The Housing Crisis and Bankruptcy Reform: The Prepackaged Chapter 13 Approach

In 2008, banks commenced foreclosure proceedings on 2.2 million homes. This year could be worse.1 While economists disagree on whether this is the worst economic crisis since the Great Depression, everybody agrees that this is the worst real estate crisis since the Great Depression. Foreclosure is not just a human tragedy, it is an economic tragedy as well. Foreclosed houses are poorly maintained if not looted. As a result, foreclosed properties lose a substantial fraction of their value, between 30 and 50 percent.2 If this was not enough, foreclosure has some very negative spillover effects. Forced sales depress the value of the surrounding properties. When forced sales become frequent, they undermine the value of a neighborhood, pushing other people to sell or default. Finally, widespread defaults reduce the social stigma of defaulting, leading to the possibility of a vicious circle of default causing other defaults, depressing real estate prices further and causing still more defaults.3

The market seems to anticipate this doomsday scenario. Figure 1 reports the price of an index of AAA mortgage-backed securities in the last six months. In spite of the fact that all the components of this index were AAA rated at origination, recent prices oscillate around 35 cents on the dollar. It is hard to make sense of these prices without assuming a contagion effect on default and a large deadweight loss conditional on default.


Even if we were to assume that all securities are backed by mortgages in Las Vegas (which with almost a fifty percent drop in prices is the most severely affected area of the country) and 100% of the underlying mortgages defaulted, the price of this index should not be below 50 cent on the dollar. The holders of securities should expect banks to recover houses worth half as much as the loans, and so the securities should be valued at half their par value. The fact that the securities trade at 35 cents implies that the market expects the houses upon foreclosure to be worth at least 40 percent less than their current market value—and even less than that if (as is likely) less than 100% of the mortgages default.4 Similarly, the fact that to rationalize these prices we need a 100 percent default rate, while even in the worst part of the country we are at 54 percent, implies that the market expects either a large contagion effect or a massive government intervention that forces a debt forgiveness or both.

Since about 10% of the $10 trillion mortgages are currently delinquent or in the foreclosure process,5 the expected deadweight loss for the delinquency started so far will be at least $300 billion or $1,000 per American. Avoiding this loss should be a top legislative priority. A major puzzle is why the market does not avoid these losses. Lenders can do better if they renegotiate loans rather than foreclose on them. To see why, suppose that the outstanding debt on a house is $200,000, the market value of the house is now $150,000, and the foreclosure value of the house is $100,000. If the lender forecloses, it obtains $100,000 at best. Alternatively, it could renegotiate the loan with the homeowner for, say, $140,000. The homeowner now owns a house worth $150,000, and the bank owns a loan worth $140,000. The homeowner could resell the house and obtain a profit for $10,000, or keep the house—in either case, the foreclosure inefficiency of $50,000 is avoided, as are the negative effects on neighboring houses. With millions of houses currently in foreclosure or close to it, the cost savings from loan renegotiations could be enormous. However, if loan renegotiation is desirable from an ex post perspective, it can nonetheless create problems for banks, which must take into account the effect of loan renegotiations for future credit transactions. If borrowers with outstanding mortgages observe that other borrowers benefit from loan renegotiations, then they will realize that they, too, may be able to renegotiate their mortgage if otherwise they would default. If homeowners anticipate the possibility of renegotiation, they might deliberately maintain thin equity margins so that they can credibly bargain for a loan renegotiation if the value of the house declines. As a result, many banks appear to have a policy of either not renegotiating loans or doing so only in unusual circumstances.

Another reason that loan renegotiations are rare is that the transaction costs of renegotiating loans are high when loans are securitized. Few banks maintain the loans on the books that they originate. Loan originators immediately sell their loans to investment banks and other institutions that pool them and then divide the combined stream of principle and interest payments into securities that are sold on the market. The holder of a security receives payments from a particular pool of loans until the debts are paid off. A loan servicer collects mortgage payments from the homeowner and passes them on until they end up in the pockets of the holders of mortgage-backed securities. Thus, when it comes time to renegotiate the loan, the homeowner cannot communicate with the owners of the loans—there are thousands of them dispersed throughout the world—but must deal with the loan servicer.

