Another writedown risk: Chapter 7 Bankruptcy

The risks going forward for financial institutions and their capital base are large and growing. The blog CalculatedRisk has reported on yet another story that should give chills to bankers. This one is very significant: Chapter 7 bankruptcy.

A judge recently ruled against Cleveland-based regional National City in a case involving stated income loans. These loans, otherwise known as Liar Loans, give the borrower the opportunity to state one’s income without further verification from the bank. In return for this privilege, the interest rate is set higher, because the risk on these loan types is higher.

Calculated Risk states:

Judge Leslie Tchaikovsky ruled that a National City HELOC that had been “foreclosed out” would be discharged in the debtors’ Chapter 7 bankruptcy. Nat City had argued that the debt should be non-dischargeable because the debtors made material false representations (namely, lying about their income) on which Nat City relied when it made the loan. The court agreed that the debtors had in fact lied to the bank, but it held that the bank did not “reasonably rely” on the misrepresentations.

I argued some time ago that the whole point of stated income lending was to make the borrower the fall guy: the lender can make a dumb loan–knowing perfectly well that it is doing so–while shifting responsibility onto the borrower, who is the one “stating” the income and–in theory, at least–therefore liable for the misrepresentation. This is precisely where Judge Tchaikovsky has stepped in and said “no dice.”
–Calculated Risk, 29 May 2008

Now, until recently, these loans were designed strictly for self-employed individuals with volatile income streams. They were not for general consumption. However, as the bubble took hold, banks started to market these loans to the general public. Many used this as an opportunity to lie and state an income grossly in excess of their true income, putting their ability to repay the loan at risk.

The ruling clearly shows that the lender will get stuck with some of the default risk. They cannot shift the risk over to borrowers. This has huge implications for the amount of writedowns likely to made as a result of subprime and Alt-A loans. Watch as these cases make their way through the courts. Financial service companies will fight tooth and nail to have this ruling overturned.

See also: Credit Crisis Timeline for a full list of writedowns and capital raising by institution and a timeline of the credit crunch.