Tuesday, January 27, 2009

Dischargeability of Taxes in Bankruptcy

Many clients, lawyers and accountants have called us regarding the discharge of taxes in bankruptcy filings. In these difficult economic times, the IRS and New York State have stepped up their auditing of individuals and businesses.

Many kinds of “old” state and federal income taxes are dischargeable in bankruptcy. In the case of income taxes, they are dischargeable in Chapter 7 if all of the following criteria are met:

1. The tax is for a year for which a tax return is due more than 3 years prior to the filing of the bankruptcy petition;
2. A tax return was filed more than two years prior to the filing of the bankruptcy petition;
3. The tax was assessed more than 240 days prior to filing of the bankruptcy petition;
4. The tax was not due to a fraudulent tax return, nor did the taxpayer attempt to evade or defeat the tax;
5. The tax was not assessable at the time of the filing of the bankruptcy petition; and
6. The tax was unsecured.

Section 507(a)(8) of the Bankruptcy Code provides that:

Income taxes: (i) for tax years ending on or before the date of filing the bankruptcy petition, for which a return is due (including extensions) within 3 years of the filing of the bankruptcy petition; (ii) assessed within 240 days before the date of filing the petition; (iii) not assessed before the petition date, but were assessable as of the petition date, unless these taxes were still assessable solely because no return, a late return (within 2 years of the filing of the bankruptcy petition), or a fraudulent return was filed, withholding taxes for which a person is liable in any capacity, an employer's share of employment taxes on wages, salaries, or commissions (including vacation, severance, and sick leave pay) and excise taxes on transactions occurring before the date of filing the bankruptcy petition are all not dischargeable in bankruptcy.

As part of our bankruptcy intake process, we analyze a client’s state and federal tax transcripts to determine whether or not their tax debts (if any) are dischargeable or not.

However, some of the taxes that would ordinarily be dischargeable because of their age may not be, if the Bankruptcy Court determines that the debtor has acted in “bad faith” with respect to their non-payment of taxes. Section 523 of the Bankruptcy Code (which governs exemptions to discharge) provides in Section 523(a)(1)(C) that:

“A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

However, Section 523 does not define what constitutes a “willful attempt to evade or defeat” a tax. To interpret this language, the Bankruptcy Court adopted the three-part test applicable under Section 6672 of the Internal Revenue Code, which imposes civil penalties on any taxpayer “who willfully attempts in any manner to evade or defeat any . . . tax or the payment thereof.” Under that test, a willful attempt to evade or defeat a tax is established if the debtor (1) had a duty to pay the tax, (2) knew of that duty, and (3) voluntarily and intentionally violated the duty. Numerous courts have adopted this test as the standard for willful evasion under Section 523.

With respect to the attempt to avoid or evade taxes, the IRS takes the position that if a well-to-do individual (doctor, investment banker, or attorney) pays creditors other than the IRS, when they have available assets, this is “an attempt to avoid or evade taxes.”

In Lynch v. United States, 299 B.R. 62 (Bankr. S.D.N.Y. 2003), the debtor, Christine Carter Lynch, brought an adversary proceeding under chapter 7 of the Bankruptcy Code seeking a discharge of the claims of the Internal Revenue Service, totaling approximately $600,000 as of the time of trial, with respect to her tax liability for two groups of tax years -- for tax years 1980, 1981 and 1982, totaling approximately $542,000 (the “1980s Taxes”), and for tax years 1993, 1994 and 1995, totaling approximately $55,000 (the “1990s Taxes”). The IRS opposed her request for relief, with respect to both groups of tax years, contending that she is subject to the statutory exception to discharge of §523(a)(1)(C).

The Court noted that the caselaw applying §523(a)(1)(C) has consistently held that its requirements are satisfied in situations where the debtor -- even without
fraud or evil motive -- has prioritized his or her spending by choosing to satisfy other obligations and/or pay for other things (at least for non-essentials) (emphasis added) before the payment of taxes, and taxes knowingly are not paid.

Here, with respect to each of the 1980s Taxes and 1990s Taxes, the Court had to determine whether that latter principle applies under the facts here. Assuming it did, the Court had to also determine, with respect to the 1980s Taxes, to what extent it applies when if the Debtor not acted in that manner, she could not have paid all of the tax debt anyway.

After hearing the evidence, the Court found that Ms. Lynch - among other things, spending money on a Central Park West Apartment at a cost of more than $6,000 per month; eating dinner in restaurants four days a week; traveling considerably, to California, China and Paris; running up credit card bills; and making huge gratuitous transfers to her church, all ahead of payment of the back taxes due -- of the same type that has been held to constitute a willful attempt to evade the payment of taxes in earlier cases. And the Court further found that, but for her spending priorities, Ms. Lynch could have paid the majority of the 1980s Taxes -- even after payment of the 1990s Taxes, which plainly could have been and should have been paid in full.

The Court held that Ms. Lynch’s extravagant lifestyle was a factor in her failure to pay both the 1980s Taxes and the 1990s Taxes, stating:

“By electing to make discretionary expenditures on the incremental cost of a Central Park West apartment, the restaurant dining, the credit card purchases and payments, the travel, the tuition and the ‘tithing,’ Ms. Lynch evidenced exactly the kind of conduct that resulted in nondischargeability in Wright, Haesloop, Angel, and the other discretionary spending cases.” Lynch at 65.