The loan servicer probably has no financial incentive to renegotiate the loan. It does not lose if the homeowner defaults. The loan servicer may have a contractual obligation to the MBS holders to renegotiate the loan as foreclosure nears, but the MBS holders will usually not be in a position to enforce these rights. Indeed, when loan servicers do renegotiate loans, they face the risk of lawsuits from MBS holders who claim that the loan servicer was too generous to the homeowner. MBS holders today may also believe or hope that the government will purchase their MBS’s, maybe at par or above-market value, and thus prefer to avoid renegotiations that will lower their value. And none of these parties has much interest in ensuring that a borrower’s neighbor’s house maintains its value rather than being dragged down by a foreclosure.6 Consistent with these claims, Piskorski, Seru, and Vig find that seriously delinquent mortgages controlled by servicers of securitizations enter foreclosure much more quickly than portfolio loans.7 One of the great challenges of the financial crisis, then, is to discover a way to ensure that houses are either kept or sold by their owners, rather than foreclosed, when the owners default on their mortgages. The goal is to force a renegotiation between the homeowner and the owner or owners of the mortgage. At the same time, a system that forces such renegotiations should be designed so as to minimize administrative costs and to avoid, as much as possible, negative ex ante effects on the cost of credit.

In this paper, we propose a plan that will help reduce the costs from foreclosure by, in effect, giving the homeowner the option to force a renegotiation on the owner or owners of the loan. This option takes the form of what we call a prepackaged Chapter 13 bankruptcy, in which the mortgage is automatically readjusted in line with the decline of housing prices in the homeowner’s ZIP code. The homeowner ends up with positive equity in his house, so that he will either maintain the house or sell it outside foreclosure, and the creditor ends up with a claim of greater value than the foreclosure price of the house. Because both parties are made better off, the cost of credit should not increase in the long run; and taxpayers do not have to subsidize the scheme. The plan is premised on the assumption that widespread negative equity mortgages, as a consequence of the popping of the housing bubble,8 are the chief cause of the crisis, rather than loss of income caused by the recession, which the plan does not address.

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1 Mortgage Bankers Association, Delinquencies Increase, Foreclosure Starts Flat in Latest MBA National Delinquency Survey, December 5, 2008,

2 “For properties sold at foreclosure auctions in 2006, first resales that occurred that same year brought 63% of county-estimated market values. First resales that occurred in 2007 brought only 44% of estimated market values.” Josiah Madar, Vicki Been, and Amy Armstrong, Transforming Foreclosed Properties Into Community Assets New York University Furman Center for Real Estate and Urban Policy (2008).

3 Guiso, L, P. Sapeinza, and L. Zingales, Moral and Social Constraints to Strategic Default on Mortgages, University of Chicago Working Paper (2009).

4 Alan M. White, Deleveraging the American Homeowner: The Failure of 2008 Voluntary Mortgage Contract Modifications (2009),, reports that the losses in foreclosure of forced lien mortgages were 55 percent. Assuming an initial down payment of 5 percent and a decline in house prices of 30 percent, the deadweight loss in default is around 40 percent.

5 Mortgage Bankers Association, supra.

6 In some contracts, MBS holders can approve a loan renegotiation by vote, for example, 60 percent; however, this process appears to be cumbersome.

7 Tomasz Piskorski, Amit Seru, and Vikrant Vig, Securitization and Distressed Loan Renegotiation: Evidence from the Subprime Mortgage Crisis, Chicago Booth School of Business Research Paper No. 09-02 (2008),

8 See Shane M. Sherlund, The Past, Present, and Future of Subprime Mortgages, Finance and Economics Discussion Series 2008-63 (Federal Reserve Board, 2008); Elmendorf, supra.

