Legislation that would force lenders to restructure many loans through means including "cramdowns" by bankruptcy judges could raise the cost of borrowing and make loans harder to obtain, opponents say.
Sen. Richard Durbin’s Homeowner Assistance and Taxpayer Protection Act is aimed at forcing lenders and loan servicers to modify hundreds of thousands of mortgages they might otherwise foreclose on.
Backers of the Illinois Democrat’s bill say lenders and loan servicers aren’t moving fast enough to head off preventable foreclosures — in part because in many cases, the loans have been securitized and sold to investors.
Durbin’s bill would require restructuring of loans where federal regulators such as the FDIC hold a controlling interest, and also require loan servicers to restructure all loans that qualify for the Hope for Homeowners FHA loan guarantee program, which is currently voluntary.
Another controversial provision of Durbin’s bill is a proposal to allow bankruptcy judges to modify the terms of mortgages on primary residences, including writing down principal. Senate lawmakers killed an attempt to include cramdown powers in a previous foreclosure prevention bill.
Allowing forced "cramdowns" or "lien-stripping" — the reduction of mortgages to the fair market value of the property — will encourage large numbers of bankruptcies, opponents say.
At a Senate Banking Committee hearing today, opponents warned of a potentially bigger problem. If judges can rewrite loan terms, they said, lenders will be even more cautious about extending credit to home buyers — at a time when the government is trying to relieve pressure on banks and stimulate additional lending at favorable terms and rates.
The unintended result of bankruptcy cramdowns would be "large numbers of bankruptcies, higher losses to servicers, lenders and investors, and reduced ability by the financial industry to extend affordable credit," Mortgage Bankers Association Chairman David Kittle said in prepared testimony to the Senate Banking Committee.
Bankruptcy cramdowns, he said, would "have a negative impact on individual borrowers, a housing recovery and the economy as a whole."
Kittle noted that in recent weeks investors have been less willing to buy mortgage-backed securities backed by Fannie Mae and Freddie Mac.
"Giving bankruptcy judges the ability to cram down mortgage debt does nothing to reassure investors as to the value of their investments," Kittle said.
"If, with a stroke of a pen, the U.S. government could eliminate the secured nature of these investments whenever there is a cyclical downturn, why would investors return to our mortgage markets?" Kittle asked. Investors will "simply take their money to other, more secure and predictable investments or demand a much higher return for the added risks."
Cramdowns would also send the value of existing mortgage-backed securities plummeting, he said, as more investors dumped securities collateralized by subprime mortgages.
In the past, the MBA has warned that cramdowns could increase rates on mortgages by 1.5 percent to 2 percent. That would put further downward pressure on housing prices, as higher interest rates reduce home shoppers’ buying power. The National Association of Realtors is pushing for the government to move interest rates in the other direction, through temporary buy-downs of mortgage rates to 4.5 percent or less (see story).
Cramdowns would not only push up interest rates and other fees, Kittle warned, but lenders would have to raise minimum down-payment requirements, because there would be no other way to protect themselves from the risk.
Given an average U.S. home price of $313,600 in 2007, a 10 percent minimum down-payment requirement would mean home buyers would need $31,000 to purchase a home. Many borrowers would be required to put 20 percent down, Kittle said, "leaving them in search of more than $62,000 for a down payment."
Borrowers seeking to purchase a home with a down payment of less than 20 percent rely on FHA and VA guarantee programs and private mortgage insurance that cramdowns will "render useless," Kittle said.
Kittle said the FHA and VA aren’t allowed to pay claims for amounts stripped down in bankruptcy court. So servicers that administer Ginnie Mae securities backed by FHA and VA guaranteed loans would be forced to absorb "losses they never contemplated," placing Ginnie Mae in the position of having to keep payments flowing to bond holders.
While Durbin’s bill and other failed legislation to allow bankruptcy cramdowns have been aimed at subprime and nontraditional loans, "FHA and VA loans are not insulated from the havoc bankruptcy reform would wreak," Kittle said.