Because Ms. Lynch elected to spend her money elsewhere and not to satisfy her tax obligations -- especially when she had the ability to easily pay them in full -- the Court held that she willfully evaded her 1990s Taxes.

At the same time, the Court conceded that the IRS was unrealistic in expecting Ms. Lynch to be able to pay the entirety of her 1980s Taxes without a reduction, and criticized the government’s conduct in the case. However, the Court found that Ms. Lynch could have easily paid her 1990s Taxes without a drastic adjustment in her lifestyle.

Anyone who has questions concerning the discharge of taxes should contact Jim Shenwick.

Monday, January 26, 2009

Bankruptcy as a Step to Solvency

Published: January 23, 2009

The idea of declaring bankruptcy may be unpleasant, even abhorrent, but for many people right now it could be the best option.

The question is: How do you make that choice? How bad do things need to get before you throw in the towel, and most of your debts, and petition the courts for a fresh start?

More than a million people filed for personal bankruptcy in the 12 months that ended last September, a staggering 30 percent increase over the period a year earlier, according to the Administrative Office of the U.S. Courts. And thousands more “are unofficially bankrupt” and reluctant to file, said Justin Harelik, a lawyer with Price Law Group in Los Angeles.

“I’m aware that the word itself carries so much shame and stigma,” said Mr. Harelik. “But it’s right for so many people.”

The sting of failure and the dread of ruined credit are, understandably, deterrents to a bankruptcy filing. But those fears can prevent people from taking advantage of the financial protection offered by bankruptcy, which may allow you to erase most of your consumer debt while preserving assets like your retirement accounts and sometimes even your home and car. Instead, many people delay filling until they are truly desperate.

“When we surveyed people about how long they seriously struggled, over 40 percent said more than two years,” said Katherine M. Porter, associate professor at the University of Iowa law school and a researcher with the Consumer Bankruptcy Project, a continuing study of consumer bankruptcy filings. “A lot of attorneys say they wish people would come earlier, before they emptied their retirement accounts or lost their car to repossession,” she said.

Because bankruptcy is so complex, and because bankruptcy laws underwent a major overhaul in 2005, many people are not only wary of filing, but also confused about their options and what the possible outcomes are.

One common misunderstanding is that declaring bankruptcy will ruin your credit. If you’re at the point of even considering bankruptcy, it’s likely that your credit is in tatters anyway, notes Ms. Porter.

“You may not end up that much worse off,” she said. In some cases, your credit could emerge in better shape once you’ve dealt with your debts.

Another myth is that you must be at the frayed end of your financial rope before you file. You won’t lose everything in a bankruptcy because some assets are protected, and you will need those to move forward, says Elizabeth Warren, a professor at Harvard Law School and one of the lead researchers on the Consumer Bankruptcy Project. Waiting until your resources are entirely depleted defeats an important purpose of bankruptcy, “which is to help people rebuild their lives on a sounder footing,” Ms. Warren said.

It was the desire to move forward with her life, not just shrug off her debts, that finally pushed Claire Morgan, who lives in Chicago, to begin the bankruptcy process in December. In addition to lingering student loans of about $12,000, Ms. Morgan had been struggling to pay $40,000 in credit card debt — a sum slightly higher than her annual income, she said. But she couldn’t make any headway.

In part, it was the sense of futility that finally pushed Ms. Morgan over the edge. But she also happened to hear a cautionary tale about a friend, also deeply in debt, who had decided not to declare bankruptcy — and ended up living in constant strain, unable to move forward with life.

“That really made me think twice,” she said. “Bankruptcy was the last thing I wanted. But it’s better to be able to say ‘I’m in the clear’ than to be still be struggling in five years to pay $40,000 in debt on a $35,000 salary.”

Knowing whether to file, when to file and whether to do so under Chapter 7 or Chapter 13 of the bankruptcy code is a decision best made with the help of a lawyer. Most bankruptcy lawyers offer a free initial consultation, Ms. Porter said. The National Association of Consumer Bankruptcy Attorneys has a Web site where you can search for a lawyer by location.

Copyright 2009 The New York Times Company. All rights reserved.

Tuesday, January 20, 2009

More Headaches on the Way for Madoff Investors

The Bernard Madoff Ponzi scheme was announced on December 11, 2008, and already, much has transpired. The U.S. Justice Department has a criminal action pending against Madoff, the U.S. Securities Exchange Commission has an enforcement action against him and his brokerage firm, and numerous suits have been filed against various parties. Bernard L. Madoff Securities, LLC is now in bankruptcy and a Trustee has been appointed. The Trustee recently sent claim forms to customers of Madoff Securities in order to provide them with information on how to take advantage of insurance protection that is available from the Securities Investment Protection Corporation.

What lies ahead for investors? Investors are likely to be faced with a lawsuit by the Trustee seeking the return of some or all of the proceeds they received from Madoff Securities. As an example, in another recent Ponzi scheme, the trustee brought suit against more than 10,000 investors for the return of proceeds received from the Ponzi scheme operator.

