The only way to guarantee help for those facing disclosure is to supplement the Wall Street bailout.
Six thousand American families are due to lose their homes in foreclosure today.
Many more American families are going to be grist for the foreclosure machine unless Congress acts to help them. But, as of today, it appears that any bailout of the financial institutions that are now in trouble after years of reckless, making predatory loans is not going to include help for homeowners.
The basis of the bailout plans now under discussion is the government’s purchase of hundreds of billions of dollars in mortgage-backed securities, or MBS. Purchasing MBS alone, however, will not solve the foreclosure crisis because it will not give the government the legal ability to modify loans and keep families in their homes.
This is because of the complicated structure of most of the troubled loans. Many are held by securitization pools, each of which was carved up into highly complex securities and sold to tens of thousands of investors around the globe.
MBS are debt securities — essentially bonds. A bond is a right to a steam of payments. It is not a right to direct management decisions. So an MBS holder has no more right to direct the management of the mortgage loans than corporate bondholders have to direct the management of the corporation.
The decision to do loan modifications rests with the mortgage servicer, which manages the mortgages on behalf of the MBS holders. For most securitization deals, the servicer’s instructions cannot be changed without the consent of two-thirds of the MBS holders.
So, in order to modify the underlying mortgages, the government would have to reassemble more than two-thirds of the tens of thousands of pieces of each of the carved up MBS deals. Many pieces have themselves been pooled and securitized, sometimes multiple times, which makes the government’s Humpty-Dumpty problem even more difficult.
The task is further complicated because many borrowers took out second or third mortgages, the pieces of which also have to be reassembled by the government in order to prevent foreclosure.
Even if the government could reassemble the pieces needed to change the servicer’s instructions, it could still not modify the mortgage loans without the consent of all MBS holders earning income from the affected MBS. So bailing out financial institutions is unlikely to provide relief to the millions of Americans facing foreclosure.
To date, efforts to help financial distressed homeowners keep their homes have relied largely on the financial services industry’s voluntary efforts. These have been ineffective at best — and harmful at worst. It seems no longer possible to trust the industry to set the terms of the public policy debate about the mortgage crisis.
First, the financial industry insisted that there would be no mortgage foreclosure crisis. It was wrong. Then it insisted the crisis would be “contained,” with minimal harm to homeowners and the economy. Wrong again. Today, as foreclosures continue to dwarf the number of voluntary loan modifications, threatening the entire U.S. economy in the process, the industry is still arguing that a limited solution — Federal Housing Admin.-guaranteed refinancings — will take care of the problem.
Given the industry’s track record, can the public gamble on their assurances — especially when mortgage servicers, who make the decisions about how to manage loans, often have a financial incentive to foreclose on distressed mortgages rather than modify them?
The only way to ensure that help is available for homeowners is to supplement the Wall Street bailout with help for consumers. One answer might be bankruptcy relief for mortgage debt, which has been the primary mechanism for resolving consumer financial distress for more than a century.
The bankruptcy system, however, is incapable of handling the current home mortgage crisis because of the special treatment due residential mortgages. Unlike virtually every other type of debt, mortgages on single-family primary residences may not be modified in bankruptcy.
This means that a family can write down credit card debt, car loans, medical bills, payday loans, loans on yachts, jewelry, and household appliances, even mortgages on vacation homes or rental property. But if they cannot make their original single-family home mortgage payments, right down to the last penny, they lose their home.
Permitting modification of mortgages in bankruptcy does not require the lenders’ consent. Bankruptcy provides a solution when lenders are unwilling, or incapable, of making a deal with homeowners. Bankruptcy relief would help homeowners keep their homes with no cost to taxpayers, would not be available for speculators, would spread losses between lenders and homeowners, and would be immediately available — unlike government programs that can take months to set up.
The financial services industry has argued that permitting bankruptcy modification of mortgages would result in a constriction of mortgage credit, higher prices for consumers, and instability in the market. These are serious concerns. But the industry has presented no evidence to support this, and all available research indicates that there would be little effect on mortgage credit availability or cost.
Widespread financial distress among homeowners lies at the base of this financial crisis. Without resolving this, a bailout of financial institutions will not right the economy. A bailout of the financial services industry could come with an explicit price tag: relief for homeowners now and serious regulatory reform later. Otherwise, the financial crisis will continue — which means Congress is just signing a blank check.
Adam J. Levitin is an associate professor of law at Georgetown University Law Center, where he teaches bankruptcy and credit transactions.
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