Citi backs foreclosure prevention plan
Banking giant gives nod to legislation that would allow judges to alter mortgages for homeowners who have filed for bankruptcy.
NEW YORK (CNNMoney.com) -- Citigroup reached an agreement with Democratic lawmakers Thursday on legislation that would allow judges to reduce mortgage debt for individuals who have filed for bankruptcy.
Sen. Dick Durbin of Illinois, the bill's architect, said he hoped the participation of Citigroup would entice other mortgage lenders to sign onto the program.
"I hope other institutions will follow suit," he said. Durbin appeared at a press conference along with fellow sponsors of the bill, Sen. Christopher Dodd of Connecticut and Sen. Charles Schumer of New York.
Until recently, members of the banking industry, including Citigroup (C (C, Fortune 500), Fortune 500), as well as other housing-related groups like the National Association of Realtors, have criticized the notion of allowing the courts to have a say over their mortgage portfolios.
The Mortgage Bankers Association is extremely resistant to this idea. The trade group insists that so-called "mortgage cram downs," which allow bankruptcy courts to reduce the size of a home loan, will add considerably to future borrowing costs.
"We remain opposed to bankruptcy cram-down legislation because of the destabilizing affect it will have on an already turbulent mortgage market," said John Courson, president and CEO of the Mortgage Bankers Association.
Under the proposed mortgage bankruptcy bill, judges could treat the portion of the mortgage balance that exceeds a home's newly appraised value as unsecured debt - loans not backed by collateral. If a homeowners owes $400,000 on a house worth $300,000, $100,000 would be unsecured debt and eligible to be dismissed.
In addition, judges would have the discretion of lowering mortgage interest rates. They would also be allowed to extend the term of the loan to as long as 40 years, which would reduce monthly payments as well.
Opposition to the bill has been eroding. Long time opponent the National Association of Home Builders recently did an about-face.
"This crisis is so severe that every possible solution must be on the table," said Jerry Howard, president of the National Association of Home Builders, in a prepared statement released on December 31. "To be clear, we don't support any specific legislation that would implement cram downs, but we are willing to discuss this tactic and any other solutions with Congress, the administration and other stakeholders."
Lawrence Yun, chief economist for the National Association of Realtors, indicated that his organization may also be backing away from its opposition.
"In general, tinkering with mortgages by judges will tend to lead to higher interest rates," he said. "But by handing judges this authority now, perhaps some of the foreclosures, which can lead to even larger financial hits, can be mitigated."
Under the proposed plan, only homeowners with existing mortgages would be eligible to have their loans reduced. Additionally, homeowners would have to certify that they attempted to contact their lender about modifying their loan before filing for bankruptcy.
An earlier version of the bill proposed in 2008 only made this option available to borrowers who held either a subprime or non-traditional mortgage, such as an adjustable rate loan.
The Center for Responsible Lending backs the bill, and expects that it could help more than 600,000 households across the country avoid foreclosure.
Credit Suisse estimates that more than 8 million homeowners could face possible foreclosure over the next five years. More than a million homes have been lost to foreclosure since the housing crisis took off in August 2007.
"We don't think this will remedy the whole [housing] situation, but we think this is an essential and necessary tool," said Kathleen Day, a spokeswoman for the non-profit group.
The bill's opponents charge it would add to risk for investors in mortgage backed securities. Allowing borrowers to have some of their mortgage debt written off reduces the value of those securities, according to cram-down critics. Investors would demand an extra risk premium to offset that risk, raising the costs of mortgage borrowing for everyone. That could add as much as a percentage point and a half to rates, according to the Mortgage Bankers Association.
Bill supporters deny that the risk premium would be anywhere near that. For one thing, relatively few homeowners would take advantage of the bankruptcy protections. There were only about a million bankruptcies filed last year in the United States, and not all of them involve mortgage debt.
Of those that do involve mortgage debt, not all of the homeowners are upside down, owing more on their mortgages than their homes are worth, so the cram down would not apply to them. And, only existing mortgages, not newly issued ones, would qualify for cram downs under the bill, so no risk premium should come into play.
In the past, according to Adam Levitin, a Georgetown University law professor who examined historic interest rates during periods when judges were authorized to reduce mortgage debt, the impact of cram downs on mortgage rates was probably not more than a negligible 0.15 percentage point.
Supporters also claim that the mere threat of bankruptcy may be enough to encourage lenders to voluntarily offer at-risk borrowers more sustainable mortgage workouts. Critics have consistently charged that lenders are dragging their heels on mortgage modifications, which has led to continued high rates of bank repossessions. Faced with the threat of having judges step in and alter the terms of their loans, banks may be more willing to make the adjustments themselves.
As a leading mortgage lender, Citigroup's approval of this bill may appear puzzling. But participation in the program could go a long way to helping the ailing institution, which has been one of the hardest-hit banks during the housing crisis. It is expected to report a fourth-quarter loss later this month, due in part to its exposure to the U.S. housing market.
It remains to be seen whether other lenders will back the cram-down measure, but Durbin is hopeful.
"There is clearly a need to try something new," he said. 
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