5 Responses to "The Housing Crisis and Bankruptcy Reform: The Prepackaged Chapter 13 Approach"

  1. ex VRWC   February 26, 2009 at 12:25 pm

    This is just double speak. Look at the fuzzy math being perpretrated here:

    To see why, suppose that the outstanding debt on a house is $200,000, the market value of the house is now $150,000, and the foreclosure value of the house is $100,000. If the lender forecloses, it obtains $100,000 at best. Alternatively, it could renegotiate the loan with the homeowner for, say, $140,000. The homeowner now owns a house worth $150,000, and the bank owns a loan worth $140,000.

    How did the house lose $50,000 just because it was foreclosed? If the market value of the house (as reflected by its foreclosure value) is $100,000, then, in the end, the house is still worth $100,000, not $150,000. Therefore, the homeowner ends up owing $150,000 on a $100,000 house, and the bank takes a $50,000 writedown, and the house is still underwater.The basis for this argument is that the homeowner ought to have a right to be able to cram a renegotiation of his principal down the lenders throat. It attempts to wrap this in doublespeak about how it is ”better’ for both because the house magically gains value because it is not foreclosed. Please.

    • AnnS   February 28, 2009 at 11:38 am

      It “loses” $50,000 in value because of the COSTS of doing the foreclosure.That is all the notices of default and processing the paperwork; the hiring of counsel to either do the (a) non-judicial foreclosure or (b) the judicial foreclosure as is mandated in a minority of states and means a lawsuit; the foreclosure auction in non-judicial foreclosure; the evicting the borrowers; the things that need to be done to get the property ready to sell (cleaning, lawn etc); the hiring and then paying the realtor their obscene 6%; the taxes and utilities while the property is on the market plus lawn maintenance; and finally closing the sale with the attendant costs of title insurance etc.

  2. Guest   February 26, 2009 at 10:24 pm

    ex VRWC, you don’t understand. These guys are trying–like good flunkeys of the scrutiny regime–to do ANYTHING to mitigate the negative political consequences of the economic collapse, SHORT OF granting new rights. Of course you sound like you don’t believe in any rights. But for what it is worth, what they are trying to do is to AVOID raising the level of scrutiny for housing.For your information, it is currently at minimum scrutiny, thanks to Lindsey v. Normet. As I argue in my book, The Eminent Domain Revolt, it should be at strict scrutiny. If that were the case, there would be a ban on housing evictions, period.You should start thinking about rights, because you obviously know nothing about them, and yet this is a rights crisis, not an economic crisis. We are at the end of the West Coast Hotel v. Parrish scrutiny regime, and are in the painful throes of installing the maintenance regime, which I describe in the book.Good luck to you and the authors understanding this. All of you sound like you are such lunatic scum that you will never understand anything.More American garbage.Cheers,John Ryskamp

  3. William Besaw   February 27, 2009 at 10:42 am

    This reinforces my argument that mortgage back securities are only worth as the are now bundled together are only worth 35 cents on the dollar. If we are going to get our banks healthy again, the bank needs to unbundled the securities and sort the bad out from the good by market to market accounting rules and bundle good and bad separate.The banks with the help of the treasury (in order to over come any anti-trust issues and to have oversight) should set a debt factoring company. This new factoring enterprise would then issue common stock and exchange it for the bad bundles of mortgage back securities at their market to market value. The factoring enterprise would than either collect on them or sale the securities bundles.Unless, these bad securities are cleared off the banks books I think investing taxpayer’s banks won’t help a bit to get the banks loaning money again. If we don’t get these bad apples out of the barrow, the whole barrow is going to turn bad.William Besaw

  4. Anonymous   March 2, 2009 at 10:26 pm

    It is presumed that everyone who is going through foreclosure elected to be there. It is presumed that everyone in foreclosure is looking for “handouts”, not worked hard to get where they are, it is presumed they mismanaged their finances and/or bought more than they could affort. It is presumed these folks do not pay taxes. You presume all too much, there is nothing further from the truth. Wake up people, there are elderly who are loosing their home and their life savings because of the state of the arts!Step off your pedestals and look at the real turn of events. The banks have made their beds, let them now take the hit for what they have done to America. Better yet, use one of their calculators on affordability, see how much it has changed with your income from last year to this year. MAJOR DIFFERENCE!!