If "subprime" is defined as a loan with an APR three points over comparable Treasury securities, that captures many government and prime loans originated after the first quarter of 2008, when spreads between Treasuries and Ginnie Mae securities widened.
There are similar issues with private mortgage insurance, Kittle said, meaning Fannie Mae, Freddie Mac and portfolio lenders who depend on such insurance would see greater losses from cramdowns than foreclosures.
One proponent of cramdowns, professor Adam Levitin of Georgetown University Law Center, said the foreclosure prevention efforts put in place by the lending industry and government have showed "dismal results." At the current rate, Levitin said, the U.S. is on track for 6.5 million homes to end up in foreclosure by 2012.
While the industry’s HOPE Now Alliance of loan servicers claims to have completed nearly 2.5 million workouts, most of those have been repayment plans that provide a short-term fix rather than sustainable loan modifications, Levitin said. The "vast majority" did not reduce monthly payments, making them "near worthless," he said.
Interest by lenders in the FHA’s Hope for Homeowners program has been "underwhelming," said Michael Calhoun, president of the Center for Responsible Lending, noting that the FHA received less than 100 applications during its first month of operation.
The Bush administration today announced that it is broadening the Hope for Homeowners program to allow participating lenders to take smaller write-downs when they agree to let troubled borrowers refinance into more affordable loans. The expanded Hope for Homeowners program will also offer holders of second or "piggyback" loans an immediate payment if they agree to release their liens.
Calhoun called another proposal — for the government guarantee 50 percent of investor losses on loans modified under guidelines proposed by the FDIC — "the most promising voluntary program proposed to date." The Bush administration has so far rejected that approach, opting instead for a voluntary streamlined modification process spearheaded by the HOPE Now Alliance, Fannie Mae and Freddie Mac.
But Calhoun said even the FDIC proposal may not help significant numbers of subprime borrowers whose loans serve as collateral for "private label" mortgage-backed securities that are not guaranteed by Fannie Mae or Freddie Mac. Cramdowns, he said, would provide "a critical backstop for borrowers who could afford market-rate loans but are not assisted by voluntary efforts."
Calhoun said allowing bankruptcy cramdowns could help 600,000 families at risk of foreclosure remain in their homes. Not all of those families would need to file for bankruptcy, Calhoun said, because loan servicers would be more willing to do voluntary modifications if they knew they could be forced to do so in court.
"The primary goal of lifting the ban on court-supervised modifications is to induce voluntary modifications," Calhoun said.
Because more than 80 percent of residential mortgages are securitized and sold to private investors, "private, voluntary efforts at mortgage modification will inevitably fail," Levitin said. Forced loan modifications by bankruptcy judges are "the only sure method of preventing preventable foreclosures."
Loan servicers are required to follow pooling and servicing agreements, which typically require loans be in default or imminently defaulting before they can be modified. Some agreements forbid loan modifications altogether, or restrict the number and type that can be carried out within a pool of loans.
It’s "virtually impossible" to change the terms of a restrictive pooling and service agreement to give servicers more leeway to do modifications, Levitin said, and the consent of all investors in a particular mortgage-backed security is needed to change the agreements. A pool of loans may be held by thousands of investors, and practically speaking, "it is impossible to gather up 100 percent of any MBS issue," Levitin said.
He dismissed past claims by the Mortgage Bankers Association that allowing bankruptcy cramdowns would raise interest rates by 1.5 to 2 percent as "patently false."
Because bankruptcy judges are already allowed to modify the terms of investment properties but not a homeowner’s principal residence, the MBA bases its claim on the interest-rate spread between mortgages on single-family homes and investment properties.
Levitin questioned the MBA’s calculations of that spread, and said that regardless of how the math is done the idea that the entire spread is due to bankruptcy risk "is preposterous."
"At best, the MBA’s figure is a wild and irresponsible guess; at worse it is a deliberately concocted falsehood," Levitin said in his prepared testimony.
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