‘Cramdown’ in Your Future?

Some homeowners’ mortgages have been shrinking recently. Not by a few dollars a month as borrowers pay them off, but by thousands of dollars at once.

Financially strapped homeowners whose houses have declined in value are benefiting from two recent court decisions that have permitted the use of “cramdowns” in personal bankruptcy cases.

In a cramdown, the bankruptcy judge lowers the balance of the homeowner’s mortgage to an amount equal to the home’s value. The remainder of the original mortgage balance becomes an unsecured loan--one that is unlikely to be fully repaid under the eventual debt-reorganization plan.

The phenomenon is so new that some lenders haven’t heard of cramdowns. Other lenders wish they had never heard of them.

Lenders who have been involved in cramdowns have almost always appealed them--so far, unsuccessfully. They argue that if cramdowns become widespread, lenders could lose millions of dollars. They also say they might be forced to change lending practices to compensate for the increased risk. Loans permitting down payments of less than 20% might be eliminated, they say, and lenders might also stop making mortgages in areas where property values have been unstable or have high rates of bankruptcy and foreclosure.

But some bankruptcy attorneys say cramdowns, besides helping financially troubled borrowers get back on their feet, are better deals for lenders than foreclosures, because the borrower continues to make payments and a larger portion of the outstanding mortgage will eventually be recovered.

The number of residential cramdowns in effect nationwide, while not known, is believed to be small, said William E. Cumberland, general counsel for the Mortgage Bankers Assn. of America, a trade group. The Federal Home Loan Mortgage Corp., or Freddie Mac, which buys loans from lenders, has six in its portfolio of 5.7 million mortgages.

But, Cumberland said, “Lenders fear that if someone finds a convenient way of doing cramdowns, they could spread like wildfire.” The bankers group and other lenders are urging Congress to amend the bankruptcy laws to disallow residential cramdowns.

When Congress rewrote the bankruptcy laws in 1978, it allowed cramdowns in Chapter 11 filings, earmarked for businesses. Thus, commercial lenders were the first to deal with cramdowns. Chapter 13, under which most personal bankruptcies are filed, didn’t have a cramdown provision.

Two court decisions, however, expanded the horizon for cramdowns:

--In 1989, a federal appeals court in Oregon ruled that cramdowns could be used on a primary residence in Chapter 13 bankruptcy cases. Two other appeals courts have since made similar rulings. Twenty states are covered by these rulings, including California and Pennsylvania.

--In June, the U.S. Supreme Court said that, for the first time, individuals could file for bankruptcy under Chapter 11.

Lenders fear that those court decisions, falling property values in many areas and rising personal bankruptcies will add up to a surge in cramdowns.

Chapter 13 cramdowns are the biggest concern for lenders, said Dean Cooper, a counsel for Freddie Mac. In a Chapter 11 cramdown, a lender can place a lien on the property for the full mortgage amount. If the owner later sells the house or refinances the loan, the lender recovers the full mortgage amount. The lender loses the unsecured portion of the loan only if the owner remains in the home and pays off the mortgage. Statistically, that isn’t likely.

Under Chapter 13, there is no provision for a lien. The homeowner who has been granted a cramdown obtains not only a reduced mortgage, but also benefits from future property appreciation. If the home’s value rises, the unsecured portion of the mortgage is not restored, Cooper said. The homeowner “could end up with a real windfall,” he said, while the lender winds up with a loss.

Distributed by the Los Angeles Times-Washington Post News Service.