Bankruptcy and Mortgage Stripdowns: Learning from Experience

by devteam August 10th, 2010 | Share

Usingrnthe farm crisis of the early 1980s as a model, two economists have refutedrnseveral of the arguments against legislation that would permit bankruptcyrnjudges to cramdown or stripdown of mortgage loans.  Thomas J. Fitzpatrick IV and James B Thomson,rneconomists with the Federal Reserve Bank of Cleveland, published their paper, Stripdowns and Bankruptcy: Lessons fromrnAgricultural Bankruptcy Reform in the bank's EconomicrnCommentary on its website.</p

Allowing stripdownsrnof mortgages during Chapter 13 bankruptcy reorganization has been suggested asrnone way to deal with the housing crisis. rnIf such legislation were passed, bankruptcy judges would be allowed tornreduce the outstanding balance on a mortgage loan to the actual value of thernunderlying collateral, turning the remaining balance of the mortgage into an unsecured claim whichrnwould receive the same proportionate payout as other unsecured debts includedrnin the bankruptcy petition. Some proponents of this provision maintain it couldrnbe a partial solution to the foreclosure crisis, reducing the number of homesrngoing into foreclosure by improving the chances of a successful loanrnmodification.  Others favor the law onrnthe basis of equity, saying that mortgages on rental properties and vacationrnhomes as well as virtually every other type of secured loan can be strippedrndown during Chapter 13 proceedings.</p

Those opposing stripdown legislation fear an increase in mortgagerninterest rates, apparently in response to any increase in loan modificationsrnrather than to the stripdown itself.  Thernunintended consequences of this, they argue, might be to make homeownershiprnless affordable and accessible to low and moderate income families.  Opponents also cite the possibility of an avalanchernof Chapter 13 filings should stripdowns become law in the midst of the currentrnfinancial crisis. Lenders have been the most vocal of opponents, arguing that stripdownsrnwould shift losses from borrowers to lenders, give bankruptcy judges too muchrndiscretion, and that such shifting is unfair in that it changes the rules ofrncontracts after the fact. </p

The economists maintain that such arguments are best viewed against thernempirical evidence from the actual experience with stripdowns done underrnlegislation establishing the BankruptcyrnJudges, United States Trustees, and Family Farmer Bankruptcy Act of 1986.</iThis legislation established a separate chapter in the U.S. Bankruptcy Code,rnChapter 12 intended solely for farmers. rnThe legislation was passed in response to an agricultural and bankrncrisis in the 1980s and originally had a sunset provision, but worked wellrnenough that it was twice extended and then made permanent in 2005. </p

The agriculturalrnlending crisis had some strong parallels with the more recent home lendingrnmeltdown, as well as, Patrick and Thomson point out, some distinct differencesrnand many ofrnthe claims and concerns expressed in the current debate were central in therndebate over Chapter 12. </p

The agricultural lending crisis started in the 1970s when US farm exportsrnrose over 500 percent, from $8.24 to $43.78 billion in a nine year periodrnstarting in 1972. This led to a dramatic rise in commodity prices and farmrnincomes over that time period. Net farm income peaked at over $27 billion inrn1979, a rise of 41 percent over the decade. </p

It was a typical boom-bust scenario: When prices for their goods werernrising, farms expanded and farm real estate prices increased significantly; in Iowa,rnfor example, the price of farm land more than quadrupled from 1970 to 1982. But,rnwhile demand for their products had increased sharply in the early 1970s,rnfarmers watched it fall almost as fast in the late 1970s and early 80s. Withrnthe drop in demand and price for products the demand and price for land fellrntoo.  That Iowa land lost nearlyrntwo-thirds of its value in five years, and the same thing happenedrnnationally.  The average price ofrnfarmland increased more than 350 percent by 1982 then fell by more than a thirdrnin the next five years. </p

As the price was going up, so did agricultural debt loads as manyrnfarmers borrowed to acquire additional acreage. Cash-short and expectingrnincreased income, many farmers used variable-rate notes to purchase realrnestate. Caught up in the boom, lenders eased underwriting standards, relying onrnthe continued appreciation of the land for security rather than the ability ofrnthe farmers to service their debt.  Butrnas prices and cash flows decreased and the variable-rate notes used to purchasernfarm real estate reset, many farmers saw their interest rates increase, foundrnthat they could not make payments and were underwater on their mortgages.</p

