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Key Tool for Stabilizing the Housing Market

January 23, 2009
Mortgage Lending

The foreclosure crisis is even worse than expected, and projected to worsen

Recent industry projections are that over 8 million families will lose their home to foreclosure over the next four years. That's 1 in every 6 homeowners with a mortgage. If the economy enters deep recession, the number of homes lost could exceed 10 million. With the housing sector responsible for one in eight US jobs, the flood of new foreclosures will contribute to the growing unemployment rates, and further constrict consumer spending.

Many of the coming foreclosures are needless because the homeowner could afford to pay a market rate mortgage, for the full current value of the house – an outcome that is far preferable to foreclosure for homeowner and mortgage lender alike. All the lender would have to do is to modify the loan to make it economically rational, and sustainable.

Unfortunately, this has not been happening. In October, Credit Suisse reported that only 3.5 percent of delinquent subprime loans received modifications in August 2008 – and in many cases, these "modifications" actually increased the borrower's monthly payments. The State Foreclosure Working Group of Attorneys General and Banking Commissioners found that nearly 8 out of 10 seriously delinquent homeowners are not on track for any loss mitigation at all.

The problem is that the lenders who made the loans no longer own them, and the "loan servicers" – the companies that manage the loans for far-flung investors – have strong disincentives to modifying loans, even where modification is in the clear best interest of the investors as a whole. Moreover, many homes have two mortgages, owned by two separate sets of investors, and the holder of the primary mortgage will not modify without the cooperation of the second mortgage-holder, and the second mortgage-holder has no incentive to cooperate.

Unless a court is empowered to break the deadlock, and implement a rational solution when the parties themselves are unable, the foreclosure crisis will continue unabated.

This is precisely what bankruptcy courts do every day, for all debts – except for the mortgage on the primary residence. S 61 and HR 200 would eliminate this exception, for existing loans at risk of foreclosure.

Court-supervised loan modification in bankruptcy is available for owners of commercial real estate and yachts, as well as subprime lenders like New Century, and Wall Street firms like Lehman Brothers, but is denied to families whose most important asset is the home they live in. In fact, current law makes a mortgage on a primary residence the only debt that bankruptcy courts are not permitted to modify in chapter 13 payment plans.

S 61 and HR 200 would lift the ban on modification of mortgages on the primary residence. The court would be able to "cram down" the mortgage to the current value of the home. The rest of the loan balance would be repayable with other unsecured debts out of the borrowers assets and income over the 3 to 5 years in which the bankruptcy case is pending.

This has been done before, successfully: Congress did this for Family Farmers during the Farm Crisis of the 1980s.

Precedent for this solution can be found in the Family Farmer Bankruptcy Act of 1986, which created what is now Chapter 12 of the Bankruptcy Code. The Act was enacted in response to the farm crisis of the 1980s for the specific and express purpose of permitting Bankruptcy judges to modify mortgages on family farms, permitting adjustment of interest rates and the "cram-down" of principal, in order to help distressed farmers avoid foreclosure, including on their primary residence. It proved effective in helping farmers through the crisis, and did not give rise to any of the problems, discussed below, that are now raised as concerns about the current bill. In fact, after being extended several times, the Family Farmer Bankruptcy Act was made a permanent part of the Bankruptcy Code, with bipartisan support, in 2005.

S 61 and HR 200 provide greater protections to lenders than exist in Chapter 12.

  • Lender Gets Right to Voluntarily Modify: Relief is available only to borrowers who were unable, after trying, to reach a workable agreement with the lender.
  • Relief is Available Only as an Alternative to Foreclosure: Only homeowners facing foreclosure qualify for relief. Homeowners who can repay their loans do not qualify.
  • Strict Limits: The Act limits the kinds of modifications the court can do, and guarantees lenders market rate terms. Courts cannot reduce interest rate below market rate plus a premium for risk, and cannot reduce lien amount below the home's current value.
  • Only for Homeowners Who Can Afford to Comply With Modified Terms: Homeowners who cannot afford to repay the loan on the above terms cannot get relief under the Act.
  • Provides no relief for "scammers"
    • Relief requires compliance with a Chapter 13 repayment plan – and 3 to 5 years under court-supervision of all payments and credit transactions.
    • Does not let high income borrowers off the hook–the amount of the mortgage that is "crammed down" is still repayable out of the borrower's income during the 3 to 5 years of the bankruptcy plan.
    • The borrower must be acting in "good faith" – Lenders who believe the borrower is "scamming," can challenge on this basis the borrower's right to relief.

S 61 and HR 200 would be effective, immediately implementable, and cost the Treasury nothing, and puts the burden of the solution where it belongs – with the lender and borrower who made the troubled loan.