So Why Did the Cramdown Bill Fail?

On April 30th, the Senate rejected the hotly debated "mortgage cramdown- bill (S.R. 61), which would have allowed bankruptcy judges to modify mortgages by reducing interest rates and even cutting down principal balances. This bill was part of the "Helping Families Save Their Homes in Bankruptcy Act- -“ a broad package of legislation the Obama administration proposed in an effort to address the continuing fallout in the housing market. The cramdown bill makes sense. Mortgages on commercial properties and vacation homes can be modified in bankruptcy. It's certainly fair to provide the same relief for struggling homeowners stuck with under water mortgages that no one will refinance. And, it likely would help restabilize the housing market.

So why did the bill die in the Senate? The defeat could simply be a reflection of growing concern about the government's ever-increasing involvement in the affairs of the private sector. With hundreds of billions of dollars in bail-outs throughout the financial industry, we haven't seen this level of government involvement since FDR's New Deal era. The "too-big-to-fail- argument can only go so far, right?

There is another explanation. The banking industry and mortgage companies waged a small war against the cramdown bill, lobbying vigorously to see it die in the Senate. The theme of their campaign was that we'd all pay higher interest rates for the losses the industry would take in crammed down mortgages.

On the face of things, it seems odd that the banking industry would want to defeat the bill. The foreclosure process is costly, and leaves the lender with a property likely to sell for far less than the balance of the loan. If the delinquent mortgage is modified into an affordable arrangement for the borrower, the lender would avoid these losses and keep receiving interest payments over the life of the loan. In the long run, banks and mortgage companies would stand to benefit from a greater number of performing loans. The only downside for the banking industry would be a forced valuation of billions of dollars of toxic assets, a reality check the banking industry is avoiding like the swine flu.

As it stands, there is simply no incentive for lenders to voluntarily modify home mortgages. With a never ending supply of bailout funds, the banking industry's best bet for survival is to put off asset valuation until the bitter end. Partly for this reason, voluntary mortgage modifications have been a complete failure. A recent study by the National Association of Bankruptcy Attorneys shows that the majority of voluntary modifications actually put homeowners in a worse position, by capitalizing unpaid interest and fees into a larger mortgage balance- placing homeowners at even greater risk for foreclosure.

What's more, many lenders carry mortgage insurance policies that protect them against losses in the event of foreclosure. These policies are available through private entities (private mortgage insurance or PMI) and the federal government's Federal Housing Agency. Basically, if the property forecloses, the lender can just submit an insurance claim and get compensated for its losses. The same types of losses typically would not be covered if they are the result of a cramdown in bankruptcy. So there's the rub: the lenders have little incentive to sign on for the cramdown bill; in fact, they have a strong incentive not to.

The banking industry apparently succeeded in diverting attention away from this sobering fact by playing on trumped up fears of "higher interest rates for us all.- Hopefully, as lawmakers discuss how to revive the bill, the true interests of the industry will come to light. In the meantime, homeowners should be reminded that bankruptcy is still the best option if you are facing foreclosure. By allowing you to catch up on your missed payments and getting rid of your unsecured debts, you can put your family back on solid financial ground in these tough times.