Bankrupting Homeowners With Mortgage Bankruptcy Protection

If your household is anything like mine, your TV has been tuned to the cable news networks and CNBC for the past week. The discussion of the looming financial meltdown has been "must see TV"; although judging the merit of the proposed solutions has been mainly beyond my layman's economic understanding. What I do understand very clearly, however, is that, as a Realtor, I very well could be one of the first casualties if this financial crisis is not averted. I would bet that many other Americans feel the same way.

Most of the pundits agree that some action must be taken to preserve our financial system and our economy. Its what exact action that they disagree on. One of my concerns is that, in our rush to a solution, we will push through a recovery package with ancillary provisions that will have unintended, negative side effects. That in retrospect the cure may be as painful as the disease.

The drive to provide homeowners with Bankruptcy protection for their mortgages is one such provision.

As you can imagine, the debate breaks down along ideological and political party lines. I have linked below recent editorials and opinion pieces that are both pro and con for extending Bankruptcy protection. They are a useful primer for understanding the debate:

New York Times: What About The Rest Of Us?

California Progressive Report: Focus On FDIC Issue Not Bankruptcy

Wall Street Journal: Bankruptcy Ploy

Washington Independent: Bailout Bill Must Include Help For Homeowners

RGE Monitor: Let Bankruptcy Judges Make Bankruptcy Judgments

HughHewitt.com: Durbin's Using Financial Crisis To Extort Redistribution Of Wealth From Responsible Homeowners To The Profligate

Wall Street Journal Law Blog: Will Bankruptcy Judges Get Power To Strip Down? (make sure to read Comment section…good opinions)

As someone who operates a service, Stop Foreclosure Illinois, to help homeowner stop their foreclosure, I am very sympathetic to the needs of distressed homeowners. What caring human being wants to see families thrown out on the street? Providing bankruptcy protection to these folks, on the surface, appears to be the moral and correct choice. But is it?

Lets put aside the legal, & ideological arguments against Bankruptcy protection, and look at the practical impact on not only distressed homeowners, but also current homeowners and future homebuyers.

The primary motivation for a lender to write a mortgage (or any loan) is to make money. Lenders write loans with the expectation that the loan will be repaid in full with an additional profit margin for the risk the lender took. As the risk increases, the reward (profit margin) must increase to justify that risk. That is pretty much Econ 101.

So how would lenders respond to the idea that a Bankruptcy judge could modify a homeowner's mortgage, essentially resetting it so that they now owed 50, 60, or 80 cents on the dollar? How would banks react if they lent $300,000 and a judge ruled that the homeowner now owed only $200,000?

Unless the lender decided to become a charitable organization, they would make some changes to their business model in order to stay profitable:

1. Some lenders would stop writing mortgages. Granted, most mortgage lenders would utilize less extreme counter measures, but some lenders (primarily smaller banks with porfolio programs) would decide that mortgage lending was not worth the risk. Outcome: smaller supply of loans leads to a higher cost for loans.
2. Lenders would ask for more money upfront.To balance the heightened risk, lenders could start requesting larger downpayments (30% or more?) and collect higher closing costs upfront. I think that competition amongst lenders would mean that we would not witness extreme downpayment requirements, but consider that 30% down is par for commercial loans. Outcome: more expensive for homebuyers to purchase and for homeowners to refinance.
3. Lenders would charge higher interest rates. Consider the interest rates that a homeowner pays for a HELOC. They pay a higher rate because that loan is a junior lien to the primary mortgage, and as such, is subject to be drastically altered by a foreclosure sale. Better yet, consider how difficult it is to get a HELOC now that foreclosure rates have risen. Outcome: monthly mortgage payments are more expensive.
4. Lenders might require a new form of mortgage insurance. Obviously mortgage lenders don't want to leave the field of mortgage lending, they just want to minimize their risk. They could do so by creating a new form of mortgage insurance to protect their investment. Outcome: again, monthly mortgage payments are more expensive.
5. Lenders would tighten their guidelines. As credit worries have increased, we have seen a radical tightening of qualifying guidelines. Used to be that a mid 600 credit score meant you were a solid citizen, now it means you are a bum. New credit guidelines in an era of Bankruptcy protection for mortgages would be extremely tight. Outcome: drastically less people would qualify for mortgages.

These are just a few of the consequences that a change in Bankruptcy law might bring. As I'm not a banker nor attorney, my guess is that there are additional measures that I am omitting.

So if we don't provide a Bankruptcy workaround what is the solution?

Part of the solution going forward is to return to mortgage guidelines that protect consumers and limit foreclosures. That is already being done by eliminating sub-prime and non-A paper loans. We won't have the need to cure sick loans if we don't issue them. Of course that would temporarily eliminate some buyers, but they would have recourse to change their circumstances by improving their credit, saving for a downpayment, and proving their credit worthiness.

And how about those sick loans that exist now? How do we cure them? Well there are some remedies that already being implemented, such as repayment plans, loan modifications, and Short Sales. In addition, the Hope For Homeowners Act offers many of the same benefits that Bankruptcy protection does. Hopefully, the Act will be utilized to help homeowners, but that remains to be seen. Again, some homeowners might have to become renters, but they too will have the opportunity to rebuild their finances and reprove their credit worthiness (I suspect that some of these same people who would utilize Bankruptcy protection might find, that after doing so, they could never get a home loan again; this is not true of folks who work with the lender to solve their foreclosure).

I certainly don't have all the answers (probably not even a few), but even as Realtor, I can recognize potential consequences. What is clear to me is that to help the 2% to 4% of those homeowners that end up in foreclosure, the remaining 96% to 98% of the population would bear the additional direct cost. I meet with these distressed homeowners everyday, and I am certain that the majority of them would not find that to be moral or correct.

UPDATE: It APPEARS that Bankruptcy protection will not be include in the $700 Billion bailout plan. I'll keep my fingers crossed and keep you updated.