The Foundry

If the Senate Democrat/Citigroup plan to allow bankruptcy judges to rewrite mortgage contracts becomes law, there is no doubt that many homeowners who are struggling to pay their mortgages will be helped in the short term. But there is never any such thing as a free lunch. What benefits these homeowners in the short term, only hurts other homeowners trying to sell their homes, and all home buyers trying to afford one.

A mortgage cram down law would:

• Add the government as a silent third party to all private contracts between a home buyer and a lender. Until now, the government has rightly stayed out of these transactions. A cram down would create an incentive for mortgage seekers to agree to any terms, confident that a bankruptcy court will bail them out at a later date.
• Such a move builds in a greater chance that the mortgage contract will not be paid as agreed. In order to protect their shareholders, financial institutions must price that uncertainty and add it to the cost of a mortgage.
• It will be much harder for low-income homebuyers or new homebuyers to find mortgages. Because of the even higher risk that courts may restructure loans to those groups, lenders will focus on upper-income borrowers or those with high downpayments and good credit histories.
• If the cram downs are allowed, this premium is likely to be higher until the industry has enough experience to more accurately price the added uncertainty.
• Even if they can get loans, low-income workers, first-time borrowers, and those with impaired credit histories will pay much higher interest rates since they have the highest probability of running into financial trouble.

As the Mortgage Bankers Association still opposes the cram downs “because of the destabilizing effect it will have on an already turbulent mortgage market.” Markets need stabilizing rules, not more uncertainty, in order to recover.