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Shift in bankruptcy laws staggers mortgage holders

New rules prompt debtors to pay off credit cards first

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Bloomberg News / November 11, 2007

Washington Mutual Inc. got what it wanted in 2005: a revised bankruptcy code that no longer lets people walk away from credit card bills.

The largest US savings and loan didn't count on a housing recession. The new bankruptcy laws are helping drive foreclosures to a record as homeowners default on mortgages and struggle to pay credit card debts that might have been wiped out under the old code, said Jay Westbrook, a professor of business law at the University of Texas Law School in Austin and a former adviser to the International Monetary Fund and the World Bank.

"Be careful what you wish for," Westbrook said. "They wanted to make sure that people kept paying their credit cards, and what they're getting is more foreclosures."

Washington Mutual, Bank of America Corp., JPMorgan Chase & Co., and Citigroup Inc. spent $25 million in 2004 and 2005 lobbying for a legislative agenda that included changes in bankruptcy laws to protect credit card profits, according to the Center for Responsive Politics, a nonpartisan Washington group that tracks political donations.

The banks are still paying for that decision. The surge in foreclosures has cut the value of securities backed by mortgages and led to more than $40 billion of writedowns for US financial institutions. It also reached to the top echelons of the financial services industry.

Citigroup chief executive Charles O. Prince III stepped down this past week after the country's biggest bank by assets said it may have $11 billion of writedowns on top of more than $6 billion in the third quarter. Stan O'Neal was ousted as chief executive of Merrill Lynch & Co., the world's largest brokerage, after an $8.4 billion writedown. Both firms are based in New York.

Morgan Stanley, the second-biggest securities firm, said in a statement that subprime losses will cut fourth-quarter earnings by $2.5 billion. The New York-based bank said it lost $3.7 billion in the two months through Oct. 31 as prices for securities linked with home loans to risky borrowers sank further than traders expected.

Even as losses have mounted, banks have seen their credit card businesses improve. The amount of money owed on US credit cards with payments more than 30 days late fell to $7.04 billion in the second quarter from $8.37 billion two years earlier, according to data compiled by Federal Deposit Insurance Corp.

In the same period, the dollar volume of repossessed homes owned by insured banks doubled to $4.2 billion, the federal agency said. New foreclosures rose to a record in the second quarter, led by defaults in subprime adjustable-rate mortgages, according to the Mortgage Bankers Association in Washington.

People are putting their credit card payments ahead of their mortgages, said Richard Fairbank, chief executive of Capital One Financial Corp., the largest independent credit card issuer in the country. Of customers who are at least three months late on their mortgage payments, 70 percent are current on their credit cards, he said.

"What we conclude is that people are saying, 'Honey, let the house go,' " but keep the cards, Fairbank said at a conference earlier this month in New York sponsored by Lehman Brothers Holdings Inc.

The new bankruptcy code makes it harder for debtors to qualify for Chapter 7, the section that erases nonmortgage debt. It shifted people who get paychecks higher than the median income for their area to Chapter 13, giving them up to five years to pay off nonhousing creditors.

The court-ordered payment plans fail to account for subprime loans with adjustable rates that can reset as often as every six months, said Henry Sommer, president of the National Association of Consumer Bankruptcy Attorneys.

Two-thirds of such debtors won't be able to complete their payback plans, according to the Center for Responsible Lending.

"We have people walking away from homes because they can't afford them even post bankruptcy," said Sommer, a Philadelphia-based bankruptcy attorney. "Their mortgage rates are resetting at levels that are completely unaffordable, and there's nothing the bankruptcy process can do for them as it now stands."

Four million subprime borrowers with limited or tainted credit histories will see their mortgage bills increase by an average 40 percent in the next 18 months, according to the National Association of Consumer Advocates in Washington. About 1.45 million of those will end up in foreclosure by the end of 2008, said Mark Zandi, chief economist at Moody's Economy.com, a research firm.

Bad mortgages slashed Washington Mutual's profit by 72 percent in the third quarter from a year earlier, the Seattle-based thrift said Oct. 17. Income from credit card interest rose 8.8 percent to $689 million in the period, helping to offset losses.

"The law had an unintended consequence of taking away a relief valve that mortgage borrowers used to have," said Rod Dubitsky, head of asset-backed research for Credit Suisse Holdings USA Inc. in New York. "It's bad for the mortgage borrowers and bad for subprime investors because it means more losses."

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