WASHINGTON — It took nearly nine years for Republicans and the banking industry to successfully revise federal bankruptcy laws, but the subprime mortgage crisis could prompt substantial changes in a matter of months.
Efforts to let borrowers restructure their primary mortgage during bankruptcy proceedings gained steam last week as a House Judiciary subcommittee approved legislation and two Senate bills were introduced.
Lawmakers say the bills are critical to resolving problems in the subprime market, but lenders say they would potentially devalue portfolios across the board.
Rep. Linda Sanchez, D-Calif., the chairman of the House Judiciary subcommittee on commercial and administrative law, said the House bill approved by her panel simply recognizes that the mortgage market has changed since the Bankruptcy Code was amended in 1978 to prevent primary loan modifications.
“It’s addressing an artificial distinction that was made 30 years ago when the market conditions for mortgages were much, much different,” said Rep. Sanchez, who cosponsored the bill.
But industry analysts and representatives see the effort as wider-reaching, arguing the bills would allow judges excessive leeway to change the terms of a mortgage.
The legislation “could wreak havoc on the credit markets,” said Jaret Seiberg, an analyst with Stanford Washington Research Group. “It takes an asset that had been protected in bankruptcy and priced as if it was protected and now opens it up for wholesale changes. The mortgages that banks are holding in portfolio or the mortgage-backed securities that an investor has could suddenly be worth substantially less.”
Of the three bills that have been winding through Congress, the one by Senate Majority Whip Richard Durbin, D-Ill., is considered the most expansive. Its provisions include one to let borrowers rescind a mortgage if the lender violated Truth in Lending Act or any other state or federal consumer protection law.
The Durbin bill also would give bankruptcy court judges the power to reduce the interest rate on home mortgages and extend the maturity of it up to 30 years. Additionally, it would mandate more up-front disclosure of all charges that debtors would be responsible for and would allow the U.S. trustee overseeing the Chapter 13 bankruptcy case to pursue claims that were not initially sought by the debtor. And it would allow more debtors to skip the credit counseling mandated by the 2005 bankruptcy reform law.
Sen. Durbin’s position on the issue is key. As Majority Whip, he is a top member of the Democratic leadership and helps determine what bills get floor time.
The scope of Sen. Durbin’s bill is said to have caused a last-minute split with Sen. Arlen Specter, R-Pa., who planned to work with the Illinois Democrat on a bipartisan proposal. Sen. Specter, the lead Republican on the Senate Judiciary Committee, introduced his own bill on Wednesday that would allow mortgages to be modified only if they were underwritten before Sept. 26.
Sen. Specter also split with Sen. Durbin on a provision that would allow bankruptcy judges to “cram down” a mortgage’s principal value. Sen. Specter would allow judges to decrease the value of the loan only with the consent of both the lender and borrower.
Aides to Sen. Specter said Sen. Durbin is seeking permanent changes to the Bankruptcy Code instead of helping homeowners struggling with the subprime crisis. A memo outlining the differences between the two bills says, “The Durbin bill effects permanent, far-reaching changes to the way mortgages are treated in bankruptcy by eliminating provisions that have kept interest rates on home mortgages low for the past 30 years.”
A bill from Rep. Brad Miller, D-N.C., is designed to be more targeted. It would require timely notification of fees and would not expand the power of the U.S. trustee to go after claims the debtor did not request. The House bill would also give fewer debtors the option to waive their credit counseling.
But the bill would allow bankruptcy court judges to reduce the interest rate on home mortgages and extend its maturity. The bill passed the House administrative law subcommittee along party lines 5 to 4 on Thursday, and is expected to be voted on by the Judiciary Committee this week.
Though the three bills vary in scope, industry representatives said privately that they would probably oppose all of them, because each contains a provision to allow terms of a mortgage to be altered, which they say is unfair and would inject even more uncertainty into the mortgage market.
“In the short run, when the game book changes there are a whole bunch of players who got in and thought they were playing by another playbook,” said Sandeep Bahiya, an associate professor at Georgetown University’s business school. “To change the book on them in the middle is wrong.”
Several industry representatives agree. Scott Talbott, the senior vice president of government affairs at the Financial Services Roundtable, said that risk would be passed on to consumers in the form of costlier mortgages and less access to credit.
“It would increase the cost of owning a home to middle-income Americans and would prevent lower-income borrowers from owning a home,” he said. “The lenders and the markets would respond by adjusting, which translates into higher down payments or increased interest rates or both.”
Lawmakers say the industry is overreacting. In an interview Thursday, Rep. Miller said the markets would adjust for added risk without hurting homeowners.
“Apparently I have more faith in the market than they do,” he said. “I think that the market can assess risk and price for risk, and a home mortgage is the only kind of secured debt that cannot be modified now. I don’t think that the effect on the pricing of home mortgages will be measurable.”
And though bankers contend that any change to the Bankruptcy Code could eventually lead to a broader overhaul of the Bankruptcy Abuse Prevention and Consumer Act of 2005, one of the industry’s key legislative victories in recent years, lawmakers said they are keeping their bills targeted for now.
“This bill has nothing to do with that,” said Rep. Melvin Watt, D-N.C. , speaking of the Miller bill, which he cosponsored. “This is an emergency bill that’s in response to what’s going on in the market now and what we anticipate is going to continue to go on in the market.”
Rep. Sanchez also said the bill is “not an attempt to undo the bankruptcy reform that was passed. It’s trying to react to a specific crisis that we see in a way that’s very strategic.”
Prospects for the bankruptcy reform bills remain uncertain, but analysts said the subprime crisis continues to put pressure on Congress to act.
“We believe the odds are 1 in 3 for enactment, because we expect there to be enormous political pressure to provide relief to troubled borrowers,” Mr. Seiberg said. The legislation under consideration is the only option “on the table that provides relief without bailing out lenders or costing taxpayers a dime.”
