Nowick to Congress: Focus on the FDIC Issue Not Bankruptcy

Maxine, Doris, and Susan in almost no case voted for the legislation that in many cases created this meltdown but they may have to “cough up some tough votes for Leadership” to paraphrase Dr. Cavala on a bill they do not particularly like. While they are getting a ton of flesh this is still not palatable. They have a right to know long term gain for short term pain with the pain being on Republicans in the main. They have a right to know that House Republicans will cough up or vomit up at least 120 to 140 votes for this. Rule 1 of Member Protection is that you do not put marginals at risk which means that the Speaker should put up no more than the minimal number of votes – end of discussion.

However, to avoid this problem down the road the FDIC issue must be addressed. Because if it is not we may have major problems in 5 years.

I had an extended conversation about this issue yesterday with Mike Stevens at the Coalition of State Bank Supervisors (CSBS) about my Blog posting on this.

Because of the influence of small States in the Senate, what CSBC thinks is therefore very important. CSBS is suggesting that the FDIC $100,000 limit be looked at closely – some are suggesting that the amounts subject to protection be increased or lifted. I am not unsympathetic to doing something here.

There are two major concerns that CSBS has which are legitimate. One, as part of other Treasury-Fed-SEC actions, the United States Government has provided dollar for dollar FDIC style protection for money market mutual funds which is the high grade [we hope] commercial paper market. This FDIC style – uncapped protection places banks at a competitive disadvantage vis-a-vis traditional FDIC protections

And, two, the number of FDIC insured accounts has skyrocketed based on everything I have heard – both in conversation with the banking people I know and what I read – when coupled with the regional resource boom I noted – creates some real issues and challenges for bank regulators and Rural America which must be addressed and need to be addressed in order to avoid this issue coming back 10 years from now. I think that lifting the cap or eliminating it on a regional basis may make some degree of sense.

In rural areas where there are not a lot a lot of banks and branch banking is not as prevalent as in this State lifting the cap makes a lot of sense. On the other hand, in a state like California lifting the cap could cause a number of problems and reduce the number of banks and the competition that engenders. We have to recognize that while this is one country, Sacramento is different in it’s banking conditions is not the Eastern Slope of Colorado or the Williston Basin of Western North Dakota and Eastern Montana - people in the Sacramento area have options that people tin Colorado or Montana or North Dakota do not.

As you can tell from reading my comments, I come out of the Roosevelt-Truman tradition. One of the strengths of the Democratic Party is – as Speaker Rayburn said is that we look out for all the people. If California has a problem, then Kansas has a problem and vice-versa.

There has got to be a way without even more distortions to deal with this FDIC issue. There has been some discussion about some sort of tax change to shore up regional banks who suffered as a result of their stock losses in the government takeover of the two mortgage finance giants, Fannie Mae and Freddie Mac. The problems that exist here is not per se taxes but maintaining a strong depositor base. Without getting into specifics, it may be that you allow increases in the FDIC limit if the premiums increased and it is tied to a population-bank density factor.

The second issue is the power of bankruptcy judges and here while I may take some flack this should not be part of any agreement – primarily for constitutional reasons. There are also policy concerns as to this applying to new mortgages as well but we can leave that for a future article. Certain Congressional Democrats – particularly in the Senate – want or wanted the legislation to allow U.S. judges to modify existing mortgages for people in bankruptcy proceedings.

There are constitutional considerations as to existing secured lien holder rights. In all the discussions of the takeover it has to be remembered that this is a voluntary process albeit under some degree of moral suasion. No one has to participate in whatever the final package if they do not want to though their stockholders may insist.

Also, when the Government goes in and rewrites mortgages under this proposal it is doing it as the owner of the debt - it is not forcing anyone to do anything. Also, as a condition of the deal the Government could force as a contracting power the lender to “do the right” thing with other loans it holds.

In contrast, in the bankruptcy situation this involves a judge rewriting or changing a pre-existing security agreement which the Constitution allows subject to limits provided that the secured creditor is not substantively harmed.

When a trust deed or a mortgage is issued reflected in the relevant instruments which are the deed of trust and the note secured thereby. They include the right to repayment of the principal in monthly installments over a fixed term at specified adjustable rates of interest, the right to retain the lien until the debt is paid off, the right to accelerate the loan upon default and to proceed against the property by foreclosure and public sale, and the right to bring an action to recover any deficiency remaining after foreclosure depending on whether it is a judicial or non judicial proceeding and whether or not it is a purchase money interest in residential property.