On the basis of fraudulent transfer laws, the Trustee can pursue investors to recover money paid to them. Under Section 548 of the Bankruptcy Code, the Trustee may avoid any transfer of monies from the Ponzi scheme operator made within two (2) years prior to the date of filing of a petition in Bankruptcy. Under similar state statutes, the Trustee to go back even longer, up to six (6) years in some cases. Other actions can also be initiated. Under fraudulent conveyance law, as long as the transfer of payment was made with the intent to hinder, delay, or defraud a bankrupt entity, the Trustee can seek to recover funds.

Unfortunately, for the investors, the courts have determined that actual fraud always exists in a Ponzi scheme. Based on this theory, the Trustee can seek to recover all the amounts that have been paid to the investor, both principal and any return on the investment. Other theories of recovery also exist. In any event, lawsuits are on their way.

The investor must then defend the suit or be subject to entry of default judgment. The investor can try to avail himself of certain defenses, including one based on "good faith." In such instance, if the investor can prove that payments were received in good faith, the Trustee will only be able to recover profits, not any principal that was returned to the investor. A good faith defense will be judged by an objective standard, that is, the investor must prove that he did not know and should not have known of the debtors Ponzi scheme. One of the factors that determines whether the investor should have known that a Ponzi scheme was in place will be an analysis of the profits promised in contrast to returns that can be obtained under actual market conditions.

If the investor successfully proves a good faith defense, the Trustee's recovery will be limited to the amount of profits received and the investor will be able to retain any principal repayments.

The Trustee can also proceed based on the theory of "constructive fraud" under the fraudulent transfer laws. However, under this theory, the Trustee can only recover profits paid to the investor, not the principal.

The Trustee also has another option in attempting to recover money from investors. Under the bankruptcy law provisions, the Trustee can seek recover, as a preference payment, any payment to the investor made within ninety (90) days of filing the petition in the bankruptcy case. This period can be extended to one (1) year for "insiders." Depending on the facts, the investor may have defenses available to this action.

Where will all this "recaptured" money go? To the Bankruptcy Estates.
Eventually, after the expenses of the bankruptcy case and litigations are paid, the money will go back to claimants and investors. The leftover funds will to be distributed pro rata, on the basis of valid claims against the Bankruptcy Estate, and in order of priority established under the Bankruptcy Code.

It is clear that another headache awaits the investors in this Ponzi scheme... defending themselves from lawsuits brought by the Trustee.

Copyright 2009 LeClairRyan. All rights reserved.

Monday, January 12, 2009

Business Week: The Madoff Case Could Reel in Former Investors

By Matthew Goldstein

The managers of the Fort Worth Employees' Retirement Fund thought they had dodged a bullet when Bernard L. Madoff was arrested on Dec. 11 for alleged fraud. Just a few months earlier the $1.7 billion public pension plan had pulled $10 million out of a hedge fund that invested exclusively with Madoff. But now the managers face the possibility of having to give back the money—a sum that includes all of the pension's purported gains over the years plus its initial investment.

The Fort Worth plan and other Madoff investors who got out before the operation imploded may yet be snared by the bankruptcy proceedings. Under federal law, the trustee in the case can sue former investors to force them to return their profits and principal, a process known as a clawback. The legal theory is that investors who stick around to the bitter end shouldn't bear all the pain. With the multibillion-dollar tally of losses rising daily, the Madoff case could take years to unravel in court, leaving hundreds of pensions, endowments, and other former investors in the lurch as they await a ruling on their financial liability. "It depends on what the trustee wants to do," says Michael Missal, a lawyer at K&L Gates. Irving Picard, the trustee named on Dec. 15 to oversee the liquidation of Madoff's business, declined to comment.

Picard may take his cues from the recent bankruptcy case of Bayou Group, the $450 million hedge fund whose managers were convicted of conspiracy and fraud in 2005. The trustee in those proceedings, Jeff Marwil, filed more than 130 suits against investors who had pulled money from the fund within the prior six years. Marwil argued that former clients, even those who barely knew Bayou manager Samuel Israel, should have to take a hit as well, since Bayou was nothing more than a Ponzi scheme. The judge ruled in his favor.

The clawbacks in the Madoff case could prove more controversial. In most hedge fund scandals, including Bayou, the majority of clients invested directly with the dubious money management firm. But most of Madoff's customers came through a half-dozen or so "feeder" funds. Those affiliated vehicles operated under their own brand name but handed much of the money over to Madoff.
"financial death sentence"

Some investors may not have known what they were buying. The Fort Worth pension fund, for example, owned the Rye Select Broad Market, a hedge fund managed by the Tremont Group. The Rye marketing literature rarely, if ever, mentioned Madoff by name, even though his fund was the only investment. Says Steven Caruso, a lawyer for a number of Tremont investors: "Some investors may be facing the prospect of a financial death sentence if they're forced to return funds." In a letter to investors, Tremont's managers say they "exercised appropriate due diligence."

Managers of the Fort Worth pension fund, who first invested with Rye five years ago, started to rethink their investment in early 2008 after hiring Albourne Partners, a London due diligence firm, to assess their hedge fund portfolio. The Rye fund raised red flags almost immediately. Albourne's managing director, Simon Ruddick, says the firm, which had long-standing concerns about Madoff's trading strategy and consistent returns, had urged clients for nearly a decade to avoid affiliated funds such as Rye. In July the pension's board voted unanimously to dump its Rye stake. "If you are person who has nothing left, naturally you want everyone to share in the pain," says Robert Klausner, a lawyer for the Fort Worth pension. "But if you are someone with no inside knowledge of fraud who redeems an investment in the ordinary course of business, you shouldn't be punished."

