Bankruptcy Cramdown Returns in Proposed Servicer Settlement

WASHINGTON — For years, Sen. Richard Durbin, D-Ill., and consumer advocates tried to enact legislation that would allow judges to reduce mortgage principal in bankruptcy proceedings, only to be repeatedly defeated by the banking industry.

But if state attorneys general prevail in settlement talks with the five largest mortgage servicers, Durbin may finally get his wish — with a twist. In addition to pushing banks to reduce mortgage debt in bankruptcy, the 27-page draft agreement would give Elizabeth Warren, the interim head of the Consumer Financial Protection Bureau, new authority to determine if all borrowers should receive a principal writedown.

"It's worse than cramdown," said Paul Miller, managing director of FBR Capital Markets Corp. "This is with Elizabeth Warren."

At issue are provisions in the draft settlement agreement, which must still be negotiated with the banks, which are designed to pressure banks into offering principal writedowns. If the agreement were finalized in its current form, banks would be required to set up a special loan modification process for bankruptcy cases. They would be encouraged to reduce principal to the fair market value of a property while other unsecured debt is discharged or, as part of a Chapter 13 plan, lower the borrower's interest rate to zero for five years and then reamortize at a market rate for 25 years after that point.

That, industry observers said, is largely the same as what Durbin was seeking.

"It kind of is like the mortgage bankruptcy cramdown," said Phil Swagel, a visiting professor at Georgetown University and a former Treasury Department official in the Bush administration. "It seems inappropriate. The robo-signing is terrible and any misdeeds should be dealt with … but it seems this is an end run around Congress."

The banking industry isn't the only one that sees the similarity. A spokesman for Durbin said the draft agreement was close to what the Illinois Democrat was trying to accomplish.

"At first glance, this is quite similar to a solution to the foreclosure crisis Sen. Durbin has been pushing for years," the spokesman said. "Giving underwater homeowners the chance to alter the terms of their mortgages in bankruptcy will help families save their homes and cost taxpayers nothing."

But it may also go further by giving the CFPB a large role in determining who else — outside the bankruptcy process — should receive a modification.

Under the term sheet, servicers must take loss-mitigation steps whenever the net present value of a modification would be greater than that of a foreclosure. Because servicers conduct such calculations differently, the CFPB could request those models from servicers, raising the prospect that the new agency could tell servicers how to determine the net present value of a loan.

Indeed, the entire agreement turns on the concept of net present value. If a borrower requests a modification and a servicer believes it is prevented from granting one because of a pooling and servicing agreement, the servicer must still conduct the NPV test and, if positive, present that to trustees in order to obtain a consent for a modification.

Under the agreement, the CFPB will also oversee an internal review by servicers of all loss-mitigation denials.

Banking industry representatives are protesting these and other provisions, arguing that the state AGs, backed by the CFPB, Justice Department and Department of Housing and Urban Development, are trying to enact bankruptcy cramdown by another name.

"Congress took up and considered the cramdown and rejected those because it didn't want to change judicial rights in bankruptcy or any other court," said Bob Davis, executive vice president of government relations for the American Bankers Association. "Yet this settlement not even subject to rulemaking would seek to eliminate some of those rights and judicial proceedings. It seems clearly to violate the intent of Congress and its own votes."

Mark Calabria, director of financial regulations studies at the Cato Institute and a former top aide to Republican Sen. Richard Shelby, agreed.

"I sort of predicted that, that regulators would now try to do things they couldn't get through in Congress," Calabria said. "There's been and there is a massive power grab from the executive branch from the courts."

Industry observers saw similarities in how the legislation and the draft settlement treated investors.

"What the legislation ignored is also what the proposed settlement so far has ignored: There is a third group with legal rights in this and that is investors," said Joseph Engelhard, an analyst at Capital Alpha Partners LLC. "I do think it has the same problems as the proposed legislation.

Laurence Platt, a partner at K&L Gates, said there were some minor differences.

"It is like a bankruptcy cramdown," Platt said. "Basically bankruptcy cramdown writes down the debt to the fair market value. This would write down the debt to a net present value test. It isn't necessarily the fair market value, but it must produce a net present value. It may produce more than a cramdown. It may not."

Either way, however, Platt said "it's a big giveaway. It's a unilateral rewriting of the mortgage contract."

Platt also said it was worse than the failed legislation, which only would have affected consumers in bankruptcy. Under the term sheet, servicers would have to conduct a net present value test for all delinquent loans.

"This is worse than cramdown in that it only applies when a borrower is in bankruptcy," Platt said. "Here they don't even have to apply for bankruptcy. There is an affirmative duty to apply modifications if there is a positive NPV without regard to whether a borrower is in bankruptcy or not."

But Jaret Seiberg, an analyst with MF Global Inc.'s Washington Research Group, said the term sheet is a better deal for bankers than legislative bankruptcy cramdown.

"From the perspective of the bank this is better than mortgage bankruptcy reform because mortgage bankruptcy reform could have resulted in the cramdown or discharge of other debt such as credit card debt," he said.

Consumer groups, however, argued that cramdown and the settlement were not similar.

"I don't believe it's bankruptcy cramdown," said David Berenbaum, executive vice president of the National Community Reinvestment Coalition. "That would be a judicial process where a judge would assess the merits of a filing. … This is more of a best practices approach where servicers are being asked to examine what is in the best interest of the investor and coupled with that, it would benefit the consumer."

Julia Gordon, senior policy counsel for the Center for Responsible Lending, said the use of "consider" in the settlement gives bankers more leeway than they would in bankruptcy reform.

" 'Servicers shall consider,' I just don't even see this in the same ballpark," she said. "It looks to me like it is requiring servicers to consider principal reduction and do it where appropriate. There are a lot more details that need to be fleshed out here. Principal reduction is very hard, but the reason the bankruptcy reform would have been so effective is that it dealt with a number of problems at one time, and this document doesn't go that far."