Secret #71 – Congress Almost Prevented 500,000 Foreclosures but the Financial Industry Stopped Them

President Obama’s Chair of the Council of Economic Advisers in 2009, Christina Romer, said in 2012, “Ultimately, we didn’t push for it as much as perhaps we should have… And so it’s something I wish we could do now. Again, the financial industry fights it like crazy.”

A recent study estimated that if the legislation had passed, roughly 500,000 fewer U.S. homes would have been foreclosed on during the Great Recession.

This legislation was the “cramdown” legislation which would have allowed bankruptcy judges to lower the amount of money bankrupt people owe on their primary homes to the fair market value of their homes at the time of the bankruptcy. When house prices fell in the 2000s, many people owed more on their houses than their houses were worth.

Bankruptcy judges could write down a lot of loans, including mortgages on vacation homes and rental properties, but bankruptcy judges could NOT write down the mortgage amounts owed on the houses the owners actually lived in!

The financial industry got a ton of bailouts from the government during that time but the banks also fought hard to prevent Congress from giving bankruptcy judges the authority to lower mortgage debt to the fair market value of the primary residences of bankrupt home owners. The result was the United States and the U.S. financial industry got 500,000 more foreclosures. 

In addition, no doubt many or most of those foreclosures were dumped on the market and sold for less than the fair market value which drove down house prices even further, including driving down the value of all the other houses the banks would end up foreclosing, owning, and selling. But the financial industry considered defeating cramdowns a big victory for their lobbying.

It seems like it would be hard for home owners to abuse a cramdown policy because it only applies to people after they go through bankruptcy court. Bankruptcy judges would only approve cramdowns for people who were legitimately bankrupt according to the law. People aren’t going to go bankrupt just to get their mortgage amounts lowered to fair market value.

If the cramdown legislation had passed, it would NOT have stopped the crash in house prices but it would have made the crash smaller. House prices would have fallen less which would have helped the financial industry, and roughly 500,000 distressed American families would have avoided losing their homes to foreclosure.

There's a negative feedback loop where more foreclosures lead to lower house prices which lead to more foreclosures. So, lowering the number of foreclosures by 500,000+ would have created a positive feedback loop where fewer foreclosures would lead to smaller price declines which would lead to fewer foreclosures and so on.

The U.S. had an unnecessarily high number of foreclosures, and an unnecessarily long and deep recession during the Great Recession, in part because the Senate chickened out in 2009 and didn’t allow mortgage cramdowns in bankruptcy court. 

Someday the U.S. will have another housing bust, hopefully, not soon. But now, before the next crisis hits, would be the ideal time to change our bankruptcy laws to reduce the number of unnecessary foreclosures in the next housing bust to help stabilize U.S. house prices, U.S. family wealth, the U.S. economy, and also the U.S. financial system.