Subprime: Bailout backlash

NEW YORK (CNNMoney.com) -- As the list of proposed remedies to the subprime crisis has grown longer, the chorus against helping troubled borrowers has gotten louder.

On Wednesday the Democrats called on the White House to increase funding and implement proposals for foreclosure prevention.

But judging from the hundreds of reader responses CNNMoney.com has received in recent weeks, "foreclosure prevention" sounds a lot like "bailout" to many Americans, and they don't like it one bit.

"Let the lumps fall where they may. No bailouts! The greedy banks, local gov'ts, realtors and developers caused it and they deserve this beating." - posted by John, Richmond, Va.

"No rewards to the people that [k]new buying was way out of [their] means. They get rewarded for [being] irresponsible and I get nothing for being responsible!" - posted by Kurt, Torrance, Calif. (see more comments)

Joseph Mason, an associate professor of finance at Drexel University and a senior fellow at Wharton, argues in a research paper released Wednesday that proposed remedies could actually make things worse and even that troubled borrowers have gotten some benefit from their loans.

"It's tough to find the harm," said Mason.

Many subprime borrowers got their homes at payment levels that were as cheap or cheaper than renting, Mason said. And if they had equity, they had the option of cashing it out to pay for other things that they otherwise couldn't afford to do.

And while foreclosure is not easy for any homeowner and can damage their credit long-term, their credit was bad to begin with, he said.

Mason thinks a one-size-fits-all bailout would not cure the issue that led to the subprime crisis: lack of information about the riskiness of the mortgages sold to investors; lenders' willingness to extend credit to unworthy borrowers; and borrowers' willingness to take on too much mortgage debt.

"If I had known [three or four years ago] that I was going to be bailed out, I would have made that decision too," Mason said.

Plus, Mason said, borrowers who get in too deep, once bailed out, may load up on debts again.

Consumer advocates and lawmakers who support a broad foreclosure-prevention effort contend the idea is not just to lend a helping hand to some, but to prevent whole neighborhoods from declining in value and hurting all homeowners.

And they're sounding the alarm that the efforts so far have been paltry relative to what's needed to significantly reduce the estimated 1.7 million foreclosures that may occur by the end of 2008.

"Responses have been more Katrina-like," said George Goehl, executive director of the National Training Information Center, a network of community organizations working with borrowers to negotiate loan workouts with lenders.

NTIC has called on lenders to impose a two-year moratorium on resetting adjustable rate mortgages (ARMs). It also has called on lawmakers to more stringently regulate brokers and lenders to prevent abusive lending.

Lenders have several loss-mitigation tools they can use to prevent foreclosure.

Among them, they can convert ARMs to fixed-rate loans or extend the lower introductory ARM rates for a year or two. For delinquent borrowers, servicers can add past-due payments to the loan balance, saving the borrower from having to pay that debt in one lump sum. And they can add to the length of the loan, which lowers monthly payments.

If one defines a bailout as reducing a borrowers' debt burden, making it possible for them to stay in their homes, modifications that convert ARMs to fixed loans accomplish that most effectively. But that's also the least likely outcome.

Many servicers have not been willing to work with borrowers to modify loans before they become delinquent, and when they do work with them, they're more likely to choose options that serve to postpone foreclosure rather than prevent it, said Michele Rodriguez Taylor, the head of NTIC's foreclosure-prevention program.

Mortgage industry experts say that servicers are still too understaffed to handle all the modification requests and that they may be constrained from modifying loans immediately because of the terms of their contracts with the investors who own the loans.

If one defines bailout as simply reducing troubled borrowers' obligations but not keeping them in their homes, then short sales and deeds in lieu of foreclosures may accomplish that.

With a short sale, a lender may agree to forgive the debt not covered by the sale of the home. A deed-in-lieu-of-foreclosure allows homeowners to sign over the deed of their house to the lender and walk away without further obligation. If they choose this option, they may be able to minimize damage to their credit if they ask the lender to remove the negative reference on their credit report, according to legal information publisher NOLO.

To date, it's been hard to measure the number of short sales and deed transactions taking place. But the servicers who aren't dealing with borrowers before they become delinquent may be putting them at greater risk of having to leave their homes because the more seriously delinquent a borrower is, the fewer his options become.

The jury is out as to whether certain proposals on the Hill will provide much, if any relief to those at risk of losing their homes. Calls to temporarily increase the size of the loans that Fannie Mae and Freddie Mac may buy could ease the credit crunch in high-priced markets. But it will do nothing directly for today's troubled borrowers and some contend it will increase the risk both Fannie and Freddie and their investors assume. (Congress warned: Easy on loan fix)

A bill that would allow bankruptcy judges to reduce what homeowners filing for Chapter 13 owe their mortgage lender may allow more people to stay in their homes, but critics say it could de-stabilize the mortgage market and push mortgages rates higher. (Bankruptcy 'tweak' could save 600,000 homes)

A recent change at the Federal Housing Administration may allow 80,000 troubled borrowers to refinance into more affordable products. Critics contend the FHA would be assuming more risk by taking on those borrowers thereby potentially putting taxpayers at risk. (Refi rescue)

One proposal seems to be garnering support from everyone: exempting homeowners who foreclose or otherwise have some of their mortgage debt forgiven from having to pay income tax on the forgiven amount.