Under a provision being considered by Congress, homeowners who have been unable to get their mortgages modified by their lenders or loan servicers would be allowed to have a bankruptcy judge set new loan terms.
A bankruptcy judge could step in to reduce the principal balance on a primary residence home loan to a "current fair market value," the Treasury Department says.
This would result in savings for borrowers, but it would be an additional cost that lenders may have to absorb.
The Treasury Department calls this "judicial modification," but others refer to it as the "cramdown provision."
Michael van Zalingen, the director of home ownership services for Neighborhood Housing Services of Chicago Inc., offers this example of how a homeowner could benefit from this legislation.
The homeowner owns a house that's "underwater," that is, it's worth less than the outstanding home loan. In this case, she owes $297,000 on the house, but it's worth only $200,000. At 9 percent interest, the monthly payments of $2,887 are not sustainable because they represent 61 percent of her net income.
Under the bankruptcy option, if an appraisal confirmed that the house is worth only $200,000, the judge could reduce the loan principal by the difference, or $97,000. This would make the borrower's new monthly payment $1,609, which represents 34 percent of her net income.
The judge also would have the power to lower the mortgage interest rate, if necessary, to make monthly payments even more affordable.
Van Zalingen says the $97,000 could be wiped away by the bankruptcy judge. That would force a bank to write off this amount as a loss. Or the judge could convert the $97,000 into unsecured debt that a bank could collect if it chose to do so. But the lender wouldn't have the right to foreclose on the home.
Judicial modification doesn't currently exist for primary residence home loans. Van Zalingen says when lenders foreclose on subprime loans today they lose, on average, 58 percent of the loan's value. That means — using the above example — the lender would recover only 42 percent of the loan or $124,740 — if it chose to foreclose.
But under the provision in this scenario, the lender potentially loses $97,000 instead of $172,260 (58 percent of the borrower's loan).
The U.S. House is set to vote on a controversial measure that would give bankruptcy judges the power to rewrite the terms of mortgages. It's a key part of the foreclosure relief plan being pursued by congressional Democrats and the Obama administration.
If it passes, homeowners filing for bankruptcy could get their monthly mortgage payments lowered to something they can afford.
Proponents say that would help solve the nation's foreclosure crisis. But lenders say the measure will do more harm than good.
A 'Nuclear Weapon'
The Treasury Department calls it "judicial modification," but those in the housing industry call it the "cramdown provision," as in a judge crams a new deal that a lender probably doesn't like down the lender's throat.
"Bankruptcy cramdown is considered the nuclear weapon of foreclosure relief," says Howard Glaser, who was an official with the Department of Housing and Urban Development under President Clinton and is now a consultant to the industry. He says lenders are up in arms because they stand to lose a say in what they get paid.
"Nothing focuses the mind like a hanging. And for lenders and investors, the bankruptcy cramdown is the equivalent of a hanging," Glaser says.
Instilling that sort of fear, Glaser says, is probably not a bad thing — given the scope of 6 million or so homeowners facing foreclosure. And, he says, Washington isn't just punishing lenders without also giving them ways out.
Obama's Plan To Help Lenders, Homeowners
The Obama administration Wednesday launched its program designed to help lenders and homeowners modify mortgages outside bankruptcy court. Part of that plan involves the Treasury Department matching some concessions from lenders in order to bring mortgage payments down to affordable levels so homeowners can stay put.
If a lender offers a loan modification, a homeowner is required to at least consider it before filing for bankruptcy. Glaser says the provision would be used only if all else fails.
"Really these two things work in tandem — the carrots that are offered in the administration's housing recovery plan, and if that doesn't work, there's a big stick waiting for the investor and the lender at the end of the day," he says.
Increased Costs For Responsible Borrowers?
The financial services industry isn't convinced.
"I think that many people will be tempted to file for bankruptcy to take advantage of the cramdown," says Scott Talbott, senior vice president for the Financial Services Roundtable. He says the provision leaves homeowners the option of turning down a modification deal to try to get a better deal in bankruptcy court.
And he says it will lead to an increased cost of lending, which will get passed along to responsible families getting loans.
"It will increase the cost of borrowing for 90 percent of America that are still paying their mortgage on time," Talbott says. "It will increase the cost for future homeowners. It will have a negative effect on credit card rates as well as auto rates."
Besides, he says, the financial services industry is already doing all it can to try to stem the tide of foreclosures.
"Industry is going all out to help Americans stay in their homes," Talbott says.
No One Solution
Marietta Rodriguez directs the homeownership program at NeighborWorks America, which sponsors hundreds of community groups trying to help homeowners modify their mortgages. Rodriguez says it's hard to find a single program that will work for millions of people facing different financial circumstances. Every new program — including the latest from the administration with the judicial modification legislation — will help, but won't solve the entire problem, she says.
"The thing to remember here is all of these are tools and strategies," Rodriguez says. "There will be people who will fit into the modification program. There will be people who will fit into the refinance program, and there will be people who will benefit from bankruptcy legislation. But there will also be a sizeable pool of people that won't benefit from those three strategies or those three programs."
The Senate is expected to take up the legislation as early as this month.