Pros and Cons of Altering the Bankruptcy Code to Help Judges Fight Foreclosures

One of the more creative plans put forth by legislators as an effort to alleviate pain in the housing market and stop the rising tide of foreclosures has been to alter the bankruptcy code. This would allow bankruptcy court judges to reduce the principal balance on mortgage loans, bringing the amount the homeowners owe more in line with the current market value of the property.

For unsecured debts, such as personal loans and credit cards, as well as some secured loans, like investment property mortgages, judges already have this power. They can reduce the total owed to particular creditors and have the people filing bankruptcy to stop foreclosure pay back a lesser amount.

Ideally, when homeowners file bankruptcy, they will be able to reduce their debts to a more reasonable level, while also making good on the loans they have taken out. While the lenders may not receive all that they had been counting on, they will receive more than they would have if the bankruptcy filers had simply walked away from these debts.

Congress is now trying to extend the power to reduce mortgage balances on primary homes to bankruptcy court judges in an effort to allow them to help homeowners stop foreclosure and establish an affordable payment plan. Of course, there is a lot of opposition from the banking industry, and even the president has stated that the proposed idea will interfere directly in voluntary mortgage contracts.

But on the plus side, homeowners would be more inclined to stay in their home and seek bankruptcy protection if there was a chance their mortgage balance would be reduced. Instead of simply abandoning a home that they owe much more on than the property is worth, they may be able to negotiate down the balance and have an incentive to seek other options to save their homes.

The fact that bankruptcy court judges already have similar powers in other debts is also a positive for the proposal. Reducing the mortgage on an investment property is not very much different than reducing the balance on the primary home, after all.

Possibly the most important reason to support this plan is the speed with which it could be implemented, as opposed to tax breaks, economic stimulus checks, or creating new government agencies. The bankruptcy code could be changed within weeks and judges would instantly have the power to foster negotiations between mortgage companies and homeowners.

The proposal would also have the benefit of costing nothing to the general public, as it does not require more money to be spent through funding more government programs. Plans that involve additional costs to Americans only pushes them further towards the brink of financial ruin, and may cause more foreclosures than they solve; changing bankruptcy laws would not have that negative effect.

There are numerous drawbacks to this plan, though, not the least of which is that mortgage companies would have to increase their costs to borrowers if they knew there was a chance of the mortgage balance being reduced in the future. Interest rates on primary home mortgages are almost guaranteed to rise for all homeowners, which would have the effect of reducing how much people could afford to pay for a home.

Another problem would be that people with mediocre or poor credit, who have experienced financial hardships in the past, would not be able to get a mortgage at any decent rate. The banks may be far too worried about the possibility of bankruptcy and simply refuse to secure mortgages for anyone without pristine credit, locking large segments of the population out of ever becoming homeowners.

The proposal to change the bankruptcy plan may be quite a long-shot, but the developments are worth following as it seems to be the one proposal that involves actually helping homeowners directly. While other plans have involved bailing out the banks, homebuilders, auto companies, and airlines at the expense of foreclosure victims, altering the bankruptcy code may be the most positive plan yet put forward.

Because the plan does have the potential to assist homeowners to stop foreclosure before the bank makes money from the process, there is little chance it will pass in time. But with more than a year and a half left of resetting mortgage rates, legislators may eventually feel they have little choice but to provide some token benefit to the people in the midst of pumping out tax breaks and bailouts to the largest corporations.

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