Cram Down - Home Mortgage Loans - Historical Context

Historical Context

The prohibition on cramdowns on loans secured by primary residences was the result of a political compromise during the process of enacting the Bankruptcy Reform Act of 1978. At the time, Congress was confronted with brutal stagflation in which economic stagnation was combined with sky-high inflation and interest rates, which were severely frustrating the United States' long-term federal public policy of promoting homeownership (which goes back to the National Housing Act of 1934). Congress therefore decided to shield lenders on loans secured by primary residences from cramdowns because there was evidence that they perform "a valuable social service" through their loans.

Generally, under risk-based pricing, a rational lender will underwrite a loan with an interest rate that correlates directly to the borrower's credit risk. That is the risk that the lender cannot recover its entire expected return on investment, which in turn includes not only the probability of default, but also any external forces (like a bankruptcy court) that could delay repayment or force the lender to write off any part of the loan. The higher the risk, the higher the interest rate. Thus, Congress reasoned, if lenders knew their loans were protected from cramdowns, then they would offer loans at lower interest rates, which in turn would mean lower monthly payments, and thereby enable more Americans to afford homes. In plain English, Congress sacrificed the interests of the minority of borrower-homeowners who will inevitably default due to bad luck or bad judgment in favor of lowering the cost of homeownership for the vast majority of borrower-homeowners who will successfully repay their loans.

This rule was fiercely litigated in the 1980s, but the prohibitions on cramdowns on primary residences in both Chapter 7 and Chapter 13 bankruptcy proceedings were eventually upheld by the U.S. Supreme Court in the early 1990s. Finding no relief in Chapters 7 or 13, some individual borrowers tried the creative move of filing under Chapter 11 (which is normally used by corporations). As a result, the home lending industry went back to Congress, which responded by extending the cramdown restriction for loans secured by primary residences to Chapter 11 with the Bankruptcy Reform Act of 1994.

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