Unintended Consequences

If it is true that no good deed goes unpunished, there will be plenty of chances for the mortgage industry to cry, "Thank you sir, may I have another?" if and when the Obama Home Affordability and Stability Plan is passed by both houses of Congress. The plan allows judges to alter the mortgage contracts of Freddie Mac and Fannie Mae borrowers in bankruptcy, reducing payments, interest rates and principal balances due. While this is all in a good cause, it can have a number of unintended consequences that can leave permanent scars on the industry. It is interesting that these have not been explored extensively in the volumes already written about mortgage "cramdowns," as they have come to be called. When the government formulates laws without fully appreciating the potential ramifications, disaster can be the result, and this may be one of those times.

Some of the unintended consequences of the HASP legislation are subtle, but not altogether unpredictable. The most obvious of these subtleties is the prospect of enticing more borrowers to declare Chapter 13 bankruptcy in order to qualify for cramdown relief. Most reasonable people would expect to have more leverage in their seriously delinquent loan situation with the power of a bankruptcy court at their back than they would have if alone on the phone with their servicer, asking for relief. Lenders and servicers are slammed at the moment, and having meaningful conversations with borrowers is a challenge for them by virtue of the volume of cases out there. It is easy enough to declare bankruptcy, and now there is a great reason to do so. Of course, this is not necessarily a bad thing for servicers, as they may be able to get one more case out of their hair if a borrower goes bankrupt. But it certainly doesn't do the owner of the loan any good, and this is a fine point the state attorneys general and bankruptcy judges may not fully grasp. They have been maintaining that bankruptcy filings will not increase because servicers will be making more loan modifications with principal forgiveness.

The odds are actually better that servicers will not be making more of these modifications. They have some heavy lifting to do in order to get systems and processes reconfigured, and this could take a year or more to accomplish. They are currently motivated to improve those systems and find specialty servicers to bear portions of the load, but what will happen when servicers can suddenly rely upon the bankruptcy courts to make their lives a lot easier? Relying on the bankruptcy courts to drive cramdowns can actually insulate loan servicers from investor lawsuits regarding principal forgiveness. Even if Freddie and Fannie are on board with these particular loans, history has shown us the legislation has a way of broadening its reach, and all investors can be affected with the stroke of the presidential pen. The interests of one investor are not necessarily the interests of all of them, especially when it comes to arbitrary adjustments of contractual issues like mortgage loan provisions. Investor confidence could be eroded permanently as a result, because a contract is no longer a contract when it involves mortgages; a contract is only valid until the government decides otherwise.

The damage doesn't stop there. Unsecured creditors are wiped out in these situations, driving up those credit costs for others who pay as agreed. In addition, the vast majority of Chapter 13 plans eventually fail, statistically. Absent a major change in the law, cramdowns on dismissed bankruptcies evaporate, leaving borrowers even more delinquent under the now re-enforceable original terms of the mortgage, and with even less chance of ever curing. Nothing in the legislation provides for the inevitable overwhelming of the courts, either, as servicers and borrowers litigate property valuations in virtually every case prior to cramdown approval, and potentially litigate a second time if the borrower wishes to sell the home prior to discharge - if the declining settlement provision is included in any final change to the code.

The current bankruptcy system provides legitimate and powerful protections to allow those in financial straits to gain a fresh start. Overhauling the system arbitrarily for expediency's sake, however, can lead to many more problems than it solves. It is a better idea to provide institutional stakeholders with the protections they need to begin selling these distressed assets to private parties with the money, skill, technology and patience to maximize the value of each loan and find opportunities for each borrower to make their loans reperform. Whether it was the RTC in the 1980s, Japan in the 1990s, or today, these default cycles do not begin the healing process until the toxic assets are able to trade.

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