Mortgage Crisis: Will Loan Mods Bring Relief?

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Durbin and other Democrats are pushing to attach the bill to the economic stimulus package, but that "will be difficult because we've heard that Obama wants the stimulus package to pass both houses [of Congress] by 80%, and having this as an attachment would cause a lot of Republicans not to vote for the stimulus," says Paul Miller, a financial institutions analyst at Friedman Billings Ramsey (FBR) in Arlington, Va.

Even if Durbin's bill doesn't get attached to the stimulus package, the groundswell of support for the bill from the more liberal faction in Congress gives it a good chance of being attached to another piece of legislation, adds Miller. Three prior attempts to pass the bill over the past 14 months met with stiff opposition from mortgage lenders and Republicans.

Opposition to the bill stems from the notion that so-called "cramdowns," which force creditors to accept modified terms on outstanding debt they are owed, are usually bad for the market in the long run because they would spur lenders to require higher interest rates for future mortgages to compensate for the possibility of being stripped of control over assets, Miller says. It's also still unclear if the Durbin bill would be unconstitutional since Congress is prohibited from interfering with a contract such as a mortgage loan, he says.

Cramdown Solution?

Mayer and his colleagues at Columbia contend that Congress does have Constitutional authority to modify the terms of securitization contracts under the Commerce and Spending clauses. They recommend passing a law that eliminates explicit limits on modifications but say this legislation should only apply for up to three years, long enough to allow for a recovery in the housing markets and the broader economy.

It's easier to do a cramdown when the loans are still held by the banks that originated them, since banks are subject to federal supervision, while holders of securitized assets are not, according to Richard Green, director of the Lusk Center for Real Estate at the University of Southern California in Los Angeles. Cramdowns on securitized loans are also tougher because it's harder to identify the owners of the mortgages, he says.

"That's why it's hard to come up with a practical mass-modification program," says Green. "Under normal circumstances, I think cramming down mortgages is a terrible idea, but these are not normal circumstances."

A year ago, the notion of revising the bankruptcy code to allow for loan modifications would have raised fierce objections over the moral hazard of allowing homeowners to escape their contractual obligations. But the urgency of the real estate crisis has changed many people's thinking, while others "have made the judgment that the moral hazard ship sailed a long time ago," says Green. "Things have reached such crisis proportions, we have to put such niceties aside and get ourselves through this." The only cure, he adds, is a mass-modification program, which is what the government used in the Great Depression.

Mitigating Moral Hazards

One way to reduce the moral hazard risk, he says, would be some kind of clawback provision in the modified loans that require borrowers, in exchange for getting a new loan worth 90% of the reduced home value, to pay any profits they make on the sale of the home at a price higher than the new mortgage value, up to the original value of the mortgage, to the government. "I'm not naïve—I don't think that would fully repay the cost of a program like this, but it would at least say to people this is not a free ticket to future riches," says Green.

Besides legal issues, there would be logistical snags in attempting a large-scale loan modification effort through the bankruptcy courts, says Green. Servicers can't handle the heavy of volume of requests for modifications, so shifting that authority to the courts would presumably run into similar capacity constraints, he says.

Norm Miller at the University of San Diego is less sanguine about the role that mortgage modifications can play in resolving the housing crisis. He believes only 25% of delinquent mortgages qualify for modifications based on the 38% of income requirement, since he estimates that homeowners who have lost their jobs, died, or gotten a divorce account for half the defaults, while another 25% are due to higher resets of adjustable-rate mortgages that borrowers can no longer afford and loans that are underwater. Modifications will also work only in markets where home prices for the most part have stabilized.

"There are probably a few million people out there thinking this TARP money is going to help me stay in my house. We don't want to artificially prop up the process beyond what the fundamentals will support because all that does is delay the problem," he says.

Bogoslaw is a reporter for BusinessWeek's Investing channel.