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Reforms Could Backfire

The bankruptcy reforms enacted last October were backed nearly unanimously by creditors, including the mortgage industry, but now some experts see a possible dark cloud on the horizon for mortgage lenders.

By making it more difficult for consumers to discharge unsecured debt under Chapter 7 of the bankruptcy code, the new rules could leave some consumers so overburdened by debt that they default on their mortgage loans. Essentially, troubled homeowners will have more trouble reducing debt and reinstating a defaulted mortgage, because they can't shed unsecured consumer debt as easily as they could under the old rules.

Brian Spero, head of the USFN, an association of mortgage banking attorneys, said that it is too early to sort out all of consequences of the new bankruptcy rules. But he tends to agree with the analysis that the law could lead to an increase in mortgage defaults.

"My sense of the Bankruptcy Reform Act is that it was really pushed by the unsecured debt industry, so to the extent it affects the mortgage industry, I think it may have some unintended effects," he said. Mr. Spero is an attorney with Partridge, Snow & Hahn, which represents creditors in Rhode Island and Massachusetts.

That said, he pointed out that consumers still have the option of filing under Chapter 13, which is generally preferable for many borrowers with assets such as a home to protect. Still, relatively few Chapter 13 repayment plans are successful, Mr. Spero noted.

John Ayer, a former U.S. bankruptcy judge who is now a law professor at the University of California Davis, said mortgage lenders were already pretty well protected under the bankruptcy reforms enacted in 1978, the last time major changes were made to bankruptcy rules. But he said the new rules make it more difficult for consumers to reorganize their debts under a repayment plan. Even Chapter 13 is less attractive to consumers seeking to repair their finances, Mr. Ayer said.

He also said that to some extent the new bankruptcy laws were driven by creditors, who essentially were fighting amongst themselves for priority position in debt collections. Who among creditors will win and who will lose under the new rules remains to be seen.

"At this point, it's all speculation. I'm not going to feel comfortable generalizing about this stuff for two or three years," he said. Mr. Ayer is also currently a resident scholar with the American Bankruptcy Institute.

And Mr. Ayer noted that the new rules do make it more difficult for mortgage borrowers to use repetitive bankruptcy filing to delay or avoid foreclosure on a home, something Mr. Spero said was a widespread problem afflicting the mortgage industry.

Vicki Vidal, a loan administration executive with the Mortgage Bankers Association, said that while the new law has "pluses and minuses" for the industry, she said the reduction in bankruptcy abuse should be a key benefit for home loan servicers.

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