Don't Let Judges Fix Loans

By ALAN SCHWARTZ

In his housing plan, President Obama has asked Congress to give bankruptcy judges the authority to rework the terms of mortgages and allow more people to stay in their homes. Though the president’s idea sounds appealing, there are at least three reasons it is misguided.

First, the proposal would swamp bankruptcy courts. There are only about 300 bankruptcy judges, and they are already busy with an increasing number of bankruptcies. Clearing millions of new mortgage cases will take a long time and thus have little immediate effect on the foreclosure crisis. In addition, the flood of new cases would delay the resolution of business bankruptcies, to the detriment of the economy.

Second, many debtors will be disappointed. Consider the parties’ incentives. Debtors will argue for low home values while lenders will argue for the opposite, to minimize their losses. Lenders will win many of these valuation contests: they have more expertise than individuals in making their case and greater resources.

Finally, the proposal worsens economic uncertainty. A major cause of the financial crisis is that many banks do not know what their assets — and particularly home mortgages — are worth. Valuing homes is simple when prices are stable. An appraiser can look at prices in a neighborhood and plausibly infer that a particular house is worth about as much as similar houses there.

But even experts do not know how to value individual houses when a large number of them are in default, and thus potentially for sale, and cash is tight for prospective buyers. Under the president’s proposal, however, bankruptcy judges who are not experts at valuation would be required to price individual houses. Valuation thus will likely be a shot in the dark, inevitably affected by a judge’s personal sympathies. The arbitrariness of valuing single homes in bankruptcy will further increase the already considerable uncertainty regarding the value of the banks’ “toxic assets.”

There are many things that can be done to help debtors retain their homes. It would help, for instance, to change regulations to let loan administrators modify mortgages without fear of liability from the mortgage’s ultimate holders. What won’t help, however, would be to put bankruptcy judges in the business of reworking bad home loans.

Alan Schwartz is a professor of law and management at Yale.

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