Last summer, Congress approved what was billed as a bold plan to stave off foreclosures by luring lenders and borrowers into renegotiating mortgages. So far, fewer than 400 homeowners have applied. Other government and private programs to modify loans have had somewhat more uptake, but still haven't done much to slow the unprecedented wave of foreclosures sweeping the country.
And so next month, lawmakers will reconsider another, bolder plan: letting bankruptcy judges force lenders into modifying mortgages. It might actually work.
The bankruptcy proposal came up in Congress several times over the past year, but was thwarted by opposition from Republicans and the banking industry. Now, however, the banking industry and its lobbyists have lost a lot of sympathy, the new Congress that meets Jan. 6 will contain significantly fewer Republicans, and President-elect Obama—unlike the current occupant of the White House—is a big supporter of the plan.
Even some in the mortgage business are beginning to warm to the concept. "As a matter of general policy it is probably bad," says Scott Stern, CEO of Lenders One, a national cooperative of independent mortgage brokers. "But I think extreme circumstances call for extreme responses."
Just what is this plan? As the law stands now, a mortgage on a first home cannot be modified as part of a personal bankruptcy proceeding. Second-home mortgages, apartment-house mortgages, and loans on yachts and other property all can. In those cases, a bankruptcy judge has the power to force forgiveness of some of the debt as part of a repayment plan. The bill that Sen. Dick Durbin of Illinois and Rep. Brad Miller of North Carolina plan to introduce on the first day of the new session would give judges the power to do the same thing with first-home mortgages.
The problem the bill is intended to address is that there are so many different parties involved in modern mortgages that it's sometimes impossible to get them to agree on anything. Servicers have different incentives from investors—and those investors are often scattered around the world. First-lien holders have different incentives from second-lien holders. The result is often deadlock, even when renegotiating the mortgage and writing down its value would result in lower losses than foreclosure. A bankruptcy judge could cut through all this and force compromise.
Banking industry groups, and some finance scholars, counter that there's a downside: If you make it easier for people to get out of their mortgage debts, mortgage lenders will demand bigger down payments and higher interest rates to compensate them for the added risk. This argument makes some sense in terms of economic theory, but there are several real-world problems with it.
One is that we're in the midst of an epic housing collapse that demands dramatic solutions—even if they might come with some costs down the road. That's mortgage broker Stern's position. "There is currently already a loss of integrity in the system," he says, "and we're not letting bankruptcy judges modify mortgages." Stern only endorses a temporary change in the law. Durbin and Miller's bill will call for a permanent shift, but last year Durbin amended it so it applied only to mortgages extended before the bill was passed, and he'll presumably be willing to do the same if that's what it takes to pass it.
It's not clear, though, that the arguments against allowing a permanent change bankruptcy law really hold any water. For one thing, too-small down payments were a major cause of the current foreclosure epidemic, so a change that would goad lenders into requiring bigger ones might do more good than ill. What's more the bankers' economic argument is not backed up by the available evidence.
Georgetown Law professor Adam Levitin and Columbia economics graduate student Joshua Goodman gathered this evidence recently by taking advantage of a quirk in judicial history. Between 1979 and 1993, about half of all federal judicial districts interpreted bankruptcy law to mean that judges could modify first-home mortgages, while the other half interpreted it to mean they couldn't. The Supreme Court put an end to this in 1993 by ruling that the latter approach was what the law called for. Levitin and Goodman examined mortgage data from before then, and concluded "that mortgage markets are largely indifferent to bankruptcy modification outcomes." The reason for this, they contend, is that "lender losses in foreclosure would be greater than in bankruptcy, and so permitting bankruptcy modification as an alternative to foreclosure would, if anything, benefit lenders."
Before 1979, lenders had veto power over any loan modifications in bankruptcy. But before 1979, lenders were generally banks and thrifts that held onto the loans they made. If modifying a mortgage loan would result in less of a loss than foreclosing on it, they would modify. Today the gridlocked mortgage markets that securitization has wrought don't seem capable of making such rational economic decisions. Bankruptcy judges may need the power to do it for them.