In praise of cramdowns

Principal reduction (cramdowns) granted by bankruptcy courts is the only solution to underwater homeowners’ plight, a recent article from Daily Finance argued. Unlike recent endeavors to implement cramdowns through bank settlements, cramdowns granted through the bankruptcy courts have historically proven to effectively mitigate widespread negative equityThe condition of a property owner owing more on a mortgage than the current fair market value of the encumbered property. without undue moral hazard.

In the 1980s, farmers in the Midwest faced a post-bubble plight similar to that of today’s California negative equityThe condition of a property owner owing more on a mortgage than the current fair market value of the encumbered property. homeowners. Top-heavy loan-to-value (LTV) ratios resulted in defaults and foreclosures until Congress passed special legislation enabling bankruptcy courts to grant cramdowns to farm owners declaring bankruptcy.

Just as today’s lenders cry out in fear against the moral hazard created by cramdowns, lenders in the 1980s negative equityThe condition of a property owner owing more on a mortgage than the current fair market value of the encumbered property. crisis opposed the emergency measure. While cramdowns were given to many homeowners, most of the damage control was accomplished without resorting to cutting principal amounts on loans. After bankruptcy courts were given authority to cut principal, lenders became suddenly more willing to negotiate mortgage modifications with farm owners than suffer the alternative now at the property owner’s disposal.