Reasons NOT To Modify Troubled Home Loans


I'm not exactly sure where I stand yet on the issue of solving the housing crisis by having bankruptcy judges modify loans, but I do know that the President-elect has spoken in favor of the proposal.

I've heard a lot of arguments against, but today I read the most compelling testimony from David Kittle, Chairman of the Mortgage Bankers Association before the Senate Judiciary Committee:

First, no one should make filing for bankruptcy appear attractive. There are real and severe consequences for consumers who declare bankruptcy. Bankruptcy stays on a credit report for seven to ten years. It makes it very difficult to acquire future credit for a new home or car. It can stand in the way of getting insurance. It can make it harder to get a new job or even to rent a home or an apartment.

Two-thirds of those people who file for bankruptcy are unable to fulfill the terms of their repayments plans. Two thirds. In other words, two-thirds of those who file will still lose their home, and still have the bankruptcy on their record.

Second, changing the law will force lenders to impose tougher standards on people trying to get a mortgage. Cramdown legislation would add new risks to the calculation lenders make in setting prices. For the first time, lenders will have to pay more attention to markets with the most volatility and those with higher risks, such as rural areas, inner cities and new subdivisions, where history shows the greatest fluctuation of home values. This could even lead to a new era of redlining. Lenders would be forced to demand larger down payments and raise interest rates to balance the risk from judges who could change the mortgage contract and cause lenders or investors to suffer an economic loss.

Third, as you know, our financial markets are incredibly fragile right now. Cramdown legislation will only add more instability. The only option for many low-income borrowers today is to get an FHA-insured loan, where the government minimizes the risk to the lender of making a low-down payment loan. Cramdown legislation would make it harder for borrowers to get an FHA loan, because lenders would face the possibility that FHA insurance would not cover the loss from a principal reduction. The same is true for VA lending. In effect, Congress would end the only meaningful lending option currently available to most low-income borrowers - almost overnight.

I have to say I've never focussed on that last one regarding FHA loans. FHA's slice of the mortgage pie (sorry, Thanksgiving on the mind) has grown exponentially in the last year, and therefore so too has its importance as a driver of the housing recovery.

To put the FHA loans farther out of reach would, I fear, be even more detrimental than making bankruptcy more attractive. Also, given how risk-averse the current financial system is, adding to it with the unknown random judges making near-random decisions on loans, could throw yet another wrench into the mortgage-backed securities market, which, as we all know, is basically on life support as it is.

Questions? Comments?