When James Madison and Alexander Hamilton and the other Founding Fathers [and there were Founding Mothers as Cokie Roberts has properly noted in two good books] helped create the Constitution in 1787, they created a series of compromises. One of those compromises is that they placed on state legislature a ban on “impairing” the obligation of contracts while at the same time authorizing the Congress to enact per Article 1, Section 8, Clause 4 "uniform Laws on the subject of Bankruptcies throughout the United States." Congress has exercised this authority several times since 1801.

The Bankruptcy Clause provides Congress with the clear authority to retroactively impair contracts. Unlike the states, Congress is not prohibited from passing laws that impair contractual obligations under its Bankruptcy Powers. In fact, the very essence of bankruptcy laws is the modification or impairment of existing contractual obligations. Railway Labor Executives' Ass'n v. Gibbons, 455 U.S. 457, 466 (1982).

Discharge in bankruptcy necessarily impairs or modifies the rights of the creditor by eliminating the personal liability of a debtor to a creditor – which Congress may limit – as the United States Supreme Court has also repeatedly noted. Grogan v. Garner, 498 U.S. 279, 286 (1991); United States v. Kras, 409 U.S. 434, 445-446 (1973).

I should add that the power of Congress in this regard is so expansive that the United States Supreme Court held in Central Virginia Community College v. Katz, 546 U.S. 356 (2006) that the Bankruptcy Clause of the Constitution allows Congress to abrogates state sovereign immunity that it might otherwise have under the 11th Amendment. Katz to my knowledge is the only case allowing Congress to use an Article I [as opposed to 14th Amendment power] power to authorize individuals to sue states.

That brings me to the current discussion. Current bankruptcy law [dating back to 1978] allows judges to approve the modifications of the terms of certain debts [secured and unsecured] such as auto and student loans and even second-home mortgages. However, it is not necessarily true that second homes have protections because relief from the automatic stay – and hence foreclosure – is very easy to obtain.

However, per the Bankruptcy Code, bankruptcy [federal] judges cannot approve individuals’ reorganization plans that would allow debtors to pay a lower interest rate for their primary-residence mortgages or to in effect value down the value of the collateral turning a secured creditor into an under or un secured creditor.

The policy reasons for this distinction were noted by the unanimous decision of the United States Supreme Court in Nobelman v. American Savings Bank, 508 U.S. 324(1993). Justice Stevens - who as everyone knows I am not a big fan of – noted in his concurrence that:

“At first blush it seems somewhat strange that the Bankruptcy Code should provide less protection to an individual's interest in retaining possession of his or her home than of other assets. The anomaly is, however, explained by the legislative history indicating that favorable treatment of residential mortgagees was intended to encourage the flow of capital into the home lending market. See Grubbs v. Houston First American Savings Assn., 730 F.2d 236, 245-246 (CA5 1984) (canvassing legislative history of Chapter 13 home mortgage provisions).”

Things have changed but I doubt the attitudes of the United States Supreme Court have in terms of protecting secured creditor rights. Under the initial draft of the Senate Democrats’ proposal [I believe Section 11 of a discussion draft that Senator Dodd has circulated] bankruptcy judges could approve individuals’ reorganization plans that would allow debtors to pay a lower interest rate for their primary-residence mortgages notwithstanding the creditor’s objection.

Furthermore, if the value of the property falls below the loan amount, debtors potentially could reduce the balance of the loan to equal the current value of the property — a process commonly known as a “cram down” or “strip down.” Some of the rewrite probably would survive barely a constitutional challenge but turning a secured into a substantially under secured or un-secured creditor would not.

The dropped Dodd proposal was canned after it became clear that it was as drafted unconstitutional as to present mortgages. The reason was that folks realized that a retroactive change in the Bankruptcy Code in reducing the overall core substantive rights of the secured creditor by that creditor losing the value of the security that he or she had in the collateral itself – in other words turning a secured creditor into an unsecured creditor – is [at least I believe] constitutionally suspect to say the least.

