The fine-tuned version of mortgage bankruptcy reform in President Obama's housing plan would be considerably less painful for lenders than the legislation making its way through Congress.
The administration said this week that it would let bankruptcy judges modify mortgages on primary residences only if the loans were made in the "past few years." Recent proposals from lawmakers would have let judges rewrite any such loans made before the enactment date.
Loans bigger than the conforming limit of $729,750 would not be eligible for judicial modification under the administration's plan. The White House said it added this restriction "so that millionaire homes don't clog the bankruptcy courts." Importantly, the plan would also have the Federal Housing Administration and the Department of Veterans Affairs cover bankruptcy-related losses on the loans they insure. Currently those agencies — whose loans have become increasingly popular since the subprime mortgage market imploded in 2007 — exclude such losses from their coverage.
If that remained the case and bankruptcy judges were allowed to modify loans, servicers of FHA and VA loans would take the hit, industry sources said.
"It would have been disastrous for servicers," said Vicki Vidal, an associate vice president at the Mortgage Bankers Association. "It would have been an extreme burden on the servicing industry to absorb principal losses. The industry is not structured to accept that level of loss."
Bose George, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc., wrote in a note to clients Thursday that allowing the FHA and the VA to reimburse servicers for principal writedowns in bankruptcy "should offset any potential negative impact to holders of FHA loans and FHA servicers."
Though the administration's tweaks came as a relief to the industry, cramdowns would still pose problems for lenders.
For example, FHA and VA loans are typically securitized through the Government National Mortgage Association. That agency requires servicers to repurchase loans when the borrower files for bankruptcy protection.
As a result, servicers currently "have to use capital" to buy loans out of Ginnie Mae pools and are "stuck with the loans on their balance sheets," and that would continue to be the case, said Larry Platt, a partner and co-head of the financial services practice at K&L Gates LLP.
Nevertheless, he called the use of conforming loan limits to narrow the field of borrowers eligible for judicial modifications "a big deal" for banks, thrifts, and other holders of mortgage-backed securities.
Because many securitization documents contain language that identifies bankruptcy as a condition in which all bondholders share losses equally, any cramdown legislation could prompt ratings agencies to downgrade triple-A bonds.
"The fear was that this could result in a reduction in the value of bank balance sheets and create an impairment of capital," Mr. Platt said.
In the Obama plan, cramdowns would still hurt the cash flow of bondholders, but not for jumbo mortgages, because of the exclusion of any loans above conforming limits, he said.
Observers also said there remained some potential for abuse.
Edward Morrison, a law professor at Columbia University, said borrowers who did not qualify for a loan modification under the new guidelines could file for protection from creditors under Chapter 13 of the federal Bankruptcy Code and try to receive a bigger principal reduction. "It's a theoretical possibility that bankruptcy might offer a more generous modification than an Obama modification," Prof. Morrison said.
The Obama administration specified that to receive a judicial modification in bankruptcy proceedings, before the filing, "homeowners must first ask their servicers/lenders for a modification and certify that they have complied with reasonable requests from the servicer to provide essential information."
Mr. Platt said that language needs to go further.
"You shouldn't get a better deal in bankruptcy than you can get in a modification," he said. "If a servicer offers a standard modification pursuant to the Obama uniform terms, the borrower can reject that, file for bankruptcy, and get a better deal."