Congress Forces Mortgage Modifications

This post first appeared on Minyanville and Cirios Real Estate.

The road to over-regulation has begun.

In an effort protect struggling homeowners, Senate Democrats are advocating new bankruptcy laws that allow judges to alter mortgage terms, known as a "cramdown," during a Chapter 13 bankruptcy filing. Lawmakers hope the new rules will prevent foreclosures, help borrowers in danger of losing their homes, and begin to stabilize the reeling housing market.

Despite good intentions, however, these efforts will raise the cost of borrowing for everyone, reduce the availability of mortgage credit and prolong the housing market's recovery.

According to the Wall Street Journal, the proposal's backers won a major victory when Citigroup (C), which has received $45 billion government capital since last fall, withdrew its opposition. Big mortgage lenders like Citi, Wells Fargo (WFC), JPMorgan (JPM), and Bank of America (BAC) have been resistant to the changes, since courts would gain the power to force losses on altered loans. But with the government snatching up pieces of the country's biggest banks, their ability to resist such regulation is diminishing.

Democrats now hope to include the bill in President-Elect Obama's $800 billion economic stimulus package.

The proposed rule-change applies to Chapter 13 bankruptcy filings, which allow individuals to gradually repay debts as the work their way out of economic trouble. Under the current laws, judges are provided leeway to alter the terms and payment schedules of credit cards, auto loans and other consumer debt. First mortgages, however, are off limits. Even though courts can't wipe out home-loan debt or reduce interest rates, a homeowner doesn't necessarily lose his house in a Chapter 13 filing. As long as the borrower can keep making payments, the bank can't take the house.

Advocates of the bill believe relaxing cramdown restrictions will shelter homeowners who otherwise would lose their homes by effectively forcing loan modifications. And since the success of government-backed modifications programs have thus far been disappointing, bureaucrats are eager to press the issue.

Mortgage rates, when compared with other type of consumer debt, have historically been kept low because lenders are secured by a home: When the homeowner defaults, the bank gets the house. Miss too many car payments, on the other hand, and a bank is left looking for an asset that's far tougher to chase down. For as painful as foreclosure is for the borrower, this lender protection keeps mortgage money flowing to the rest of the economy.

The proposed rule change, which lawmakers also hope will encourage lenders to modify mortgages on their own before courts get a chance to hack up a loan's terms, greatly reduces a bank's financial incentive to giving out mortgages at low rates. If borrowers have the ability to file for bankruptcy and plead their case to a judge for lower payments, banks will be reticent to lend. If they do give out loans, they'll charge higher rates for the privilege.

As is typical of recent government-sponsored economic initiatives, lawmakers ignore long-term implications in favor of immediate good press. This over-aggressive consumer protection directly counteracts efforts by the Federal Reserve and Treasury Department to push down interest rates - and further illustrates bureaucrats' ineptitude at effectively managing an economy. As soon as they actually manage to get mortgage rates moving down, another wide-eyed economic simpleton tries to start them in the opposite direction.

But such are the pitfalls of a planned economy - and this, unfortunately, is just the beginning.