Mortgage relief via the courts
Congress is poised to give bankruptcy judges more power to modify primary home mortgages in an attempt to halt the foreclosure crisis, a move Democrats and housing advocates have been pushing for two years in the face of stiff opposition from Republicans and the mortgage industry.
The House is expected to pass the legislation today, and supporters are optimistic that the Senate will follow next month.
For existing mortgages only, the measure would remove an oddity in bankruptcy law: Judges can reduce, or cramdown, the principal on a vacation home, car or boat, but they cannot do it to a mortgage for a primary residence.
As it is now, bankruptcy often results in higher mortgage payments on a primary residence because skipped payments and other fees are tacked onto the principal, for which homeowners are responsible under their repayment plans.
Backers hope the change in the law would be a strong incentive to banks and other mortgage holders to modify existing loans. They don’t believe it would send borrowers rushing into court seeking to reorganize their debts under Chapter 13 of the bankruptcy code, an unpleasant and arduous task that stains a credit report for at least seven years.
They also have the support of President Obama.
“We thought bankruptcy was needed as a way to say to the industry, ‘If you don’t do it, somebody’s going to do it for you,’ ” said Kathleen Day, a spokeswoman for the Center for Responsible Lending, a nonpartisan group that targets what it calls abusive lending practices.
A provision in the legislation would force people to seek a voluntary modification of their mortgage before going to Bankruptcy Court. And the change would apply only to mortgages in place when the legislation is signed into law, not future ones.
But the mortgage industry, with a few exceptions, opposes the bill. Companies argue that allowing bankruptcy judges to modify mortgages for primary residences ultimately would hurt consumers because lenders would have to raise loan costs to compensate for the increased risk that some principal might be forgiven.
“That’s exactly what we need, the cost of financing homes to go up, in the economy we have right now,” said David G. Kittle, chairman of the Mortgage Bankers Assn., adding that the risk of Bankruptcy Court revisions is what makes the interest rates on second-home mortgages and even credit cards higher than those on primary residence loans.
But opposition is faltering as foreclosures continue to drive the dramatic fall in home prices. Foreclosures, including default notices, jumped 81% last year, involving 2.3 million properties -- 523,624 in California -- according to foreclosure data firm RealtyTrac. As many as 8 million homes are believed to be threatened with foreclosure.
Troubles in the housing market -- existing home sales dropped in January to the lowest level since mid-1997 -- have helped fuel the deep recession, and economists say that reducing mortgage debt is a key to recovery.
Congressional Democratic leaders tried to change the bankruptcy provision last year but were unable to overcome Republican opposition in the Senate and the threat of a veto from President Bush.
But more Democrats are now in the Senate, and Obama sits in the Oval Office.
“My administration will continue to support reforming our bankruptcy rules so that we allow judges to reduce home mortgages on primary residences to their fair market value, as long as borrowers pay their debts under a court-ordered plan,” Obama said this month in unveiling his plan to reduce foreclosures.
“I just want everybody to understand, that’s the rule for investors who own two, three and four homes,” he said. “So it should be the rule for folks who just own one home as an alternative to foreclosure.”
The legislation would limit the new bankruptcy rules to existing mortgages. Homeowners would have to seek a voluntary modification from their mortgage holder at least 15 days before filing for bankruptcy. And the bill would require the homeowner to share the profit from a home sale with the lender if it takes place within four years of the bankruptcy. The bank would get 80% of the profit in the first year, 60% in the second, 40% in the third and 20% in the fourth.
Citigroup endorsed the legislation in January, providing a strong boost to supporters such as Sen. Richard J. Durbin (D-Ill.), who has pushed for the change for two years.
And though the American Bankers Assn. opposes the legislation, it also is working to tighten some provisions to limit any negative effects. For instance, it seeks better assurance that homeowners seek a voluntary change in their loans 15 days before heading to Bankruptcy Court.
“If we’re going to make changes in the bankruptcy code, how can we ensure that bankruptcy is the last resort, not the first option?” said Floyd Stoner, the trade group’s executive vice president for congressional relations.
The Congressional Budget Office estimated that more than 1 million households would benefit financially by filing for bankruptcy protection if the legislation is approved. But based on studies of how many people who could benefit from such protection actually file for bankruptcy, the agency estimated that the change would lead to 350,000 additional cases over the next decade -- with two-thirds coming by 2012.
John C. Colwell, owner of the Debt Relief Legal Clinic, which has three locations in San Diego County, predicted that he would see more people looking to file for bankruptcy because of mortgage problems if the law is changed. But he also predicted it would increase the number of voluntary loan modifications made by lenders.
“It’s going to be a powerful tool, no question,” said Colwell, a board member of the National Assn. of Consumer Bankruptcy Attorneys. “Either we’re going to do it in Chapter 13 or the banks are going to say, ‘Oh, we don’t want that to happen. We’ll do it ourselves.’ ”
Four Republican members of the House -- Spencer Bachus of Alabama, Shelley Moore Capito of West Virginia, Trent Franks of Arizona and Lamar Smith of Texas -- wrote to Treasury Secretary Timothy F. Geithner this week warning of the legislation’s potential fallout. They were particularly concerned with taxpayers’ exposure to losses on modified loans backed by the government or bailed-out banks.
“Although allowing for this type of modification in bankruptcy may have the short-term effect of lowering bankruptcy petitioners’ monthly payments, it is certain to yield negative long-term consequences for taxpayers and the federal government that will dwarf any benefit to the economy that cramdowns might create,” they wrote.
But the budget office estimated that the legislation would result in the government making $23 million over the next 10 years, largely because of the increased Bankruptcy Court filing fees.
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