Can Mortgage Industry Block Help?

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February 25, 2008 7:29 p.m.

The pending bankruptcy amendment that would let judges make a downward adjustment on mortgages when the loan exceeds the value of the property goes to a vote in the Senate tomorrow. It will take 60 votes to push the bill forward. The mortgage lenders think they can block it, giving the Republicans a chance to kill the bill through filibuster.

Right now this is the only bill pending in Congress that would have any meaningful impact on the slide in the real estate market. The bill would provide critical benefits: It would put an estimated 500,000 families into long term, permanent mortgages that they could afford, and it would cost investors far less than a foreclosure. Best of all, it would force the write downs to be absorbed by the investors, not the taxpayers.

The mortgage industry is opposed. Perhaps the industry believes it can squeeze out more by talking people into handing over the keys to their homes or in pushing through to foreclosure. Or perhaps the industry believes that if things get bad enough, the government will bail them out. Either way, the industry doesn’t want to have to write down the loans.

Larry Summers weighed in via his column in the Economist. He supports the bill as a way to create a mechanism to get the borrowers into deals that are good for the borrowers and cheaper for the lenders. He points out the the current ideas of jawboning the lenders just isn’t working. But he seems to be having some trouble with the details of how bankruptcy works.

Despite his support, Dr. Summers would change the bill by letting the lenders have some upside appreciation if the market recovers because, he says, that already happens in business bankruptcies. I think Dr. Summers needs to re-read the Bankruptcy Code. There is no upside participation for the unsecured portion of secured debts. Unsecured creditors (including the unsecured portion of a secured claim) get pro rata participation in any distributions, but there is nothing special for mortgage lenders. There may be equity participation in a Chapter 11, but only if such participation is needed to secure a majority vote of the creditors for the plan of reorganization. Moreover, that participation goes to all the creditors and is not based on specific property appreciation. It is simply an equitable ownership in the business — a concept we don’t have for live human beings.

I’m very glad to see Dr. Summers support for the basic idea, and I hope he sticks with that. More importantly, I hope Congress is listening to what he says: this is a bill that is good for families and good for lenders. The proposal is the best chance we have to avert a full-fledged collapse in the real estate markets.

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