CRAMDOWN WON'T RUIN THE MORTGAGE MARKET.

Critical legislation to limit foreclosures has been stalled in the Senate for a while, as regular readers know. A bill that would allow primary home loans to be modified by a judge during bankruptcy is being opposed by the usual coalition of mortgage bankers, Republicans (all of them) and a sprinkiling of moderate Democrats. (Strangely enough, primary home loans are one of the few loans that a judge can't already modify). The mortgage bankers make two arguments against the new law, known as cramdown: One is that the modifications judges will make are going to force them to take a big loss. However, that's not really true -- compared to foreclosure, loan modification will save money.

The other argument from the mortgage bankers is that the change will force them to raise interest rates 2 percent or more to cover potential losses; essentially, as is often the case with financial regulation, they are trying to blackmail legislators with the idea that any changes to mortgage law will result in less available credit. But a report out from Credit Suisse's Structured Assets Research division, of all places, disputes that idea and concludes that "we are not very convinced that the current bankruptcy reform alone will drag the mortgage and housing markets down further." More specifically:

A new study by Adam Levitin from Georgetown University didn’t find empirical evidence that the proposed mortgage cram down will have meaningful impact on mortgage interest rates (based on looking at pricing of mortgages that currently permit cram down, such as second homes and comparing them to pricing on owner-occupied homes (which don’t allow cram downs today) ... rule changes in the middle of the game are nothing new. Did rates drop dramatically after the 2005 bankruptcy law for credit card and auto borrowers (both of whom faced increasing restrictions on bankruptcy filing)? If tightening the bankruptcy law for borrowers in 2005, failed to lower rates for affected borrowers, it’s hard to imagine that rates will necessarily rise based on the proposed bill. Further, filing a Chapter 13 bankruptcy is a fairly onerous procedure and many borrowers may choose foreclosure rather than bankruptcy. Assuming most borrowers who file can’t pay their mortgage anyway, the losses lenders would suffer would not seem to be any higher under the bankruptcy proposal and may in fact be lower as shown in our test.

The report also points out that compromise provisions in the legislation would limit cramdown to existing mortgages issued before the bill became law, suggesting that the mortgage market won't change completely; new compromises being floated (for instance, that loans could only be modified in court if a borrower failed to qualify for the Obama administration's voluntary loan modification plan) will limit its affects even further. But even in that format, this is a hugely important measure for stopping foreclosures, both through bankruptcy and more important, as a stick to encourage mortgage originators and investors to modify their loans voluntarily. Arguments that this cure is worse than the disease rely more on fear than fact.

-- Tim Fernholz

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