Farmland values peaked in 1981 in the Midwest, where the land-pricernappreciation had been the greatest, and declined by as much as 49 percent overrnthe next few years before bottoming out in 1987. Farm-sector debt quadrupledrnfrom the early 1970s through the mid-1980s. Debt declined by one-third fromrn1984 through 1987, but much of this reduction reflected the liquidation ofrnfarms.</p

Many farmers, especially in the South and Midwest, were underwater withrntheir agricultural loans and were in danger of losing their primary residencesrnwith little relief possible under the existing bankruptcy laws.  Chapter 13 did not allow for modification ofrndebt secured by a primary residence, and Chapter 11, intended for corporations,rnwas too complex for most small and medium sized farmers and also containedrnprovisions that made a stripdown problematic.</p

Some states enacted moratoriums on foreclosures but they provided onlyrntemporary relief given the underlying economic factors (does any of this soundrnfamiliar yet) and left many farmers unable to service their debt and withrnalmost no possibility of renegotiating their secured loans. </p

Fitzpatrick and Thomson point out that, unlike in the currentrnforeclosure crisis, the troubled debt then was highly concentrated a few FarmrnCredit Banks, Farmer Mac and commercial banks in the affected regions.  Nonetheless, these agriculturally relatedrnbanks began to fail in 1984 and accounted for a third of all bank failuresrnbetween 1983 and 1987.  This led to the Chapterrn12 legislation and its related stripdowns provisions. Despite the samernarguments we hear today, Congress permitted stripdowns for farmers becausernvoluntary modification efforts, even when subsidized by the government, did notrnlead agricultural lenders to negotiate loan modifications. </p

The actual negative impact of the legislation was minor. Even thoughrnthe new section of the Bankruptcy Code was created specifically for farmers, itrndid not change the cost and availability of farm credit dramatically. In fact,rna United States General Accounting Office (1989) survey of a small group ofrnbankers found that none of them raised interest rates to farmers more than 50rnbasis points. The economists say that while this rate change may have been arnresponse to the Chapter 12, it is also consistent with increasing premiums duernto the economic environment and  suggestrnthat the changes in the cost and availability of farm credit after the bankruptcyrnreform differed little from what would be expected in that economicrnenvironment, absent reform.</p

The Commentary says, “What was most interesting about Chapter 12rnis that it worked without working.  According to studies by Robert Collenderrn(1993) and Jerome Stam and Bruce Dixon (2004), instead of flooding bankruptcyrncourts, Chapter 12 drove the parties to make private loan modifications. Inrnfact, although the U.S. General Accounting Office reports that more than 30,000rnbankruptcy filings were expected the year Chapter 12 went into effect, onlyrn8,500 were filed in the first two years. Since then, Chapter 12 bankruptcyrnfilings have continued to fall.”</p

Despite the controversy that accompanied Chapter 12 and is stirringrnaround the idea of a stripdown authority today, economists say that the “effectsrnof the stripdown provision, in place for more than two decades, on thernavailability and terms of agricultural credit suggest that there has beenrnlittle if any economically significant impact on the cost and availability ofrnthat credit.”  They do, however,rnpoint out some significant differences between the agricultural foreclosurerncrisis of the 1980s and the current home foreclosure crisis. </p

“First, the structure of the underlying loan markets is different.rnUnlike mortgages today, few if any of the farm loans in the 1980s were sold orrnsecuritized. Moreover, there was more direct government involvement inrnagricultural loan markets in the 1980s than there was in the mortgage marketsrnleading up to the current housing crisis. Finally, the scale of the currentrnforeclosure crisis is several times larger than the 1980s agricultural crisis,rnwhich was limited geographically to the Midwest and Great Plains states. Yet,rndespite these differences, the response to the farm foreclosure crisis and thernimpact of bankruptcy reform on agricultural credit markets is still informativernfor the current debate.”

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About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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