Copyright 2000-2009 by The McGraw-Hill Companies Inc. All rights reserved.

Friday, January 09, 2009

NYT: Citi Reaches Deal with Lawmakers on Home Loans

Published: January 8, 2009

WASHINGTON — In a move that would help troubled homeowners, Citigroup agreed to support legislation that would let bankruptcy judges adjust mortgages for at-risk borrowers, leading Congressional Democrats said on Thursday.

Financial industry lobbyists, however, said the plan was flawed and vowed to fight legislation aimed at easing up on homeowners facing foreclosure.

Members of the House and Senate said Citigroup had agreed to drop its opposition, providing no future mortgages are covered by the law.

Citigroup, which is receiving more than $300 billion in bailout assistance, says that it is open to measures that would help homeowners.

“Citi shares this legislation’s goal to help distressed borrowers stay in their homes, and believes it will serve as an additional tool to the extensive home retention programs currently in place to help at-risk borrowers,” Vikram S. Pandit, the chief executive of Citigroup, wrote in a letter released Thursday night.

The revised bill that Citigroup endorsed would allow bankruptcy judges to adjust the principal payments or interest rates on existing loans.

Judges could also extend the terms on mortgage loans, according to the language of the bill, which would force lenders to take losses without a say in bankruptcy court proceedings.

Senator Richard J. Durbin of Illinois, the No. 2 Senate Democrat, said he and fellow backers of the plan see it as a way to create more voluntary negotiations between struggling homeowners and financial institutions. So far, voluntary programs have proved ineffective, Democrats said.

Citigroup had been part of the Bankruptcy Coalition of the Financial Services Roundtable, an industry group, since it aggressively lobbied for changes to the bankruptcy code in 2005.

The coalition — a group of major trade associations and lenders like Bank of America, JPMorgan Chase and Wells Fargo — also fought to block the so-called cramdown legislation last year.

No other bank has broken ranks with the industry on the proposed bill. Mr. Durbin said he hoped the move by Citigroup, should other banks and financial trade associations take the same stance, would lead to backing by enough Democrats and moderate Republicans to push the bill through.

Senator Charles E. Schumer, Democrat of New York, said he had been contacting officials of top financial institutions for months, trying to persuade them that it would be to their advantage to back the plan since it could help stabilize a housing market that has severely hurt the economy.

Three changes were made to the legislation sponsored by Mr. Durbin and Representative John Conyers Jr., Democrat of Michigan and chairman of the House Judiciary Committee: only existing mortgages will be eligible; homeowners will have to certify they tried to contact their mortgage holder lenders regarding loan modifications before filing for bankruptcy; and only major violations of the Truth in Lending Act will cause lenders to forfeit their claims in a bankruptcy.

Backed by bankers and other financial groups, many Congressional Republicans and some Democrats have balked at the plan to let bankruptcy judges alter mortgage terms on primary residences, saying that would drive up mortgage costs.

But officials said financial institutions were coming to the conclusion that it might be better to get a reduced loan payment through a bankruptcy or voluntary negotiations than to get no money at all.

Aides to Senator Richard C. Shelby of Alabama, the senior Republican on the Senate banking committee, said he would have no immediate response to the plan.

Scott E. Talbott, senior vice president for government affairs at the Financial Services Roundtable, said the group opposed cramdown legislation because it “creates huge risks” for the mortgage market.

He suggested the bill would force banks to further restrict lending and absorb huge losses as the economy worsens. He also suggested the bill would create perverse incentives that might encourage more homeowners to seek bankruptcy protection.

Citigroup recently began negotiating with lawmakers, in a move that some observers suggest reflects its desire to win favor on Capitol Hill after receiving billions in funds from the bailout program.

The government has invested $45 billion in Citigroup and agreed to guarantee about $269 billion in highly illiquid mortgage investments.

“If you’re looking at a way to get to the bottom of the economic problems in our country, this is the cause of our economic problems,” said Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the banking committee. “It is the housing foreclosure problem. We’ve got to address that.”

The plan has been backed by members of Congress who see it as a way to help distressed homeowners and balance federal relief efforts that have been aimed at Wall Street and the automobile industry.

Mr. Schumer said he had been in contact with other large banks and he expected they would soon announce their support or at least drop their opposition to the plan.

“Citigroup’s action has broken the dam,” he said.

Eric Dash in New York contributed reporting.

Copyright 2008 The New York Times Company. All rights reserved.

Thursday, January 08, 2009

NYT: Gentler Tax Laws Urged on Debt Default

Published: January 7, 2009

Congress should ease certain tax laws governing defaults on mortgages, credit cards and other consumer debt to help Americans who are struggling in the economic downturn, the watchdog agency of the Internal Revenue Service said Wednesday.

In its annual written report, the agency, the National Taxpayer Advocate, said that without the changes hundreds of thousands of Americans could mistakenly pay taxes this year on their canceled debts, adding to their financial malaise.

The I.R.S. generally treats canceled debts as subject to federal income tax unless the taxpayer is insolvent or in bankruptcy proceedings.

