. And under its proposal, only the unsecured portion of the loan could be modified. The rest could not be reduced below the value of the property at the time the loan was made, even if the value had since declined.
The lender group, the National Consumer Bankruptcy Coalition, isn’t even happy with the commission’s proposal to keep debtors from abusing the system by barring repeat filings, because the coalition believes that the ban isn’t strong enough.
Consequently, lenders are throwing their considerable weight behind the McCollum-Boucher legislation, which would base the borrower’s relief on a formula that uses borrower income and obligations to determine the ability of the borrower to repay what is owed.
Which proposal has the best chance of getting passed? The smart money is betting that the McCollum-Boucher bill is likely to be the starting point, if only because Rep. McCollum is a senior member of both the House Banking and Judiciary Committees.
Either way, though, look for Congress to take some action.
“We are seeing countless numbers of `bankruptcies of convenience’ as more and more people are choosing bankruptcy as a financial planning tool,” says Rep. McCollum. “With today’s system, bankruptcy has become the first stop rather than the last resort.”
