As the troubles in the housing market drag on and government programs like HAMP fail to make any significant dent in the problem, many pundits are again bringing up the question of granting bankruptcy judges "cramdown" powers in Chapter 13 bankruptcy.

"Cramdown" basically means that bankruptcy judges would be allowed to reduce what is owed on a mortgage without discharging it completely. The judge would "strip" the loan into two parts: a secured loan equal to the current market value of the home and an unsecured loan equal to the rest of the original mortgage. Because the payment priority of the unsecured portion would be lower, many borrowers would qualify for Chapter 13 repayment plans that essentially resulted in that part of their loan never being paid off.

The idea of giving bankruptcy judges cramdown powers came up early in the debate after the housing market crashed, but it never came to fruition. Many people believe the banking industry simply wouldn't tolerate it.

In a recent editorial in the Atlantic, business and economics editor Megan McArdle argues that it may not be just another case of Washington protecting banks at the expense of the little guy. She says there are good reasons to believe that cramdown wouldn't really help -- at least not without overall bankruptcy reform.

Would Chapter 13 Cramdowns Help a Lot of Troubled Homeowners?

McArdle's main argument is that mortgage cramdowns wouldn't be a good solution for all that many people, but the negative impact they would have on the availability of credit and on real estate values could be big. Here are some of her arguments:

First, bankruptcy cramdown wouldn't help people who aren't otherwise insolvent but can't pay off their mortgages. Most people put into Chapter 13 plans are better off because they're already paying virtually all of their discretionary income to creditors. For people whose only real problem is a deeply underwater mortgage, McArdle argues, a Chapter 13 repayment plan could actually accelerate their repayment, resulting in them with even less discretionary income than before.

Some scholars estimate that nearly two-thirds of Chapter 13 filings fail. If that is true, McArdle points out, many homeowners could end up with the same debt load they had before they filed for bankruptcy -- but they would have been making smaller payments during the period of the plan. Now they'd be even worse off.

Worse, if a lot of underwater mortgage borrowers failed, we might see another big dump of foreclosed homes on the market. That would drive real estate prices down.

Because of the high administrative costs caused by the 2005 bankruptcy law (BAPCPA), 15 to 18 percent of Chapter 13 plan payments are actually going to cover attorney fees and court costs. Ideally that money would be used to pay down the mortgage.

The reason mortgages on primary residences are immune from cramdown is because Congress wanted to keep the cost of borrowing down. The idea was brought up in the 1977 bankruptcy reform, and the banking industry argued that mortgages that were subject to cramdown would be more expensive. It's true -- mortgages on vacation homes and investment properties, which are currently subject to cramdown, are more expensive.

Allowing cramdown could entice homeowners into premature bankruptcy, driving up lending costs. If a lot of distressed homeowners chose Chapter 13 for the cramdown, a lot of mortgages might be discharged that would otherwise have been paid off. That could cause banks to significantly increase mortgage costs or clamp down on lending standards.

What do you think?

Related Resource:

"Mortgage Cramdowns Are No Panacea" (Megan McArdle, The Atlantic, August 12, 2010)