Bankruptcy Primer

Conceptually, there are two types of bankruptcies: liquidation (Chapter 7) and reorganization (Chapters 11, & 13).  Liquidation occurs when the debtor surrenders all of its assets, which are then sold and the proceeds distributed to the creditors.  After the completion of liquidation, all of the debtor's debts are discharged (i.e., the debtor no longer owes any money to its creditors) and the creditors end up with pennies on the dollar. 

In a reorganization, the debtor becomes a debtor in possession, which not only allows the debtor to hold on to its assets during the bankruptcy, but also allows it to temporarily suspend debt payments.  During the reorganization, any interested party can propose a reorganization plan, which may include modification of certain lending agreements or rejection of pre-bankruptcy contracts (think union or pension contracts here).  In the event that creditors cannot agree upon or "confirm" a reorganization plan, then the bankruptcy court may unofficially step in and modify the plan in an effort to obtain confirmation.  Modification may include changing or restructuring the terms of preexisting contracts.  After the plan is approved, the debtor emerges from the bankruptcy with all of its assets and creditors end up with (a) new payment terms, (b) something more than pennies on the dollar, or (c) jack shit (see e.g., unions members and pensioners).   If it turns out that the debtor's income or assets cannot support any reasonable reorganization plan, then the court may convert the reorganization into an involuntary liquidation.

Now, to clear up some confusion: Friedmanite: While it is true that homes are protected in personal bankruptcies, that is a result of state and federal homestead protections and preferences (in the non-legal sense) given to secured creditors.  If a debtor stops making all its credit payments, but keeps its mortgage payments current, then the court isn't going to touch the home.  By the same token, the Court and the Chapter 13 Trustee are going to give the debtor some breathing room, amortize the arrerage, and try to deal with the unsecured creditors. But, bankruptcy provides no protection in the event that a debtor defaults on bankruptcy plan payments. 

What the Obama plan does is apply the reorganization bankruptcy principles to debtors seeking to prevent foreclosure on their home.  If a person files for bankruptcy, lenders would be forced to reach commercially viable compromises with homeowners.  If the lender and homeowner can't agree, the court may step in and present proposals of its own.  Of course, lenders are going to take a haircut - but they almost always do in bankruptcies.  And in the event that the homeowner's income can't reasonably support a revised loan or if the homeowner stops making payments on the revised loan, then the lender may liquidate through foreclosure. 

Nothing in the Obama plan would provide state court judges with the power to alter contracts.  The proposal is simply a change in existing federal bankruptcy legislation. 

The new legislation is unlikely to affect future lending.  First of all, the amendment is limited in time.  It won't affect new mortgages and will only affect mortgages created in past few years. 

Second, even secured creditors have to renegotiate existing contracts in Chapter 13 cases.  The legal and conceptual framework exist for the Court, Trustees, and creditors to work out issues such as market values and market rates.  The assets you typically see involved are large trucks or construction equipment.  Modifying existing contracts to protect a distressed borrower is really the core concept in Chapter 11 and Chapter 13 cases. 

Third, even if the change to the bankruptcy code were to affect new mortgages, lending institutions absolutely know how to account for bankruptcy risk and know how to factor a potential reorganization into their lending decisions.  To the extent that that the new laws create any market externalities, they are know quantities and are unlikely to present any major issues.  GG -  this is why these new laws will not freeze home lending.  If the potential for bankruptcy reorganization really did present as grave a risk to lending as GG foresees, then there would have been no commercial lending over the last 100 years.

What will likely happen is that the new laws will mitigate against moral hazards and help promote better lending decisions.  The moral hazard in this instance is that current bankruptcy law makes the home mortgage a unique type of secured lending that is almost completely insulated from bankruptcy risk.  The ability to lend without the risk of a potential reorganization creates much looser lending standards for home mortgages than for small business or commercial lending.    Go out and find someone who has actually applied for a individual commercial loan and ask them to compare the lending process with the home mortgage lending process.  I guarantee you that no one has ever provided a commercial loan based on a stated income application.  The availability of reorganization plays into the difference in the loan making process.  If the elimination of speedy home foreclosures means the elimination of the liar loan, then we will all be better for it. 

Third and finally, the new bankruptcy rules will eliminate the perverse lending incentives created by real estate booms.  If prices are steadily rising, lenders may have an incentive to create products that encourage default and foreclosure.  Take the ever-popular 5-year, interest only loan.  This is a product with a ridiculously high balloon that seems specifically designed to get people to move into houses they cannot afford.  Now, the lender knows the borrower's purported income and knows that the borrower is unlikely to be able to afford payments on a refinanced 3-year ARM in year 6.  Why not make the loan, buy the MBS, or the CDO but for the fact that you would likely make more money if the borrow defaults and you sell the house at a higher price?  The prospect of having to renegotiate the loan in bankruptcy court helps to reduce the incentives behind this type of lending speculation in boom markets.