Federal bankruptcy law has been the vehicle for handling unmanageable personal debt for generations. Today, due to the devastating impact of the recession on homeowners’ personal finances, that law is in desperate need of reform.

            Millions of Americans are involuntarily unemployed, buried in debt, or living in places where they owe vastly more than their property is worth. In the third quarter of 2009, for example, primary residences of 4.5 million homeowners were worth less than 75% of what was owed on them.[1] This is considered the point at which owners often choose to stop paying their mortgage; opting instead to rent elsewhere for less money.  It is the point where homeowners give up hope of ever building any equity in their homes, even if their income is sufficient to pay the mortgage.  Fannie Mae and Freddie Mac are in such precarious financial shape already that if too many more residential mortgages default, our country  could face a worse crisis than we experienced with investment banks.

            Buyers and lenders share the blame for the real estate crisis. The former often purchased more than they could afford, while the latter frequently extended credit too easily. For this reason, the bankruptcy reform I am suggesting needs to apportion relief among the parties instead of granting it exclusively to one group or the other.

            To be fair, any re-writing of mortgage terms that forgives or re-structures indebtedness must take into account all of these factors with regard to debtors: (A) ability to pay (financial statement); (B) credit score; (C) refinances and lines of credit; (D) substantial involuntary reductions in income; and (E) substantial involuntary increases in expenses (unforeseen medical expenses being a common example); (E) whether the property was debtor’s principal residence for at least twelve months prior to filing; and (F) whether the purchase price was within five percent of the mean comparable fair market value in the neighborhood on the date of acquisition. On the mortgage holder’s side of the equation, eligibility for relief should depend on strict compliance with law and regulation in the prior twenty-four months. This includes rigorous abstention from redlining, credit default swaps, predatory lending and the like.

            In conclusion, I believe our mortgage crisis calls for a context-specific balancing of competing interests. The size of any markdown or extended payment period for consumer mortgages needs to be scaled according to the weight accorded each consideration listed above. Absent new legislation — accompanied by a tactical infusion of Federal funds to reduce mortgage balances in appropriate circumstances — our residential housing market will not recover fast enough to keep under-water homeowners in their homes. So many of these mortgages are federally insured that a spike in defaults could be catastrophic.

[1] “No Aid or Rebound in Sight, More Homeowners Just Walk Away,” The New York Times, February 3, 2009, p. A1.