But Nina E. Olson, who leads the watchdog agency, wrote that most taxpayers eligible to exclude canceled debts from their overall taxable income were unaware that they must file an obscure, complex form with the I.R.S.

She called on Congress to change the law to exempt taxpayers with what she termed “modest” amounts of canceled debt from having to submit the form. She did not put a dollar limit on the amounts and instead asked Congress to establish a threshold.

Congress has already provided some debt relief to homeowners through the Mortgage Forgiveness Debt Relief Act of 2007, which exempts from taxes any debts reduced or canceled during foreclosure or mortgage restructuring. But the exemption applies only if proceeds are used to acquire or improve a principal residence — something home buyers do not always do.

“It appears that most subprime borrowers use a portion of their loans for other purposes (e.g., to pay off car loans, credit card balances, student loans or medical bills),” Ms. Olson wrote.

She issued her report amid a flurry of unusual activity by the I.R.S. to award tax breaks to banks and financial corporations. The breaks, which give banks more leeway to use tax losses from banks they acquire, are estimated by leading tax specialists to be worth at least $110 billion.

Ms. Olson, referring to the economic downturn, also called on the I.R.S. to ease harsh collection practices. Levies, liens and asset seizures — all increasingly used tools of the I.R.S. — should give way to installment agreements with taxpayers and deals known as “offers in compromise,” in which taxpayers offer to pay part of their tax debts.

While I.R.S. staff members are required by law and internal procedures to consider whether collection efforts impose an economic hardship on taxpayers, they often do not do so, Ms. Olson wrote.

She urged the I.R.S. to protect low-income Social Security recipients from automated tax levies, which typically total 15 percent of the federal payments they receive.

In 2008, the I.R.S. issued levies against 1.8 million payments made to Social Security recipients. More than a fourth of those taxpayers had incomes below the poverty level, and more than a third probably would be classified as unable to pay by the I.R.S. if their cases were subject to human review.

Ms. Olson also called on Congress to simplify the tax code radically, an issue she identified as the leading challenge to taxpayers, and one that has appeared frequently in her annual reports.

Copyright 2008 The New York Times Company. All rights reserved.

Monday, January 05, 2009

NYT: Credit Card Companies Willing to Deal Over Debt

Published: January 2, 2009

Hard times are usually good times for debt collectors, who make their money morning and night with the incessant ring of a phone.

But in this recession, perhaps the deepest in decades, the unthinkable is happening: collectors, who usually do the squeezing, are getting squeezed a bit themselves.

After helping to foster the explosive growth of consumer debt in recent years, credit card companies are realizing that some hard-pressed Americans will not be able to pay their bills as the economy deteriorates.

So lenders and their collectors are rushing to round up what money they can before things get worse, even if that means forgiving part of some borrowers’ debts. Increasingly, they are stretching out payments and accepting dimes, if not pennies, on the dollar as payment in full.

“You can’t squeeze blood out of a turnip,” said Don Siler, the chief marketing officer at MRS Associates, a big collection company that works with seven of the 10 largest credit card companies. “The big settlements just aren’t there anymore.”

Lenders are not being charitable. They are simply trying to protect themselves.

Banks and card companies are bracing for a wave of defaults on credit card debt in early 2009, and they are vying with each other to get paid first. Besides, the sooner people get their financial houses in order, the sooner they can start borrowing again.

So even as many banks cut consumers’ credit lines, raise card fees and generally pull back on lending, some lenders are trying to give customers a little wiggle room. Bank of America, for instance, says it has waived late fees, lowered interest charges and, in some cases, reduced loan balances for more than 700,000 credit card holders in 2008.

American Express and Chase Card Services say they are taking similar actions as more customers fall behind on their bills. Every major credit card lender is giving its collection agents more leeway to make adjustments for consumers in financial distress.

Debt collectors, who are typically paid based on the amount of money they recover, report that the number of troubled borrowers getting payment extensions has at least doubled in the last six months. In other cases, borrowers who appear to be pushed to the brink are being offered deals that forgive 20 to 70 percent of credit card debt.

“Consumers have never been in a better position to negotiate a partial payment,” said Robert D. Manning, the author of “Credit Card Nation” and a longtime critic of the credit card industry. “It’s like that old movie ‘Rosalie Goes Shopping.’ When it’s $100,000 of debt, it’s your problem. When it’s a million dollars of debt, it’s the bank’s problem.”

The recent wave of debt concessions is a reversal from only a few years ago, when consumers usually lost battles with their credit card companies. Now, as bad debts soar, it is the lenders who are crying mercy.

Credit card lenders expect to write off an unprecedented $395 billion of soured loans over the next five years, according to projections from The Nilson Report, an industry newsletter. That compares with a total of about $275 billion in the last five years.

All that bad debt is getting harder to collect. In the past, troubled borrowers might have been able to pay down card loans by tapping the equity in their homes, drawing on retirement savings, taking out a debt consolidation loan, or even calling a relative for help. But with credit tight, consumers are maxed out.

“Knowing that the sources of funding have dried up, having someone pay the balance in full isn’t a viable strategy,” said Tim Smith, a senior executive at Firstsource, one of the biggest debt collection companies.

Lenders are reluctant to admit they will accept less than full payment, lest they encourage good customers to stop paying what they can. Industrywide data is scarce.

