The U.S. Treasury Dept. broadened the Obama Administration's foreclosure-prevention program on Apr. 28 in a bid to resolve a persistent obstacle to cleaning up problem mortgages. But some financial officials say the fledgling program's success still hinges on controversial legislation pending in Congress, which is also expected to take up another contentious bill that would allow bankruptcy judges to reduce the principal owed on a home.
Although the Administration announced an ambitious housing-assistance program in February and released detailed parameters in early March, progress has been slowed by an obstacle all too familiar when it comes to modifying mortgages: second liens.
Typically the result of "piggyback" loans that let homeowners buy a house with no money down, or lines of credit, second liens can complicate mortgage modification and leave homeowners more likely to default again, even if their primary loan is made more affordable. Treasury estimates about half of homeowners at risk of default carry second liens.
On Tuesday, Treasury said it would use some of the $75 billion already allocated for housing programs to pay cash incentives to mortgage servicers and investors to reduce homeowners' payments on second mortgages when the primary mortgage is being modified under the government's program. Interest rates for second liens could be pushed as low as 1%.
Although the program is voluntary, Administration and industry officials said the big banks that handle about 80% of first mortgages and 50% of second liens are willing to sign on once contracts are drawn up. Once on board, mortgage servicers would have to modify any loan that met the government's criteria. Several big banks are already participating in the program announced in March to modify primary mortgages.
But big financial companies say one element is missing to ensure the program's success: protection from lawsuits against them by investors unhappy with how loans are modified.
Congress is considering legislation that would give mortgage servicers such a "safe harbor" under certain conditions. Many mortgages have been sliced into pieces and sold as securities to investors, who have different claims on the stream of mortgage payments from homeowners. Servicers say they are worried that they will be sued by investors who lose value because a mortgage's interest rate has been lowered, or its term extended, or interest has been waived on some portion of its principal—all tools used under the Administration's foreclosure program.
Conflicts of Interest?
By contrast, the big investors holding mortgage-backed securities counter that giving the big servicers legal immunity would encourage a host of potential conflicts of interest. A big bank wanting the government's cash incentives, for example, could decide to modify loans it serviced for investors even if doing so would hurt the investors. And banks have raised concerns that the government's emphasis on modifying the terms of securitized mortgages amounts to tinkering with contracts that investors see as sacrosanct.
Investors argue that most servicer agreements explicitly allow modifications under many circumstances. Many of the mortgage securities in question are held by pension funds benefiting ordinary Americans, says the spokesman for one nascent coalition of investors with roughly $100 billion in mortgage assets under management, and the pending legislation could let some servicers "reduce payments on first mortgages they sold to investors while keeping up payments on second mortgages, thus protecting their investments first."
For its part, the Administration has so far failed to back the banking industry's calls for a safe-harbor provision. "We don't think we need a safe harbor for our modification program to work," one Administration official says.
At the same time, government officials stress that they aren't asking mortgage servicers to violate their contracts with investors. Quite the opposite, in fact—Administration officials say servicers will be bound to modify second liens under the new program only when it wouldn't violate those agreements. "We will design this in a way that will respect contracts," the Administration official said.
Modifying Mortgages in Bankruptcy Court
Meanwhile, another highly charged housing measure may be heading for a showdown. Democrats have been backing a bill that would allow judges in bankruptcy court to modify mortgages, including the power to wipe out a portion of principal. The bill, which has already passed in the House of Representatives, has Obama's nominal support, but he has done little publicly to push it.
Even the basic concept of reducing principal is vigorously opposed by the financial-services industry, though, and the provision has languished amid misgivings among the moderate Republicans and Democrats needed to gain 60 votes in the Senate.
Now, with on-again, off-again negotiations among senior Democrats and a few key banks stalled, supporters say they could bring it to the floor of the Senate as soon as Thursday, Apr. 30. They are reaching out to key moderates to build support, including Arlen Specter, the Pennsylvania Senator who switched to the Democratic Party on Tuesday.
Francis is a correspondent in BusinessWeek's Washington bureau.