The Bankruptcy Code envisions that its remedies will act as to contractual arrangements entered into after that statutory change takes place. The reason for this is that Supreme Court has noted that that bankruptcy power, like the other substantive powers of Congress, is subject to the Just Compensation Clause of the Fifth Amendment. And, the United States Supreme Court has repeatedly held that a security interest is a specialized right in property which deserves Fifth Amendment Protection. That has been clear since the unanimous decision written by Justice Brandeis for the United States Supreme Court in Louisville Joint Stock Land Bank v. Radford, 295 U. S. 555, 589 (1935).

As Justice Brandeis noted in Radford [which held something like what had been proposed unconstitutional as to pre-existing debts in effect BEFORE the statutory change was enacted though a revised statute was upheld unanimously in 1938]:

“Under the bankruptcy power, Congress may discharge the debtor's personal obligation, because, unlike the states, it is not prohibited from impairing the obligations of contracts. But the effect of the Act here complained of is not the discharge of Radford's personal obligation. It is the taking of substantive rights in specific property acquired by the bank prior to the Act. In order to determine whether rights of that nature have been taken, we must ascertain what the mortgagee's rights were before the passage of the Act.”

As the Supreme Court noted in Radford, in its prior decisions upholding “mortgage relief legislation” in 1934 all the measures adopted for the debtor’s relief, including moratorium legislation enacted by the States during the Depression resulted primarily in a stay, and the relief afforded rested upon the assumption that no substantive right of the lien holder was being impaired, since payment in full of the debt with interest would fully compensate him. Congress has greater powers than the States because of the bankruptcy clause but it is not unlimited.

Of course, the contractual rights of a mortgage lender are affected by the mortgagor's bankruptcy. The lender's power to enforce its rights--and, in particular, its right to foreclose on the property in the event of default--is checked by the Bankruptcy Code's automatic stay provision which has long been a feature of bankruptcy law. 11 U.S.C. § 362. See United Savings Assn. of Texas v. Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365, 369-370 (1988). In addition the debtor has other rights but the essential attributes of maintaining full collateralization exists in the Code and it does not affect the value of the interest in that collateral.

As such, while some may disagree - and there are law review commentaries that go both ways, my view is that the type of “strip down” or “cramdown” as envisioned in or allowable or contained in the Dodd draft as to pre-existing mortgages is a taking. It has been so held the United States Supreme Court as recently as 1982 if not as of 1993. That is how I read the United States Supreme Court's decision in United States v. Security Industrial Bank, 459 U.S. 70 (1982) which I believe reaffirmed Radford and I believe Radford was also reaffirmed by implication in Nobelman v. American Savings Bank.

All a “taking” means is that “just compensation” has to be paid if the taking is for a public purpose. Radford held it was permissible for the Government to in effect “take the mortgage” by buying it up as it was in an economic crisis a public purpose [hence no Kelo type issues] for Fifth Amendment purposes which is what in effect is happening as part of the overall proposal – but as part of a voluntary proposal - in which the Government will pay far less.

I should conclude that on a prospective basis, this issue would be a policy issue but one that raises substantial issues. One of the rights of being a secured creditor is priority in lien rights vis-a-vis unsecured or other secured creditors. Some of this rearranging of the deck chairs can be so substantial as to effect third parties. In other words, before anyone acts full hearing should take place.

Having said that, in United States v. Rodgers, 461 U.S. 677 (1983), the Court in upholding a federal statutory provision that authorized the judicial sale of property to satisfy tax liens, cited Security Industrial Bank for the proposition that "[i]f there were any Takings Clause objection to [the statute], such an objection could not be invoked on behalf of property interests that came into being after enactment of the provision." Rodgers, 461 U.S. at 697 n.24.

The Court has repeatedly reaffirmed that the potential constitutional difficulties associated with retroactive abrogation of property rights do not arise in the context of rights created at a time when the challenged statute (or its equivalent) was part of the governing law.

As such, focus on the FDIC issue and leave the bankruptcy issue for next year.

Since the mid 1980's Irwin Nowick has worked for the California State Assembly and State Senate on a plethora of policy issues, most notably firearms legislation. He has been described as "The Assembly's resident genius" by a former Speaker of the Assembly and is seen frequently in the Capitol hallways and offices assisting legislators in drafting and amending pending legislation.