Bankruptcy and Mortgage Stripdowns: Learning from Experience

Using the farm crisis of the early 1980s as a model, two economists have refuted several of the arguments against legislation that would permit bankruptcy judges to cramdown or stripdown of mortgage loans.  Thomas J. Fitzpatrick IV and James B Thomson, economists with the Federal Reserve Bank of Cleveland, published their paper, Stripdowns and Bankruptcy: Lessons from Agricultural Bankruptcy Reform in the bank's Economic Commentary on its website.

Allowing stripdowns of mortgages during Chapter 13 bankruptcy reorganization has been suggested as one way to deal with the housing crisis.  If such legislation were passed, bankruptcy judges would be allowed to reduce the outstanding balance on a mortgage loan to the actual value of the underlying collateral, turning the remaining balance of the mortgage into an unsecured claim which would receive the same proportionate payout as other unsecured debts included in the bankruptcy petition. Some proponents of this provision maintain it could be a partial solution to the foreclosure crisis, reducing the number of homes going into foreclosure by improving the chances of a successful loan modification.  Others favor the law on the basis of equity, saying that mortgages on rental properties and vacation homes as well as virtually every other type of secured loan can be stripped down during Chapter 13 proceedings.

Those opposing stripdown legislation fear an increase in mortgage interest rates, apparently in response to any increase in loan modifications rather than to the stripdown itself.  The unintended consequences of this, they argue, might be to make homeownership less affordable and accessible to low and moderate income families.  Opponents also cite the possibility of an avalanche of Chapter 13 filings should stripdowns become law in the midst of the current financial crisis. Lenders have been the most vocal of opponents, arguing that stripdowns would shift losses from borrowers to lenders, give bankruptcy judges too much discretion, and that such shifting is unfair in that it changes the rules of contracts after the fact.

The economists maintain that such arguments are best viewed against the empirical evidence from the actual experience with stripdowns done under legislation establishing the Bankruptcy Judges, United States Trustees, and Family Farmer Bankruptcy Act of 1986. This legislation established a separate chapter in the U.S. Bankruptcy Code, Chapter 12 intended solely for farmers.  The legislation was passed in response to an agricultural and bank crisis in the 1980s and originally had a sunset provision, but worked well enough that it was twice extended and then made permanent in 2005.

The agricultural lending crisis had some strong parallels with the more recent home lending meltdown, as well as, Patrick and Thomson point out, some distinct differences and many of the claims and concerns expressed in the current debate were central in the debate over Chapter 12.

The agricultural lending crisis started in the 1970s when US farm exports rose over 500 percent, from $8.24 to $43.78 billion in a nine year period starting in 1972. This led to a dramatic rise in commodity prices and farm incomes over that time period. Net farm income peaked at over $27 billion in 1979, a rise of 41 percent over the decade.

It was a typical boom-bust scenario: When prices for their goods were rising, farms expanded and farm real estate prices increased significantly; in Iowa, for example, the price of farm land more than quadrupled from 1970 to 1982. But, while demand for their products had increased sharply in the early 1970s, farmers watched it fall almost as fast in the late 1970s and early 80s. With the drop in demand and price for products the demand and price for land fell too.  That Iowa land lost nearly two-thirds of its value in five years, and the same thing happened nationally.  The average price of farmland increased more than 350 percent by 1982 then fell by more than a third in the next five years.

As the price was going up, so did agricultural debt loads as many farmers borrowed to acquire additional acreage. Cash-short and expecting increased income, many farmers used variable-rate notes to purchase real estate. Caught up in the boom, lenders eased underwriting standards, relying on the continued appreciation of the land for security rather than the ability of the farmers to service their debt.  But as prices and cash flows decreased and the variable-rate notes used to purchase farm real estate reset, many farmers saw their interest rates increase, found that they could not make payments and were underwater on their mortgages.

Farmland values peaked in 1981 in the Midwest, where the land-price appreciation had been the greatest, and declined by as much as 49 percent over the next few years before bottoming out in 1987. Farm-sector debt quadrupled from the early 1970s through the mid-1980s. Debt declined by one-third from 1984 through 1987, but much of this reduction reflected the liquidation of farms.

Many farmers, especially in the South and Midwest, were underwater with their agricultural loans and were in danger of losing their primary residences with little relief possible under the existing bankruptcy laws.  Chapter 13 did not allow for modification of debt secured by a primary residence, and Chapter 11, intended for corporations, was too complex for most small and medium sized farmers and also contained provisions that made a stripdown problematic.

Some states enacted moratoriums on foreclosures but they provided only temporary relief given the underlying economic factors (does any of this sound familiar yet) and left many farmers unable to service their debt and with almost no possibility of renegotiating their secured loans.

Fitzpatrick and Thomson point out that, unlike in the current foreclosure crisis, the troubled debt then was highly concentrated a few Farm Credit Banks, Farmer Mac and commercial banks in the affected regions.  Nonetheless, these agriculturally related banks began to fail in 1984 and accounted for a third of all bank failures between 1983 and 1987.  This led to the Chapter 12 legislation and its related stripdowns provisions. Despite the same arguments we hear today, Congress permitted stripdowns for farmers because voluntary modification efforts, even when subsidized by the government, did not lead agricultural lenders to negotiate loan modifications.

The actual negative impact of the legislation was minor. Even though the new section of the Bankruptcy Code was created specifically for farmers, it did not change the cost and availability of farm credit dramatically. In fact, a United States General Accounting Office (1989) survey of a small group of bankers found that none of them raised interest rates to farmers more than 50 basis points. The economists say that while this rate change may have been a response to the Chapter 12, it is also consistent with increasing premiums due to the economic environment and  suggest that the changes in the cost and availability of farm credit after the bankruptcy reform differed little from what would be expected in that economic environment, absent reform.

The Commentary says, "What was most interesting about Chapter 12 is that it worked without working.  According to studies by Robert Collender (1993) and Jerome Stam and Bruce Dixon (2004), instead of flooding bankruptcy courts, Chapter 12 drove the parties to make private loan modifications. In fact, although the U.S. General Accounting Office reports that more than 30,000 bankruptcy filings were expected the year Chapter 12 went into effect, only 8,500 were filed in the first two years. Since then, Chapter 12 bankruptcy filings have continued to fall."

Despite the controversy that accompanied Chapter 12 and is stirring around the idea of a stripdown authority today, economists say that the "effects of the stripdown provision, in place for more than two decades, on the availability and terms of agricultural credit suggest that there has been little if any economically significant impact on the cost and availability of that credit."  They do, however, point out some significant differences between the agricultural foreclosure crisis of the 1980s and the current home foreclosure crisis.

"First, the structure of the underlying loan markets is different. Unlike mortgages today, few if any of the farm loans in the 1980s were sold or securitized. Moreover, there was more direct government involvement in agricultural loan markets in the 1980s than there was in the mortgage markets leading up to the current housing crisis. Finally, the scale of the current foreclosure crisis is several times larger than the 1980s agricultural crisis, which was limited geographically to the Midwest and Great Plains states. Yet, despite these differences, the response to the farm foreclosure crisis and the impact of bankruptcy reform on agricultural credit markets is still informative for the current debate."