Unlike the huge mortgage loan modification programs that are taking place, which address thousands of mortgages at once, workouts for credit card customers are still being handled on a case-by-case basis.

In addition to debt forgiveness, debt collectors are allowing many delinquent borrowers to pay down their debt over the course of a year rather than the standard six months.

Paul Hunziker, the chairman of Capital Management Services, said that before this downturn, his firm put only about a quarter of all borrowers into longer-term repayment plans. Now, it puts about half on such plans.

Some lenders are also reaching out to borrowers shortly after they fall behind on their payments to try to avoid having to write off the account. Others are reaching out to customers who seem likely to fall behind. Just as lenders competed for years to be the first card to be taken out of the wallet, they are now competing to be the first ones paid back.

And realizing that millions more consumers are likely to default on their credit card bills in the coming months, the banking industry has started lobbying regulators to make it more advantageous to lenders to extend payment terms or forgive debt.

In an unusual alliance, the Financial Services Roundtable, one of the industry’s biggest lobbyists, and the Consumer Federation of America recently proposed a credit card loan modification program, which was rejected by regulators.

Under the plan, lenders would have forgiven about 40 percent of what was owed by individual borrowers over five years. Lenders could report the loss once whatever part of the debt was repaid, instead of shortly after default, as current accounting rules require. That would allow them to write off less later. Borrowers would have been allowed to defer any tax payments owed on the forgiven debt.

Landmark changes to bankruptcy legislation passed in 2005, for which the industry aggressively lobbied, seem to have hurt card debt collections. Credit card industry data indicate the average debt discharged in Chapter 7 bankruptcy has nearly tripled since 2004. And in Chapter 13 bankruptcies, secured lenders like auto finance companies routinely elbow out unsecured lenders like card companies, trends that have contributed to the card lenders’ willingness to settle.

Borrowers should not expect sweetheart deals. Card companies will offer loan modifications only to people who meet certain criteria. Most customers must be delinquent for 90 days or longer. Other considerations include the borrower’s income, existing bank relationships and a credit record that suggests missing a payment is an exception rather than the rule.

While a deal may help avoid credit card cancellation or bankruptcy, it will also lead to a sharp drop in the borrower’s credit score for as long as seven years, making it far more difficult and expensive to obtain new loans. The average consumer’s score will fall 70 to 130 points, on a scale where the strongest borrowers register 700 or more.

For the moment, it may be easier for troubled borrowers to start negotiating a modification by contacting the card company or collection agency directly. Credit counselors can help borrowers consolidate their debts and get card companies to lower their interest payments and other fees, but they currently cannot get the loan principal reduced.

Another option is for a borrower to sign up a debt settlement company to negotiate on her behalf. But regulation of this business is loose, and consumer advocacy groups warn that some firms prey on troubled borrowers with aggressive marketing tactics and exorbitant upfront fees.

Copyright 2009 The New York Times Company. All rights reserved.

NYT: As Vacant Office Space Grows, So Does the Crisis for Lenders

Published: January 4, 2009

Vacancy rates in office buildings exceed 10 percent in virtually every major city in the country and are rising rapidly, a sign of economic distress that could lead to yet another wave of problems for troubled lenders.

With job cuts rampant and businesses retrenching, more empty space is expected from New York to Chicago to Los Angeles in the coming year. Rental income would then decline and property values would slide further. The Urban Land Institute predicts 2009 will be the worst year for the commercial real estate market “since the wrenching 1991-1992 industry depression.”

Banks and other financial companies have not had the problems with commercial properties in this recession that they have had with residential properties. But many building owners, while struggling with more vacancies and less rental income, will need to refinance commercial mortgages this year.

The persistent chill in lending from banks to the credit markets will make that difficult — even for borrowers who are current on their payments — setting the stage for loan defaults.

The prospect bodes ill for banks, along with pension funds, insurance companies, hedge funds and others holding the loans or pieces of them that were packaged and sold as securities.

Jeffrey DeBoer, chief executive of the Real Estate Roundtable, a lobbying group in Washington, is asking for government assistance for his industry and warns of the potential impact of defaults. “Each one by itself is not significant,” he said, “but the cumulative effect will put tremendous stress on the financial sector.”

Stock analysts say commercial real estate is the next ticking time bomb for banks, which have already received hundreds of billions of dollars in capital and other assistance from the federal government. Big banks — like Bank of America, JPMorgan Chase and Morgan Stanley — each hold tens of billions of dollars in commercial real estate securities. The banks also invested directly in properties.

Regional banks may be an even bigger concern. In the last decade, they barreled their way into commercial real estate lending after being elbowed out of the credit card and consumer mortgage business by national players. The proportion of their lending that is in commercial real estate has nearly doubled in the last six years, according to government data.

Just as home loans were pooled, then carved up and sold to investors as securities over the last two decades, commercial property loans were repackaged for the financial markets. In 2006 and 2007, nearly 60 percent of commercial property loans were turned into securities, according to Trepp, a research firm that tracks mortgage-backed securities.

Now that the market for those securities has dried up, borrowers cannot easily roll over the loans that are coming due.

Many commercial property owners will face a dilemma similar to that of today’s homeowners who cannot easily get mortgage relief because their loans were sliced and sold to many different parties. There often is not a single entity with whom to negotiate, because investors have different interests.

