2005 Bankruptcy Reform Act Backfires on Lenders.

Lenders who sought tougher law on bankruptcy now facing foreclosures which are making the national housing slump, and subprime lending problems worse.


Nov. 26, 2007 – Businessweek Magazine published an article last week by Christopher Farrell.  In the article the author discusses the harm that the Federal Bankruptcy Act of 2005 has done to make the real estate foreclosure problem larger than it might have been.


The new Bankruptcy law was endorsed by lenders who wanted to make it harder for households to get out from under their consumer debt.  The result has been more people are being forced to walk away from their homes, leaving lenders holding the bag.


Perversely, a law intended to help the financial industry may be damaging the housing sector, creditors and borrowers alike. “It doesn’t matter what you think of the purpose for the new bankruptcy law. The timing is bad. “ says Susan M. Wachter, professor of real estate at the Wharton School of Business.


The old bankruptcy law, in effect since l978, was considered extremely housing-friendly. Most distressed borrowers favored filing under Chapter 7, essentially cheap, quick debt liquidation. In practice, most got to keep their homes, while the rest of their property and assets were sold off to pay a portion of unsecured debts such as credit-card and medical bills. When the assets ran out the remaining loans were cancelled-although some debts were off limits, like student loans and child support.  Future paychecks could go to mortgage payments. 


By contrast the new law was designed to protect creditors. For one thing, only low-income borrowers can file for Chapter 7, which wipes out debtrs. The amended law pushes more people into Chapter 13, which forces housholds to accept 3-5 year repayment plans on all debts-secured and unsecured.


In other words, they’re trying to make payments on car, credit card, medical and other bills that used to be discharged in Chapter 7u.   That makes meeting the mortgage more onerous.  Filing for Chapter l3 temporarily halts foreclosure proceedings, but the protection only lasts as long as the borrower is making mortgage payments.


Under the old law, the average cost of filing for Chapter 7 was about $800 to $1,400 in attorney and other fees.  It is estimated that the cost is now up to $1,400 to $2,400 to file.


Another problem: Under current law, bankruptcy courts don’t have the option of reducing the payments on the mortgage for a primary residence. That means anyone who took out a subprime loan is stuck, unless they want to walk away.


Recent bills introduced into the newly controlled Democratic House and Senate would allow judges to adjust unaffordable mortgages downward. 


That change, if Congress adopts it, could transform bankruptcy into a more practical option when dealing with mortgage lenders.


Nevertheless, the current law is making the housing slump worse.  Without these amendments, it could take a lot longer than many expect for the economy to regain its footing

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