WASHINGTON — For the first time since the housing crisis began, a major mortgage lender agreed Thursday that courts should be allowed to order reductions in the principal of "underwater" loans for some troubled borrowers, cracking what had been fierce and unified industry opposition.
The agreement struck between congressional Democrats and Citigroup Inc. would permit bankruptcy judges to change the terms of mortgages as part of court-ordered debt restructuring. Democrats hope to include the provision in the upcoming economic rescue legislation under negotiation between Congress and the incoming Obama administration.
The suggested change in the nation's bankruptcy laws has been repeatedly proposed -- and defeated -- in recent years.
Under Chapter 13 of the U.S. Bankruptcy Code, judges currently have the right to reduce the principal of auto, credit-card and other loans but cannot reduce the principal on a primary mortgage under any circumstances. As a result, homeowners who go into bankruptcy often wind up with mortgage payments that are even higher than the ones they had before, after skipped payments and other fees are added to the principal.
Some housing experts and many Democrats blame this unwillingness to reduce the principal on mortgages for the difficulty that many homeowners have had as they try to modify their mortgages and avoid foreclosure.
But giving bankruptcy judges the power to "cram down" mortgages has been opposed by congressional Republicans and mortgage lenders such as Citigroup, who have warned that it would make providing loans riskier and, because of that, reduce the amount of credit available to buyers.
The measure was termed a deal-breaker in last fall's $700-billion Wall Street bailout bill and was left out of the final package. But Democratic leaders said Citigroup's about-face could be the crack that breaks the banking community's dam of opposition to the idea.
"This is the breakthrough we've been waiting for," said the bill's chief sponsor in the Senate, Sen. Richard J. Durbin (D-Ill.). "They can make a big difference in convincing their fellow institutions to join us."
Last month, the powerful National Assn. of Home Builders also switched positions, removing its objections to a similar bill in the House sponsored by Rep. John Conyers Jr. (D-Mich.). That move was another signal that the bloc of industry groups lined up against the legislation is fissuring as the foreclosure crisis has worsened.
Durbin said the measure was necessary to stem the rapid rise in foreclosures, which have quadrupled since the fall of 2007, potentially affecting more than 8 million homeowners nationwide.
So far, lenders modifying mortgages have focused on other means of reducing monthly payments, including extending the term of the loan and reducing the interest rate.
But there are indications that those borrowers were running into trouble again, either because their payments remained too high or because their homes had lost so much value that it was unrealistic to continue making payments on the full value of the principal.
Moreover, economic conditions have significantly worsened in recent months. And some banks, including Citigroup, have received new infusions of capital as part of the government's economic rescue programs and may be in a better position to resume lending.
In a statement, Citigroup said it would support Durbin's legislation provided that it applied only to mortgages in effect before passage of the act. To be eligible, borrowers would have to contact their lenders and try to work things out before filing for bankruptcy.
The company also said it would support the proposal only if a provision was eased that would void the mortgage if the lender was found to have violated consumer protection laws.
The exception would be if the lender violated specific sections of the Truth in Lending Act that already carried such rescissions of mortgages as penalties.
In letters to members of the House and Senate, Citigroup Chief Executive Vikram Pandit endorsed the proposal, saying, "This legislation would represent an important step forward. Given today's exceptional economic environment, we support its swift passage."
In his statement, Pandit did not specify why the company had changed its position.
But Durbin said that earlier efforts to slow the rate of foreclosures were obviously not succeeding.
"I think they may have come to this with some reluctance, but became resigned to the fact" that foreclosures were escalating, Durbin said.
It is unclear whether other banks will join Citigroup. But Sen. Charles E. Schumer (D-N.Y.) said his office has heard from other banking executives who wished to discuss the legislation.
"My office has now been called by heads of most of the major banks in the country, saying they want to hop on board," Schumer said Thursday after the deal was announced. "And I'm now hopeful that we can get the banking industry to be supportive of this provision -- at the very least, not oppose it."
Industry groups remain concerned that the bill would apply to all mortgages, not simply the subprime loans that helped spark the current recession. That, they argue, would provide some homeowners with an incentive to seek bankruptcy or buy a larger house than they may be able to afford.