Cramdown's Downfall

Sen. Dick Durbin was acutely aware of the stacked battle he would face as the chief advocate of anti-foreclosure legislation.

"The banks -- hard to believe in a time when we're facing a banking crisis that many of the banks created -- are still the most powerful lobby on Capitol Hill. And they frankly own the place," a dispirited Durbin recently told a radio show.

Durbin was discussing the difficulty of passing bankruptcy reform legislation commonly known as "cramdown," a measure he's supported since the sub-prime mortgage crisis became apparent. If passed, cramdown would have allowed bankruptcy judges to modify home loans, keeping borrowers in their households and safe from foreclosure. Despite support from President Barack Obama, the measure was defeated last Thursday in a 51 to 45 vote, with the entire Republican caucus and 12 Democrats voting against the bill. After successfully carrying out an extensive lobbying operation that involved millions of dollars in campaign donations, the bankers might agree with Durbin's analysis of Capitol Hill's balance of power.

"We led the way on [the legislation] and we are clearly responsible for defeating this for the third time in the last year," David Kittle, chair of the Mortgage Bankers Association, told the American News Project last week.

The failure of the bankruptcy reform legislation is certainly bad news for the financially vulnerable borrowers it aimed to help. But it's also troublesome for the president: Not just a simple political defeat, the White House's failure to aggressively push the bill raises questions about the administration's ability -- and willingness -- to challenge bankers amid anxiety that the financial sector has too much influence over public policy.

The legislation wasn't just important to help hundreds of thousands of borrowers who could lose their home in a bankruptcy. The reform was central to the White House's housing policy to limit foreclosures in the wake of the real estate market's economy-damaging collapse. In February, the administration launched Making Home Affordable, a program designed to provide refinancing to a large pool of borrowers and to set new standards for modifying troubled loans. Because these modifications require lenders to take some loss, the administration provided them with generous incentive fees. But a stick was included alongside those carrots: If lenders couldn't modify loans enough to keep borrowers out of bankruptcy, then changes in bankruptcy law would allow judges to make the terms of the loan more favorable to borrowers. The change didn't appeal to mortgage bankers, and they set out to convince Congress to reject the idea.

The bankers' larger argument against the legislation is that allowing a mortgage to be modified in bankruptcy court increases the loan's inherent risk, which will thus increase costs on borrowers and hurt credit availability. (Primary home mortgages are currently the only loans that are not subject to judicial modification.) Analysts at Credit Suisse and Georgetown University law professor Adam Levitin have argued that the legislation would not increase the cost of mortgage loans. Further, foreclosure is more expensive for lenders than modification. Among other evidence, the bill's supporters note that 2005 legislation that made it harder for credit-card borrowers to escape debt in bankruptcy -- essentially the opposite effect of cramdown -- had no noticeable effect on credit-card costs.

Francis Creighton, vice president and chief lobbyist of the Mortgage Bankers Association, makes the case that cramdown would increase the cost of home loans by citing loans for second homes, which are not protected from bankruptcy judges and cost borrowers more than primary home loans. He also notes that changes in agriculture bankruptcy law suggest that allowing judicial modification could lead to higher lending costs. But Creighton was unable to specify exactly how mortgage-borrowing costs might change under the law. Given the compromises offered in the Senate to restrict the bill to mortgages issued prior to the law's passage and to require modification attempts before bankruptcy, the legislation would likely have had a limited effect on future lending costs.

While the public's hostility toward the financial world created a favorable political climate for cramdown legislation, the administration does not seem to have pushed hard on mortgage bankers to drop their opposition. The White House also appears to have neglected to aggressively lobby fence-sitting members of Congress. That may be, in part, because the administration requires the bankers' cooperation on other issues, like the actual loan-modification process or the Treasury's broader attempt to rehabilitate the financial sector.

"I wouldn't call it pressure or anything, but certainly the people in the administration have encouraged us to be at the table and work with the Senate, to work with the House," Creighton said. "They've encouraged us to be at the table and work on this, and not to sort of say no."

Of course, the bankers eventually said no. Sources involved with the final Senate negotiations say the administration did not take an active role in the discussions among Durbin, moderate Democrats, and several large banks, including Citigroup, Wells Fargo and Bank of America. Those sources asked not to be identified due to the delicacy of the talks. While administration officials declined to discuss the specifics of their efforts to push the legislation forward, White House spokesperson Bill Burton told the Prospect that "the president did make his support perfectly and consistently clear."

In the wake of the bill's failure, the administration seems to have read the writing on the wall. Though they continue to note their support for the legislation (an official statement said that the White House is still "working with the Congress to get a bill enacted"), officials argue that the Making Home Affordable plan can work without judicial modification as a sanction on lenders.

"I'm not sure I’d call it the stick," Housing and Urban Development Secretary Shaun Donovan said of judicial modification Sunday night on C-SPAN. "I think we saw it as a last resort for families whether they have credit-card or other debt that made it impossible for a modification of their mortgage to be effective … what we’ve been clear about, though, is that if bankruptcy had been the way for millions of households to stay in their homes, then our plan would have failed."

That's true as far as it goes. Even Democrats supporting the bill last fall cracked mordant jokes about the dismal prospect of returning to their districts and telling constituents, "Hey, you can have a bankruptcy now!" Administration officials note that some 11.2 million people visited Making Home Affordable's Web site in its first month, indicating wide public interest in the loan-modification program. Thirteen major mortgage servicers, representing 80 percent of servicing capacity in the country, have also agreed to participate in the program in its present cramdown-free state.

Though participation is a good sign, it's not the ultimate measure of the program's efficacy. Individual loan modifications will be made based on factors like each borrower's income level and the size of the loan, according to the administration's guidelines. Without the backstop of bankruptcy modification, the calculus changes significantly against the borrower if the servicers see more to gain from a foreclosure than a successful voluntary modification.

Thus far, servicers have reportedly made thousands of modifications, but comprehensive numbers have yet to be released by the administration. Effectively nationalized mortgage financer Freddie Mac will handle compliance for the program, but the mechanisms for monitoring these modifications remain unclear; experts worry that fraud could undermine the whole undertaking.

It's too early to tell if the administration's efforts to stanch rising foreclosures will be effective -- refinancings are increasing under the administration's program, and experts believe the loan-modification guidelines are well designed. But if the plan's success depends on the administration's ability to stand up to the banking industry, the events of the last month aren't a good sign.

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