By many accounts, building owners have been caught off guard by how quickly the market has deteriorated in recent weeks.

Rising vacancy rates were expected in Orange County, Calif., a center of the subprime mortgage crisis, and New York, where the now shrinking financial industry dominates office space. But vacancies are also suddenly climbing in Houston and Dallas, which had been shielded from the economic downturn until recently by skyrocketing oil prices and expanding energy businesses. In Chicago, brokers say demand has dried up just as new office towers are nearing completion.

“The economic recession is so widespread that we believe virtually every market in the country will see a rise in vacancy rates of between 2 and 5 percentage points by mid-2009,” said Bill Goade, chief executive of CresaPartners, which advises corporations on leasing and buying office space.

There is no relief in sight for Orange County, where subprime lenders and title companies once dominated the market but are now shedding space because their business has dried up, and big banks are now shrinking because of a wave of mergers. The vacancy rate has soared from 7 percent at the end of 2006 to 18 percent, a rate that the Tampa area should match this month, local real estate brokers say.

In New York, where rents had risen the highest as financial companies gobbled up office space, vacancy rates are floating above 10 percent for the first time in years.

What looked like the worst possible case a few weeks ago for Chicago now appears to be the most likely outcome, said Bill Rogers, a managing director at Jones Lang LaSalle, a real estate broker. The vacancy rate, which was fairly stable at 10 percent, is now rising quickly and could hit 17 percent in 2009, he said. “A lot of companies are trying to shed excess space ahead of what is expected to be a worse market in 2009,” Mr. Rogers said.

Newmark Knight Frank, a real estate broker, expects the vacancy rate in Dallas to rise to 19 percent this year, from 16.3 percent.

Houston, like Dallas, held up while many other cities were showing the strains of an economic slowdown. But job growth and the brisk business of oil and gas exploration have come to an abrupt halt.

Vacant or unfinished shopping centers dot the highways. Among the 8.4 million square feet of office space under construction or recently completed in the metropolitan area, 80 percent has not been leased. As a result, the vacancy rate is 11 percent and rising.

“I see a wave of troubled assets coming out of Texas in the near future,” said Dan Fasulo, managing director of Real Capital Analytics, a real estate research firm.

Effective rents, after free rent and other landlord concessions, have already started to fall and are expected to decline 30 percent or more across the country from the euphoric days of the real estate boom, according to real estate brokers and analysts.

That is making it all the more difficult for owners, who projected ever-rising rents when they financed their office buildings, hotels, shopping centers and other commercial property. Owners typically pay only the interest on loans of 5, 7 or 10 years and refinance the big principal payments necessary when the loans come due.

Without new financing, owners will have few options other than to try to negotiate terms with their lenders or hand over the keys to banks and bondholders.

Among commercial properties, the most troubled have been hotels and shopping centers, where anemic sales and bankruptcies by retailers are leading to more vacancies and where heavily leveraged mall operators, like General Growth Properties and Centro, are under intense pressure to sell assets. But analysts are increasingly worried about the office market.

The Real Estate Roundtable sees a rising risk of default and foreclosure on an estimated $400 billion in commercial mortgages that come due this year. In recent weeks, a group led by the New York developer William Rudin has pleaded with Treasury Secretary Henry M. Paulson Jr., Senator Charles E. Schumer, Democrat of New York, and others to have the government include commercial real estate in a new $200 billion program intended to spur lending.

Mr. DeBoer, the roundtable’s leader, said building owners are by and large making their loan payments. It is the refinancing that is worrisome.

Most loans, he said, were made at 50 percent to 70 percent of property values. At the top of the market in 2006 and 2007, though, some owners took advantage of available credit and borrowed 90 percent or more of the value of a property, a strategy that works only in a rising market. Since then, property values have dropped 20 percent, Mr. DeBoer said.

Where possible, owners are trying to extend loans. A lender might agree to extend the term on a 10-year commercial mortgage, for example, if the borrower remains current on payments and can make an equity payment to compensate for the decline in the building’s value.

Already, $107 billion worth of office towers, shopping centers and hotels are in some form of distress, ranging from mortgage delinquency to foreclosure, according to a report by Real Capital Analytics.

New York, the biggest market by far, leads the pack with 268 troubled properties valued at $12 billion. But there are 19 more cities, including Atlanta, Denver and Seattle, with more than $1 billion worth of distressed commercial properties.

Analysts are especially concerned about buildings like 666 Fifth Avenue, One Park Avenue and the Riverton complex in New York, the Pacifica Tower in San Diego and the Sears Tower in Chicago, which were acquired in 2006 and 2007 with mortgage-backed financing based on future rents rather than existing income.

“Many of those buildings are basically underwater,” said Mr. Goade of CresaPartners. “The price they paid was too high to begin with. There’s no way anyone would lend that kind of money today.”

Copyright 2009 The New York Times Company. All rights reserved.

Friday, January 02, 2009

WSJ: Mortgage 'Cram-Downs' Loom as Foreclosures Mount


Mortgage lenders who wake up Thursday with a New Year's hangover are likely to face another headache soon: The effort to give bankruptcy judges the power to rewrite mortgages is gaining steam.

