U.S. judges see red herring in mortgage cramdown fear

NEW YORK (Reuters) - Mortgage bankers are in knots over proposed U.S. legislation that allows loan contracts to be broken up in bankruptcy court, fearing it will taint the core of their business and raise interest rates.

But their fight against the bill gaining momentum in Congress is an overreaction, or a red herring to prevent the industry from realizing inevitable losses, some judges said.

“Judges aren’t just going to run wild,” said Judge Keith Lundin, of U.S. bankruptcy court in Nashville, Tennessee.

Rising foreclosures and a recession have given strength to the legislation, which for the first time would let judges approve changes to loans on owner-occupied homes for borrowers in bankruptcy. Some provisions, such as legal protection for companies easing loan terms, have set off more alarms for investors worried about returns on mortgage bonds.

Bankers and investors are concerned that judges are inexperienced in real estate, and will make draconian changes to mortgages that may boost losses over alternatives. Judges scoff, noting they have had to value vacation, rental and farm property for decades, with the help of industry experts.

The so-called “cram-down” bill will be a key tool for authorities to offset the foreclosure crisis that is growing more acute as home price fall, judges said. In four years, U.S. foreclosures could hit 16 percent of all mortgages, unless steps are taken to slow the pace, according to Credit Suisse.

“The short-term problem is foreclosures, and the long-term problem is the U.S.’s credibility as a place where people can invest money and know that contract will be honored,” said Bill Frey, president of Greenwich, Connecticut-based Greenwich Financial Services, which is suing Countrywide Financial for breaking bond contracts in planned modifications.

“Is it good public policy to sacrifice the latter for the former?” he asked.

The housing slump, now deep in its third year, has also pushed President Barack Obama to propose helping up to 9 million troubled borrowers with refinancings and using taxpayer money to encourage loan modifications.

The ability to rework loans on non-owner occupied homes hasn’t affected those rates, said Lexington, Kentucky, U.S. Bankruptcy Judge Joe Lee, citing a Georgetown Law study.

Bankers are merely putting off the realities of the ailing housing market, Judge Lundin said.

“If these guys are worried about value, it’s about what they did, not because of what I’m going to do,” said Lundin, speaking of bankers’ roles in offering risky loans. “They don’t want someone with authority telling them what their securities are worth, that’s what they’re afraid of.”

Judges in the mid-1980s used Chapter 12 of the bankruptcy code to rewrite farmland values, aiding farmers who were also faced with falling commodity prices. After a year or two, the real estate market adjusted, Lundin said.

“I guarantee you, that is exactly what will happen if you allow home mortgages into Chapter 13” bankruptcy, he said.

Limits to reworking mortgages -- such as how deeply a loan can be cut -- may cap volume. Of the mortgages whose balances are now higher than the home value, 15 percent to 20 percent might find their way to court if the bill becomes law, said Judge Sam Bufford, of U.S. bankruptcy court in Los Angeles.

What’s more, the legislation would put the costs of reworking mortgages entirely on the private sector, quelling a rising tide of anger among Americans watching the government throw taxpayer dollars at banks and consumers, he said.

“There is not a penny of government money needed to do it at the time when Congress is wondering where is the bottom of this pit, of pumping billions into the economy,” he said.

Fixing a loan through a servicer modification or in court also promises investors a better return than if a home were sold at distressed levels after foreclosure, judges said. Investors dispute that blanket assertion, though record modifications by servicers last quarter suggests they are increasingly assuming losses would be higher in foreclosure.

A provision in the bill that protects senior investors by piling principal loss on subordinate holders is another slap in the face of contracts since it rewrites terms of how losses are disbursed, Greenwich’s Frey said.

The $3 trillion-plus market for non-guaranteed mortgage bonds was hobbled in January as Citigroup Inc. broke ranks with the industry with support of some cram-downs. The top-rated, most-recent index of subprime mortgage bonds has only sunk since then, hovering around record lows near 30.

The push by the Obama administration to incent servicers to do more modifications is thus unfairly hurting Americans that have invested in mortgages through pensions and mutual funds, said John Berlau, director of the Competitive Enterprise Institute’s Center for Investors and Entrepreneurs.

Not to worry, said Judge Lundin.