ONE OF THE most vexing aspects of the housing crisis is the plight of an estimated 4 million to 8 million homeowners who are in danger of losing their homes through foreclosure. The need to assist those homeowners is urgent.
Congress is addressing foreclosure relief through amendments to the TARP Reform and Accountability Act. A key issue is whether to allow bankruptcy judges to adjust mortgage terms for borrowers on primary home loans. If passed, there could be significant benefits to borrowers facing foreclosure. However, if the legislation is not written and vetted carefully, there could be a huge mess in the bankruptcy courts that will only make the problems worse.
A change in the bankruptcy laws for primary home loans would dramatically alter the balance of power between lenders and borrowers. Currently, bankruptcy judges are not allowed to adjust - "cramdown" - total loan amounts, principal payments, or interest rates on mortgages for primary residences. Therefore, borrowers cannot use bankruptcy as a strategy to save their homes from foreclosure. The government has tried to encourage lenders to voluntarily revise the terms of mortgages with borrowers, but it is not working.
Mortgage holders, including those of subprime loans and trustees of securitized loans, need to have more inducement to change the mortgage terms to allow borrowers to keep their homes. This has been problematic because lenders are reluctant to take losses, and in the case of securitized loans, the trustees often do not have enough incentive to deal with the multitude of borrowers that they must in order to stabilize the securitized bonds.
Proposed legislative changes have three critical provisions: only existing mortgages would be eligible; homeowners would have to certify they tried to contact their mortgage holder lenders regarding loan modifications before filing for bankruptcy; and only major violations of the Truth in Lending Act would cause lenders to forfeit their claims in a bankruptcy.
If the bankruptcy laws are changed, there will be a flood of bankruptcies - potentially overwhelming the capacity of the court system. For that reason, there needs to be a procedure to determine whether the three provisions are met. The key provision is establishing that "major violations of the Truth in Lending Law" occurred. Were the borrowers put into mortgages that they patently could not afford from the beginning? Should those who lied about their income be given the benefits of cramdown through bankruptcy? These are difficult questions, but those who truly were victims of predatory lending should be given the opportunity to stay in their homes if at all possible.
The greatest danger in tampering with the bankruptcy laws for mortgages is the impact on future mortgage interest rates. Americans have enjoyed lower mortgage interest rates historically because of the relative ease of foreclosure. The longer it takes lenders to get back houses with delinquent mortgages, and the greater their risk that mortgage terms can be changed by a bankruptcy judge, the more expensive mortgage interest rates will be for everyone.
One important aspect of unfreezing the credit markets is creating a market for the billions of dollars in Collateralized Debt Obligations and other types of securitized mortgages. This can only occur when investors are able to determine the value of the underlying mortgages, which they cannot do now. Those mortgages that can be modified to allow the homeowner to stay in place should be modified. The sooner the better.
Changing the bankruptcy laws would incentivize lenders to modify the mortgage terms themselves - and where they do not, the courts could do so. That process would set a floor price for those mortgages that are modified, thereby helping investors determine the market value of mortgages comprising the CDOs and other securities to get the secondary mortgage market trading again. This is a necessary step for resolving the crisis.
The losses have already occurred. Lenders and investors need to take them and move on. Whatever facilitates this process is helpful. However, there are enormous risks in changing the bankruptcy laws. Reforms must be clearly defined to apply only to borrowers who can prove that predatory lending occurred. Otherwise, we will be paying for this change for years by delaying the resolution of existing mortgages and imposing enormous new costs on lenders to cover the risk of expanded bankruptcy filings and cramdowns.
Richard Peiser is a professor of real estate development at the Harvard Design School. 