The banking industry hoped the mortgage "cram-down" measure died when Congress removed it from the $700 billion bailout bill that passed in October. But it has been gathering momentum in Democrat-controlled Washington, as evidence emerges that current voluntary foreclosure-prevention programs are falling short.

In a cram-down, a judge modifies a loan, often reducing principal so a borrower can afford it. Lenders hate it because they have to absorb the loss. Bankruptcy judges currently have the ability to modify certain personal loans and even mortgages on vacation homes, but they can not cram-down mortgages on primary residences.

Even staunch opponents acknowledge that mortgage cram-downs for primary residences are likely to be as part of Congress's economic-stimulus package in early 2009. The National Association of Home Builders used to reject any bill with a cram-down provision outright. Now it is saying the measure is worth a look.

President-elect Barack Obama and his incoming administration aren't disclosing details of the much-awaited foreclosure-prevention plans, but during the campaign Mr. Obama called for closing the loophole that prevents bankruptcy judges from restructuring mortgages on primary residences. Lawrence Summers, a top economic adviser of Mr. Obama, publicly voiced support for bankruptcy reform before his appointment.

"To the extent that nothing else is working, bankruptcy cram-downs are becoming more likely," says Rod Dubitsky, head of asset-backed-securities research at Credit Suisse.

The latest embattled foreclosure-prevention program is Hope for Homeowners, which was approved by Congress last summer and supposed to help 400,000 homeowners. Only 357 people have signed up so far for the voluntary program. The Department of Housing and Urban Development, which is administering the program, acknowledges that it has been encumbered by high fees and narrow eligibility requirements.
[With efforts to stem home foreclosures stagnating, mortgage 'cram-down' efforts seem destined to re-emerge under the new Congress. Here, a foreclosed home for sale in Lakewood, Colo., in September.] Associated Press

With efforts to stem home foreclosures stagnating, mortgage 'cram-down' efforts seem destined to re-emerge under the new Congress. Here, a foreclosed home for sale in Lakewood, Colo., in September.

Another government program, FHASecure, was intended to help 80,000 homeowners who had fallen behind on their payments after their adjustable interest rates reset. It has helped only 4,100 delinquent borrowers refinance since September 2007 and will stop taking new loan applications as of Wednesday.

Mortgage lenders also are modifying tens of thousands of loans without government help. But often this hasn't solved the problem. A report last week by the Office of the Comptroller of the Currency and the Office of Thrift Supervision found that nearly 37% of mortgages modified in the first quarter of 2008 were 60 days or more delinquent after six months.

"It is absolutely clear that voluntary modification is just not working," says Rep. Brad Miller, a North Carolina Democrat. "Every plan that Congress has passed, we do it and nothing happens."

Mr. Miller intends to introduce a mortgage bankruptcy-reform bill Monday, the first day of the new session. Illinois Democrat Richard Durbin plans to introduce a similar bill in the Senate.

Lenders warn that mortgage cram-downs will lead to higher interest rates and down payments, as banks seek to mitigate future losses from judicially imposed write-downs. They also are concerned that the reform measure would add to the losses they have already sustained from the housing crisis.

"Our members have modified 2.8 million loans," says Francis Creighton, chief lobbyist of the Mortgage Bankers Association, which opposes cram-downs. "Could we do better? We are trying to do better."

Proponents of bankruptcy reform say that previous modification efforts are falling short because they have focused on spreading out payment terms and forestalling delinquent payments. But that hasn't cured a big part of the problem: that one in six houses is now worth less than its mortgage. Only programs that reduce principal amounts are likely to restore equity to millions of homeowners, they say.

"You have to deal with the systematic problem of underwater mortgages or you are not going to stop foreclosures," says Harvard University economist Martin Feldstein, who has proposed his own plan to help homeowners with negative equity in their homes, which involves mortgage principal write-downs and replacing part of the original mortgage with a new, lower cost loan.

Proponents of bankruptcy reform also note that millions of troubled loans aren't being addressed by current modification programs because they were carved up and sold to investors as securities. Mortgage servicers have been reluctant to aggressively modify these loans because they have been unsure of their legal rights.

The mere threat of mortgage cram-downs could break the standoff between mortgage servicers and mortgage investors, which has slowed aggressive loan modifications. Investors may be more willing to go along with industry-driven modifications when facing the threat that a judge could ultimately order the amounts of loan principals reduced, forcing them to eat bigger losses.

"The servicers can argue we have to give this to the borrower otherwise they will get it in bankruptcy court," Mr. Dubitsky says.

Lenders argue that loans modified by bankruptcy judges often have high rates of default on the new payment plans. "We should be working on keeping people out of bankruptcy not pushing people into it,'' says Mr. Creighton of the Mortgage Bankers trade group

Bankruptcy reform is likely to be one of many proposals that Congress considers as part of comprehensive foreclosure-prevention effort. Another element is likely to be one that FDIC Chairman Sheila Bair has been proposing. Under her plan, the government and lenders would split the losses on modified loans that go into default.

Some economists are urging the new administration to go even further. Mark Zandi, chief economist at Moody's Economy.com, proposes that the government subsidize the bulk of principal write-downs to the tune of $100 billion, about four times as much as Ms. Bair's program.
—Nick Timiraos contributed to this article.

Write to Michael Corkery at michael.corkery@wsj.com

Copyright 2008 News Corp. All rights reserved.