Foreclosure prevention plan under attack

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NEW YORK (CNNMoney.com) -- Two bills before Congress would give bankruptcy court judges the authority to reduce mortgage debt, which could save thousands of borrowers from foreclosure.

Lenders are furious at the prospect of having judges seize control of their mortgage portfolios. Community and consumer advocates argue that such a move makes sense amid the current mortgage crisis.

Both the Emergency Home Ownership and Mortgage Equity Protection Act of 2007 and the Foreclosure Prevention Act of 2008 aim to provide relief for some home owners in bankruptcy. Only borrowers who live in their homes and hold subprime or non-traditional mortgages, like interest-only loans, would be eligible.

"This will help 600,000 households avoid foreclosure this year and next," said Ellen Hornick an attorney for the Center for Responsible Lending.

The policy, which in industry parlance is called a cram-down, would reduce mortgage balances and monthly payments based on how much a home's value had decreased.

It is one of many efforts by government and consumer groups to encourage lenders and mortgage servicers to restructure loans to more affordable terms for home owners in danger of default.

"While there are some loans being [voluntarily] modified," Hornick said, "foreclosures are still outstripping modifications by seven to one; subprime ARM foreclosures by 13 to one."

But opponents say the cram-downs would increase mortgage borrowing costs for everyone.

"It would affect a lot of prospective home owners," said Wayne Brough, chief economist for FreedomWorks, a conservative policy advocate, "anyone who applies for a mortgage."

Cram-down opponents argue that borrowers who take risky loans should take the fall when they fail. Without penalties, borrowers would keep making bad bets.

And forgiving debt transfers risk from borrowers to the debt holders - investors in mortgage backed securities. That means interest rates will have to be higher to attract investors.

Steve O'Connor, the senior vice president for government affairs at the Mortgage Bankers Association (MBA), claims this could add upwards of one-and-a-half percentage points to everyone's interest rates. That would translate into an increase of about $200 a month on a $200,000, 30-year, fixed-rate loan.

"Looking forward, investors will say, 'How do I know this won't happen again, on a larger scale?'" O'Connor said. "Investors have choices in the marketplace and if they see an additional risk, they'll migrate to other securities."

The CRL's Ellen Harnick argues that the cram-down provisions narrowly target relatively few borrowers.

There were only 800,000 bankruptcy filings in the United States in 2007, according to the National Bankruptcy Research Center.

And while there is little hard data as to how many of these involve homeowners, some evidence suggests that about half the cases do. In one metro area, Riverside, Calif., 62% of 2007 bankruptcies involved home owners with outstanding balances. And not all of these would qualify for cram downs.

"These bills have means tests," Harnick said. "If you can afford to pay your mortgage, you don't qualify. If you can't afford to pay even after the mortgage balance is reduced, you're not eligible."

And Adam Levitin, a law professor at Georgetown University contends that cram-downs would add little to the costs of new mortgages.

He examined historical mortgage rates during periods when judges were allowed to reduce mortgage balances, and concluded that the impact on interest rates would probably come to less than 15 basis points - 0.15 of a percentage point.

"The MBA numbers are just baloney," said Levitin.

However, even though the direct impact on borrowers would be limited, permitting cram-downs could indirectly give borrowers more leverage in dealing with lenders, according to Bruce Marks, founder and CEO of the Neighborhood Assistance Corporation of America (NACA).

Mortgage borrowers could force lenders to negotiate loan restructurings by threatening to file for bankruptcy and have the judges do it for them.

Some people with credit-card debt already win concessions from credit card lenders by threatening bankruptcy, where the debt may be discharged.

"I consider this one of the most important pieces of legislation before Congress right now," said Marks.

Will it become law?

"We believe it will be very difficult to stop this legislation and we put the initial odds of enactment at 60%," said Jaret Seiberg of the Stanford Group, a policy research company, in a press release assessing the new bills.

A vote on the Senate bill could come as early as next week.