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Bankruptcy Is No Silver Bullet

President Obama unveiled his housing plan in Phoenix on Wednesday. (whitehouse.gov)
President Obama unveiled his housing plan in Phoenix on Wednesday. (whitehouse.gov)

President Obama unveiled his housing plan in Phoenix on Wednesday. (whitehouse.gov)

While packed with carrots encouraging mortgage lenders to modify troubled loans, President Barack Obama’s plan to stem the foreclosure crisis still awaits its stick: the empowerment of bankruptcy judges to alter the terms of primary mortgages.

That controversial measure, which will require Congressional action, is viewed by housing advocates as crucial to keeping families in their homes. Obama this week reiterated his support for the idea, but even the advocates warn that the bankruptcy provision by itself is no panacea for the foreclosure crisis.

Illustration by: Matt Mahurin
Illustration by: Matt Mahurin

Illustration by: Matt Mahurin

“Bankruptcy reform alone won’t solve the problem,” said David Berenbaum, executive vice president of the National Community Reinvestment Coalition. “It’s just one tool in the toolbox.”

The debate arrives as millions of Americans have lost their homes to foreclosure and millions more are expected to follow if the government doesn’t intervene. The nation’s lenders claim they’re doing all they can to modify mortgages to mitigate foreclosures, but those efforts failed to prevent 2.3 million homeowners from losing their homes last year — up 225 percent from two years earlier. In December, Credit Suisse projected that figure could rise above 8 million — representing 16 percent of all mortgages — by the end of 2012.

On Wednesday, Obama unveiled a sweeping $75 billion plan offering financial incentives to lenders and servicers — the companies that buy the rights to manage loans — if they modify troubled mortgages rather than pursuing foreclosures. The program is voluntary on the part of the institutions, however, and some housing groups are concerned that the incentives are too small to entice banks and securities investors to participate.

The Obama plan, for example, offers servicers $1,000 for each successful loan modification, and an additional $1,000 annually for each year the borrower stays good on the payments — up to three years. To encourage industry pro-activity, servicers would receive $500, and mortgage owners $1,500, for every at-risk loan modified before a borrower falls behind on payments.

Those are the carrots. The change in bankruptcy law would be the stick.

Under current bankruptcy law, judges have the power to reduce, or “cram down,” the rates and principal of most loans, including those governing the sale of yachts, vacation homes and almost any other saleable item. An exception, however, was carved out for primary mortgages, the terms of which cannot be altered by judges — something Obama wants to see changed.

“That’s the rule for investors who own two, three, and four homes,” Obama said in unveiling his housing plan in Phoenix this week. “It should be the rule for ordinary homeowners too, as an alternative to foreclosure.”

The House Judiciary Committee passed a cramdown bill late last month, but not before weakening the proposal by limiting the bankruptcy option only to existing mortgages. That is, homeowners taking out mortgages after passage of the bill wouldn’t have the bankruptcy option. An identical proposal, sponsored by Sen. Richard Durbin (D-Ill.), the Senate’s second-ranked Democrat, awaits action in the Senate.

Durbin spokesman Max Gleischman said that many Democrats supported a stronger bill that would have applied also to future mortgages, but party leaders agreed to concessions to secure the support of Citigroup Inc., which bucked industry sentiment earlier this year by supporting Durbin’s bill. “It’s a compromise we made,” Gleischman said.

Gleischman said that lawmakers hope to have the bill — as part of a larger housing package — passed before lawmakers leave town for a two-week Easter break, which begins the first week of April.

It won’t be nearly enough. In a report released last month, Credit Suisse estimated that the bankruptcy provision would reduce foreclosures by 20 percent. While nothing to balk at, the figure also emphasizes that the problem is much larger than the bankruptcy provision alone can fix.

Berenbaum and the National Community Reinvestment Coalition are pushing an additional proposal allowing the Treasury Department to buy troubled mortgages directly from the securitized pools where they wallow. The government could then modify the loans and resell them to the banks.

“The ongoing reliance on voluntary loan modifications has failed to reduce foreclosures,” the NCRC said in a statement earlier this month, “but through compulsory purchases of troubled loans, reluctant servicers, investors and lenders would not need to be persuaded to participate.”

Advocates are also pushing anti-predatory lending legislation to accompany the bankruptcy provision — a necessity, they argue, to prevent a rash of bad loans from plaguing the future. In 2007, House Democrats passed a predatory lending bill, sponsored by House Financial Services Chairman Barney Frank (D-Mass.). But with a slim majority in the Senate, Democrats never had a chance of pushing the bill through the upper chamber.

Frank spokesman Steven Adamske said this week that the anti-predatory lending bill remains on the Democrats’ radar this year, but it won’t be a part of the housing package expected to surface next month. “That’s going to take a lot more work,” he said.

The finance industry and many conservatives continue to oppose the cramdown concept. David John, a housing expert at the Heritage Foundation, warned that the threat of bankruptcy “adds an additional layer of uncertainty” that will lead to higher costs for borrowers, particularly those with lower incomes who represent a greater risk to lenders. “Financial institutions must include some additional fee to cover the additional risk,” John said. “It might help people today, but in the long run you’re pricing people right out of the market.”

There are other hurdles. Christopher Mayer, a finance expert at Columbia University, told House lawmakers last month that the nation’s federal judges — who currently number less than 370 — would be overwhelmed by the rising tide of bankruptcy filings.

John Jackson, president and CEO of Lending Cycle, a Kentucky-based lending software company, seconded that criticism. “Several hundred bankruptcy judges won’t be able to handle it,” he said.

Supporters of the cramdown provision don’t buy the argument. David Abromowitz, senior fellow at the Center for American Progress, pointed out that the court system has already absorbed a steep rise in bankruptcy filings after the law was changed in 2005.

“We got past history where the bankruptcy courts have been able to handle a big spike [in caseload],” Abromowitz said. “I can’t imagine that an argument against something that would work is that there aren’t enough people to manage it.”

At this point much of the debate over cramdown is noise. “Most in the industry,” said Gleischman, “are resigned to the fact that this will become law.”

It’s power to prevent foreclosures remains to be seen.

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