The administration's plan to stem the housing crisis depends on Congress amending the bankruptcy laws to allow judges to modify mortgages, in particular by reducing principal to make monthly payments more affordable.
The so-called cramdown provision could put pressure on loan servicers to modify mortgages before borrowers file for bankruptcy.
A major critique of the voluntary modification programs is that servicers aren't doing enough to help struggling borrowers. But servicers will likely be more aggressive in working with homeowners if they know that the borrowers can turn to judges for relief.
"Reforming mortgage bankruptcy laws is the only remedy available that will provide the stick to go with the carrots that we have offered lenders to modify mortgages voluntarily," said Rep. Brad Miller, D-N.C., who worked on the legislation.
But congressional Democrats, who first introduced a bill broadening judges' power two years ago, are running into trouble gathering the support needed to pass the legislation. The House postponed a vote on the measure until early this week after a group of centrist Democrats voiced concerns. And its future in the Senate remains in doubt with many powerful Republicans strongly opposed to the legislation.
The House bill would allow judges to modify loans originated before the legislation's enactment. It would let the courts change mortgage terms to make a loan more affordable, permitting judges to reduce the principal to the property's market value, a step servicers loathe.
The Congressional Budget Office estimates more than one million households would benefit if bankruptcy judges were allowed to modify loans.
Debtors, however, would be required to contact their servicer about modifying their loans at least 15 days before filing for bankruptcy. And the debtor cannot have falsified information when he or she obtained the mortgage.
Trying to drum up support for the measure, administration officials are testifying before Congress and meeting behind closed doors with lawmakers to convince them of the need for the bill, while promising to limit its use.
"Carefully tailored bankruptcy reform is a piece of the solution," Housing Secretary Shaun Donovan told the Senate Banking Committee on Thursday. "We do not see bankruptcy court as the place to work out mortgages."
Giving bankruptcy judges the power to modify loans on primary residences -- they already can change mortgages on vacation homes -- is extremely controversial.
While Citigroup, which is under the close watch of federal regulators, has said it would support the measure, many key players in the financial industry are lobbying against the measure. Industry advocates argue that cramdown would force lenders to charge higher rates to compensate for the increased risk and uncertainty in mortgage contracts.
"This legislation will inject more risk into the housing and mortgage markets at a time when everyone is working hard to strengthen the housing market," said John Dalton, head of the Housing Policy Council, an offshoot of the Financial Services Roundtable.
If the measure must pass, the industry would like to see a requirement that borrowers have had to be offered and accepted a loan modification before seeking bankruptcy relief. Lobbyists also want to provision limited only to subprime mortgages. Also, they would like any principal balance above the home's current market value to be deferred rather than forgiven.
"Judicial modifications should be a last resort and only available where other non-judicial options have been exhausted or not available," John Courson, head of the Mortgage Bankers Association, wrote in a letter to Donovan and Treasury Secretary Tim Geithner.
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