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Rethinking Cramdowns as Foreclosures Roll On

As Mike Lillis reported yesterday, a small group of Senate Democrats is pushing to revive the mortgage loan cramdown idea — a sure sign of frustration as foreclosures continue to pile up. The Senate in April defeated a cramdown proposal, which involves allowing federal judges to modify, or cramdown, the terms of a mortgage for a borrower in bankruptcy. At that point, it looked like cramdown was dead. But Sen. Richard Durbin (D-Ill.) who initially pushed for cramdown measure, wants the proposal to get another shot.

Durbin’s new initiative is raising the hopes of cramdown proponents. At Creditslips, University of Illinois law professor and credit expert Robert Lawless called Durbin’s revival “hopefully an indication there may be some interest in moving the legislation forward.”

There have been increasing reports (e.g., here) recently that lenders are not doing voluntary mortgage modifications in the numbers that need to happen. Yeah, I know — who could have possibly foreseen the possibility that a solely voluntary system would not work? There need to be carrots that encourage lenders to do the modifications. The change in the bankruptcy law is the missing piece — the stick that makes the program work.

A renewed interest in cramdown may have less to do with a sudden acknowledgement of its merits than the shortfalls of Making Home Affordable, the Obama administration’s program to encourage loan modifications. The goal of that program is to rework loans for 3 to 4 million borrowers. But a new report by the General Accounting Office calls that estimate too optimistic. It also says the administration needs to do more to make sure servicers are equipped to participate – and that they follow the rules, CNN Money reports.

The GAO also critiqued the administration for not having the controls in place to properly monitor the program. Specifically, the agency is concerned that Treasury is not evaluating servicers’ capacity to meet the plan’s requirements and guidelines. Also, the agency has failed to fully staff the Homeownership Preservation Office, which is responsible for overseeing the modification program.

And, though Treasury has hired Freddie Mac to review servicers’ performance, it has not put established procedures to address those servicers who don’t comply.

Already, reports have surfaced that financial institutions are not adhering to the program’s rules. At a Senate Banking Committee hearing last week, a consumer advocate said some servicers are violating the guidelines by demanding upfront payments, denying borrowers not in default and initiating foreclosures while borrowers’ applications are being reviewed. Senator Christopher Dodd, D-Conn., has asked the administration to look into these allegations.

Given those drawbacks, it’s little wonder that tactics like cramdown are being revived. The Obama administration plans to meet with servicers July 28, to pressure them to modify more loans. But with rising unemployment contributing to a record 1.5 million foreclosures just in the first half of this year, a strategy that involves more than just a carrot may be called for. The Obama administration stood on the sidelines before, as cramdown failed, and has openly abandoned the idea. But unless it can get servicers to not only write down loans but to reduce loan balances as well — something that hasn’t happened so far – it may be forced to rethink that decision and take a second look at cramdown, the missing stick in its strategy so far.

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