Mortgage cramdowns or the ability for a bankruptcy judge to modify the terms of a mortgage, was included in a bill (H.R. 1106 - “Helping Families Save Their Homes Act of 2009″) passed by the House recently. There is a lot in this bill besides cramdowns, so I thought it deserved a look.

Mortgage Cramdowns - The Stick

The real idea behind this legislation is to get the servicers / lenders / investors to modify loans voluntarily knowing if they don’t, they judges will. The old “carrot and the stick” routine.

We all know that the current motivation for servicers to modify on a voluntary basis is lacking. If you don’t believe me, take a gander at our Mortgage Servicing Category and read the comments of all those attempting to get their servicer to simply answer the phone.

It’s not pretty.

So I do see the need to motivate servicers and lenders to work with defaulting home owners, however, this bill is lacking badly in that department. Lawmakers put in a few provisions that actually thwart voluntary modification.

First, is the “Servicer Safe Harbor” provision which reads:

“Servicer Safe Harbor : The bill provides a safe harbor from liability to mortgage servicers who engage in loan modifications workouts or other loss mitigation, regardless of any provisions in a servicing agreement, so long as the servicer acts in a manner consistent with the duty established in Homeowner Emergency Relief Act (maximize the net present value (NPV) of pooled mortgages to all investors as a whole; engage in loan modifications for mortgages that are in default or for which default is reasonably foreseeable; the property is owner-occupied; the anticipated recovery on the modification would exceed, on an NPV basis, the anticipated recovery through foreclosure). The bill also requires mortgage servicers who modify loans under the safe harbor to regularly report to Treasury on the extent, scope and results of the servicer’s modification activities.”

A big reason servicers don’t do more modification is they simply can’t. The investors have contractual rights that servicers would violate if they did which opens up the servicer to a lawsuit. The Servicer Safe Harbor seeks to relieve them of this burden.

At least on the surface…

We must realize the majority of loans in default are subprime mortgages. Subprime mortgages are predominantly “hybrid ARMS” with prepayment penalties at very high NPV’s. This provision says a servicer can only modify if the modification “maximize the net present value (NPV) of pooled mortgages to all investors as a whole”.

That’s going to be tough, if not impossible, to do. If you cut the rate…NPV goes down. If you cut the principal…NPV goes down. If you do both…NPV goes way down.

These are complex calculations and there is another requirement servicers must take on via this provision: Reporting to Treasury on the modifications.

Servicing mortgages is a very low margin business. This extra calculating and reporting crushes any profit margin a servicer currently has and the $1,000 payment is virtually no help at all. So if Congress was really attempting to get servicers to voluntarily modify loans, they did a poor job.

So there really is no “carrot” in this bill.

This Leaves Judicial Modification or “Cramdowns”

The bill outlines the judicial modification - the stick - as the only means of getting loans modified. Here’s the language:

“Judicial Modifications of Home Mortgages During Bankruptcy for Borrowers Who Have Run Out of Options: The bill will allow judicial modifications of certain mortgage loans on a homeowner’s principal residence if the homeowner meets specified stringent criteria. Under current law, virtually every other secured claim may be judicially modified, including claims secured by vacation homes, family farms, and investment properties. This relief is extended only to mortgages that originated prior to the Act’s date of enactment so that bankruptcy judges can modify mortgages when families exhaust other options. Specifically, the bill would:

Permit the mortgage’s repayment period to be extended so that the mortgage is more affordable.

Authorize an exorbitant mortgage interest rate to be reduced to a level that will keep the mortgage affordable over the long-term while also compensating creditors appropriately for risk.

Require the homeowner facing foreclosure to attempt to notify the lender and work out a loan modification before he or she can apply for judicial modification.

Ensure lenders provide proper notice when assessing fees and allow judges to waive prepayment penalties.

Maintain the debtor’s legal claims against predatory lenders while in bankruptcy.
Prohibit a borrower convicted of fraud in obtaining the mortgage from being allowed to modify his or her mortgage under this legislation.”

They did make it a requirement for the borrower to contact the servicer about a voluntary modification. But as we already discussed, this is virtually impossible under these rules.

I empathize with all those trapped in dropping value homes, who can’t refinance or sell, and are facing a massive jump in payment due to a subprime ARM rate adjustment. Talk about being stuck between a rock and a hard place.

With that said, my gut reaction to giving the bankruptcy court this power is 1) it could cause mortgage rates to climb as lenders build in the cost, 2) it could forestall a housing recovery because, like it or not, foreclosed houses go back on the market cheap so we hit a bottom sooner rather than later, and 3) it could actually thwart current voluntary loan modification efforts as dismal as they are.

As with most things political, good intentions almost never end how they begin. It’s the unintended consequences of this bill that scare me.

This bill in the current state probably won’t pass the Senate anyway, but I though you should get to know about it, just in case it does.

Good Luck!

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