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266 Cost-Benefit Analysis of Debtor Protection Rules in Subprime Market Default Situations duncan kennedy 11 Debtor protection rules ought to influence debtor/creditor interaction in the residential real estate market at three points: post-default pre-foreclosure negotiations, the rate of default, and the cost of credit. Their cumulative impact should be different for “high road” than for “low road’ subprime creditors . High road creditors make money through loan performance, invest in minimizing default, and lose money when they have to foreclose. Low road creditors also make money through loan performance, but invest in quick, low-cost foreclosure , and anticipate sometimes being able to appropriate some or all of the debtor’s equity. Enforced nonwaivable debtor protection would likely significantly increase low road but not high road costs, and shift market share from low to high roaders, possibly putting the low road out of business. This might well be desirable from an efficiency point of view, given the tendency of borrowers to underinsure against default, and from the point of view of distributive equity, as well as avoiding adverse neighborhood effects of current low road practices. Post-Default Negotiation Residential mortgages generally provide that if the debtor is in even minor default, the creditor has the option of accelerating the debt. The debtor then has a short time to cure by paying arrears and penalties, after which point the debtor must pay the full amount outstanding (plus penalties) within a short grace 16 7409-5 ch 11.qxd 7/7/2005 10:26 PM Page 266 debtor protection in foreclosure 267 period or be subject to foreclosure. In practice, after default the parties are likely to engage in some kind of negotiation. I will outline the stakes in the negotiation , the bargaining tools of the parties, the range of outcomes, the high road versus low road distinction, and the likely effects of different regimes of debtor protection. Before beginning this exercise, there are two aspects of the subprime market to keep in mind. The first is that the subprime industry is highly segmented: mortgage brokers, loan initiators, syndicators, the secondary lenders, loan servicers , and, finally, actors who specialize in handling loans in default, are likely to be distinct entities, although related through the prices they pay one another for their pieces of the business. I assume initially, counterfactually, that we can treat the creditor as a single entity that controls every stage from mortgage brokering through foreclosure. I switch to assumptions that are more realistic when analyzing the impact of debtor protection on high road and low road market shares. The second point is that while the market is segmented as above, a single economic entity can engage, through distinct subsidiary entities, in many different parts of the business and can own subsidiary entities that pursue different strategies. Thus a bank can engage in high road subprime lending while owning or financing other entities that take the low road. At the end of this chapter I speculate on the significance of this possibility. Stakes and Tools in the Post-Default Negotiation The stakes in the post-default negotiations are heterogeneous for both debtor and creditor, and require each to make complicated trade-offs. The parties pursue stakes using different bargaining tools, each of which will have a different degree of efficacy according to the specific circumstances. stakes between debtor and creditor after default. The debtor may want to: retain possession (quantifiable as the asking price of the premises, which is the home value as opposed to the market price); retain whatever equity he may have in the property; avoid a deficiency judgment (meaning liability for the difference between the loan and what the creditor recovers in the foreclosure sale); and minimize future payments. It is also possible that the debtor knows that his income has fallen so far that he has no chance of avoiding foreclosure, so that the stakes are limited to retaining equity, protracting possession, and avoiding a deficiency judgment. The creditor wants to maximize profit through some combination of: cash payment of arrears; extraction of credible promises of future payments; loan recovery by foreclosure; and, possibly, appropriation of all or part of the debtor’s equity in the foreclosure process. But the creditor must take into account the impact of the way it handles foreclosures on the rate of default, and on market 16 7409-5 ch 11.qxd 7/7/2005 10:26 PM Page 267 [3.144.97.189] Project MUSE (2024-04-24...

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