Mortgage relief via the courts

The House is expected to back legislation enabling bankruptcy judges to reduce loan balances. Lenders object, but economists say reducing mortgage debt is a key to an economic recovery.

February 26, 2009|Jim Puzzanghera

WASHINGTON — 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.

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