The Debate on Main Street Versus Wall Street

March 11, 2009

Proponents of the new HR 1106 bill fight for Main Street while opponents fear the act will fan the flame on Wall Street.

A new housing bill, HR 1106, passed the House of Representatives on March 5, 2009 by a vote of 234-191, mostly along party lines, and the Senate could consider it within a few weeks. The bill is currently supported by a number of congressional Democrats and the President, as well as an array of consumer advocates (including AARP and the Consumers Union), and Citigroup, Inc., the first major bank to jump on board with the proposal. Bankruptcy “cram-downs” have increasingly become a concern for the ABS market over the past couple of months. The bill would put into legislation an act, also known as the “Helping Families Save Their Homes Act of 2009,” seeking to prevent mortgage foreclosures and enhance credit availability by, among other things, allowing the bankruptcy court to modify certain mortgage loans on a homeowner’s principal residence if the homeowner meets specified criteria, essentially giving homeowners the ability to restructure their loans to avoid foreclosure.

The Bankruptcy Code currently allows for judicial modification on claims secured by vacation homes, family farms, and other investment properties; the proposed act would extend this relief to primary residences by allowing the bankruptcy court to modify certain terms of a mortgage, including its repayment period and interest rate, in order to keep it affordable to the homeowner over the long-term.

The act also provides a safe harbor provision for servicers, limiting a servicer’s liability when entering into any loan modification, workout or other loss mitigation plan so long as certain criteria are met. Among the mortgage modification criteria required are that a default on the payment of such mortgage has occurred or is reasonably foreseeable; the mortgage relates to property currently occupied by the mortgagor; and the servicer reasonably believes the recovery of the mortgage’s principal as the result of the loan modification would exceed that which might be recovered through foreclosure. Additionally, the servicer’s ability to modify mortgages would not be restricted by any provisions or terms of an investment contract or securitization vehicle with respect to limitations on the number of mortgages allowed to be modified, the frequency with which such modifications are allowed or the range of permissible modifications. Further, the servicer would not be bound by repurchase or payment obligations to the securitization vehicle on account of a modification.

Proponents of the bill feel that the act provides the best way to slow the pace of foreclosures given that lenders have been unwilling to reduce mortgage principal or make mortgage loan modifications on their own.. This is partly due to the fact many of them are understaffed but primarily because most lenders are concerned about being sued by investors who hold various pieces of the loans. Proponents have also pointed to the fact that foreclosure is an expensive process and that a cram-down modification would not likely result in any greater loss to the lender than a foreclosure would produce.

Proponents further feel that the act’s slight modification to the Bankruptcy Code makes sense given that bankruptcy judges already have the power to alter mortgages on rental and vacation properties; an extension of this authority to mortgages on primary residences is consistent with the Bankruptcy Code’s legislative intent.

Lastly, proponents argue that the ripple effect caused by the continued number of foreclosures will continue to be magnified throughout the economy due to the widespread use of derivatives based on these bad loans.

On the other side of the debate, opponents of the bill fear that giving bankruptcy courts the power to do what lenders are unwilling or unable to do will cause a rush on the already heavy case load of the bankruptcy courts. While the change would offer relief from unaffordable mortgages, it would inevitably swell bankruptcy filings by hundreds of thousands of cases.

Additionally, if the bankruptcy court is given the unilateral power to modify defaulted mortgages, lenders will not only be forced to sit on their assets during the bankruptcy’s automatic stay but will then take an immediate hit on their books following the bankruptcy court’s decision to modify a mortgage loan. Unlike foreclosure, which is a lengthy process (it can take up to two years between a borrower’s default on payment and an auction sale), losses resulting from loan modifications are immediate and will have to be reported in a lender’s quarterly earnings reports. So far, the slow leakage of losses resulting from foreclosures has prevented immediate large scale loss reports for some lenders. Opponents fear that reports of losses of this magnitude will only create further havoc on an already precarious credit market.

Furthermore, opponents point to the reality that some mortgage securities contain provisions that require losses arising from bankruptcies (as opposed to defaults handled outside of a bankruptcy) to be shared by all tranches on a pro rata basis. Therefore, the subsequent risk to triple A holders of these mortgage securities will sharply increase if the bankruptcy courts’ modifications to mortgage loans become commonplace.

The effect that the act would have on typical mortgage-backed securitization structures is not yet known. However, if servicers are allowed to act in contradiction to the terms of the securitization documentation, other provisions may need to be examined and re-assessed in order to avoid triggering an event of default. Further, rating agency reactions to this legislation remain to be seen in light of the fact that mortgage pool values could drop significantly if the bankruptcy courts are able to unilaterally reduce the principal values of mortgages.