Repairing the shattered subprime mortgage market is shaping up to be a contentious matter as politicians begin to collide with capitalism. While lawmakers step up pressure for reforms, a complicated debate has begun about what government's proper role should be in the recovery.
The philosophical divide on this issue will grow only more intense as Congress begins considering legislation that could lead to significant changes in the industry, say sources. Reps. Brad Miller (D-N.C.) and Linda Sanchez (D-Calif.) introduced a bill in the House on Sept. 21 that would amend the bankruptcy law, allowing courts to restructure a loan by altering the interest rates and reducing the outstanding principal. The goal of the bill -- called the Emergency Home Ownership and Mortgage Equity Protection Act -- is to stave off foreclosure for borrowers who filed for Chapter 13 bankruptcy protection.
Miller, who plans to introduce legislation in the coming weeks that addresses predatory lending, said the genesis of the bill came from speaking to consumer advocacy groups and industry players, as well as from discussions he held with bankruptcy judges in Raleigh, N.C. "They pointed to this provision of law dating from 1978 that treats home mortgages differently from any other secured debt and does not allow bankruptcy courts to modify a home mortgage in the ways that they can modify every other form of secured debt, he said.
Miller said the modification would be reasonable, with the court limiting the amount secured to the value of the home and treating the rest of the debt as unsecured. The unsecured debt would then be sent "to the back of the line with the credit card bills," said Miller. The interest rate would be set at "prime plus a couple to reflect that somebody in bankruptcy is an enhanced risk and is less creditworthy than others." He added: "I think what a lender would come out of bankruptcy with is probably the loan that should have been made in the first place.
In a research report released by Morgan Stanley on Oct. 2, however, analysts questioned whether "cram-downs of mortgages" would actually be beneficial. The idea behind the bill is to help struggling borrowers keep their homes, the analysts wrote. "However, we think the cram-down would increase the frequency of Chapter 13 bankruptcies, by making it much easier to restructure loans and keep the house, and in the process exacerbate mortgage losses. The report also noted that current law allows a homeowner to get out of paying the balance of a mortgage only through a short sale or a foreclosure, which it called, "an emotional burden that encourages many borrowers to prioritize mortgage payments.
Pete Sepp, a spokesman for the nonpartisan National Taxpayers Union, which advocates lower taxes and more accountable government, was also critical of amending the bankruptcy law. His group argues for reforming the tax code to encourage borrowers and lenders to resolve debt issues together without government involvement. For instance, if a homeowner renegotiates the mortgage loan with a lender and $10,000 of the debt is forgiven, that money is still treated as taxable income by the Internal Revenue Service.
"That's hardly incentive for borrowers and lenders to try and solve their problems together rather than calling in the government," he said. "It's almost a penalty for taxpayers who are trying to do the right thing and trying to keep their heads above water."
Sepp said efforts to stem the tide of home foreclosures should begin with helping people "who are trying to get back on their own two feet" without going through the courts. "Once we start tinkering with bankruptcy laws and we don't do something about the tax side, there will still be that incentive for people to throw up their hands and go into [Chapter] 13" he said.
Rep. Miller, however, scoffs at the notion that a homeowner would decide to file for bankruptcy as anything but an act of desperation. "I think that would be insane," he said. "I don't think anyone says, Oh what the hell, I think I'll file for bankruptcy.' It's a huge step. It damages your credit for a long time and puts everything you own in the hands of others, which puts it at risk. No one wants to go through bankruptcy."
He also questions whether lenders are even willing to renegotiate mortgages with indebted borrowers. A survey by Moody's Investors Service found that only 1% of subprime ARMs have been modified this year. "What we're hearing is that it's just not happening, and that any modifications that happen will be few and far between and not generous to the homeowner," Miller said.
Still, many in the mortgage industry have expressed a fear of lawmakers overreacting to a capital markets problem. "Part of the difficulty is coming to grips with the fact that there are a number of homeowners who simply can't be rescued," said Bert Ely, a free-market-oriented public policy consultant and principal of Ely & Co., which advises on issues related to financial institutions and monetary policy. "A lot of people were in trouble from the beginning. What happens is that borrowers are bailed out of basically really bad decisions. Particularly, you have borrowers who didn't have any equity in the property in the first place and were essentially renters.
Roger Fendelman, vice president of compliance for Interthinx, a provider of risk mitigation and regulatory compliance tools, agrees with Ely. He is in favor of forcing loan officers to obtain licenses to "weed out a lot of the bad actors," but he believes borrowers ultimately have to carry some responsibility for getting into risky loans.
"A lot of borrowers knew what they were getting into," he said. "That's an unpopular statement. But if you see on your loan application that your stated income has been inflated from $50,000 a year to $150,000, you know it's not right, and it's your job to say something.
As lawmakers step up the pressure to pass reforms, a debate is emerging about whether the market can correct itself without government intervention. Ely said that 80% of the subprime mortgages made over the past two years are actually performing well. "This is not a universal problem, even in the subprime community," he said. "My guess is that by next spring much of the market will be seen as essentially back to normal. Meanwhile, Fendelman is critical of the government for being reactive instead of proactive.
"The bottom line is: there are already laws on the books everywhere, and the question is, to what extent are they being enforced?" Fendelman said. He also contended that many laws that legislators pass are actually difficult to enforce.
Neither Fendelman nor Ely considers reform of the Federal Housing Authority a legitimate solution to the current crisis. The FHASecure program, which is meant to help borrowers with good credit refinance their mortgages to avoid foreclosure, carries a 97% LTV maximum, which could prevent a lot of homeowners from qualifying.
"The problem is not so much the income situation as it is the LTV situation," said Ely. "A lot of people's LTV today is over 100% because their property values have declined. You can save the house if you can do a refi, but if you have a very high LTV, the question is, what do those folks do?"
Although Fendelman believes that risky lending practices can decline through a long period of tightened underwriting standards rather than through government regulations, some industry observers have questioned claims that this is already happening. Morgan Stanley analysts, writing in their Oct. 2 research report, also noted that servicers are under intense scrutiny from state attorneys general who reportedly want to step up enforcement. "Under pressure from the media, mortgage companies will likely remain on the defensive," wrote the analysts.
The immediate concern for consumer advocacy groups is holding off a massive wave of foreclosures. In testimony before the U.S. House Judiciary Committee on Sept. 25, Eric Stein, senior vice president of the Center for Responsible Lending, estimated that 2.2 million families will lose or have lost their homes to foreclosure because of the fallout from subprime mortgage loans made in 2005 and 2006. The group argues that Rep. Miller's bill will save approximately 600,000 of these families from foreclosure.
While the bill would become a permanent change in the law if it is passed, Miller hopes that it will not be as necessary in two to three years, once the worst crush of resets on subprime loans has passed. During this time, he also wants to see a regulator given the authority to set new rules and practices for the mortgage industry. Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, wants to move the bill out of committee by the end of this month. Frank is considering further mortgage-reform legislation that would make servicers share liability for failed loans and eliminate brokers' yield spread premiums.
Sepp, at the Taxpayer's Union, agrees with Miller about the federal government creating a "regulatory sphere" of standards that all states would abide by to ensure a better flow of information and more disclosure between lenders and borrowers. The government's role in the wake of the subprime crisis is to look forward, rather than trying to correct the present, Sepp said.
"The market is already in the midst of correcting itself," he said. "Congress shouldn't be legislating for a simple problem that might be in the midst of wrapping itself up, or at least slowing down."
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