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Who Should Be in Charge of Modifying Bad Loans?

April 15, 2008 - by Donny Shaw

When the Senate debated their housing stimulus bill last week, Democrats decided to leave out their proposal to let bankruptcy judges modify the terms of subprime loans in order to help ensure bipartisan support for the overall bill. But they are still hoping to get the bankruptcy proposal passed in the form of a stand-alone bill. While Democratic leaders in both the House and Senate are trying to shore up support for the measure, the mortgage industry is intensifying their push against the bill and trying to refocus Congress’ attention on a milder alternative.

The bankruptcy bill, which has been introduced in the Senate by Dick Durbin (D-IL) and in the House by Brad Miller (D-NC) and Linda Sanchez (D-CA) could help 600,000 or so families save their homes from foreclosure, according to research by the Center for Responsible Lending. According to a post Miller’s DailyKos diary, “home mortgages are the only form of secured debt that is exempt from modification in bankruptcy. A bankruptcy court can modify a mortgage on investment property, a car loan, or a loan secured by a washer and drier, but not a home mortgage.” Both the Senate and House bills would eliminate the home mortgage exemption, and because bankruptcy courts are already modifying other kinds of debt, there’s already an established body of law on how to do it:

>If the debt exceeds the value of the collateral, the court can limit the debt secured by the collateral to the value of the collateral and treat the rest as unsecured, which goes to the back of the line for payment. And the court can then set a term of up to thirty years and an interest rate of prime plus a couple of points, because someone in bankruptcy is a greater risk than the typical debtor.

The reporters at CongressDaily ($) are true Hill insiders, and on Tuesday they reported that mortgage industry lobbyists have come to D.C. this week to “fight hard” against the measure. Here’s part of an op-ed from the chairman of the Mortgage Bankers Association that explains their opposition:

>For all of its well-intentioned language, the current bankruptcy proposals in both houses of Congress will result in higher interest rates, larger down payment requirements and tighter lending restrictions, all to the detriment of future borrowers.
>Why? Because lenders will respond to new risks associated with loans being altered by a judge. The result — the American Dream of homeownership will be put on hold for millions.
>The real winners in bankruptcy reform are bankruptcy attorneys. At an average of $3,000 per filing, this group stands to gain $1.8 billion.

According to the CongressDaily article, the mortgage industry lobbyists are “taking a more neutral approach” to a competing loan modification bill, the Emergency Mortgage Loan Modification Act. That bill would shield banks and other financial institutions that services mortgages from being sued by debt-holding investors when they modify subprime loans.

“I think it’s in the best interests of at-risk homeowners and investors to work out payment terms that give a homeowner financial stability and the investor some return for their investment,” the bill’s sponsor, Michael Castle (R-DE) said upon introducing it. “Without this legislation, I am concerned that lawsuits could bring modifications to a halt.”

In order to be legally protected while modifying loans, the bill requires mortgage servicers to work towards maximizing, or at least not adversely affecting, returns for mortgage investors in the aggregate. It states that servicers will be considered to be working on behalf of the investors, and shielded, if they can show that they reasonably believed that their loan modificatios would “maximize the net present value to be realized on the loan over that which would be realized through foreclosure.”

This financial protection for the mortgage industry is not a part of the Democrat’s bankruptcy proposal. Under the Democrats’ bill, the bankruptcy judges who would be in charge of reworking mortgages would not be held liable for maximizing investors’ profits. There would be no aggregate consideration — just case-by-case rulings for people who file for bankruptcy as an attempt to save their homes.

It seems to me that the mortgage servicer shield bill isn’t being tacitly supported by the mortgage industry as a lesser of two evils, but because it would actually be boon for them. It would create an army of independent mortgage servicers, motivated by the fees they collect, delaying foreclosures just to the extent that it is still financially beneficial to investors, and no more.

This is all well outside my area of expertise, so I’d love to hear anybody else’s thoughts on this. Is there some major part of this that I’m missing?

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