Mortgages, Congress and Contractual Rights

A number of stories regarding mortgages and Congress have been circling this week. More specifically, Congress has been working on legislation that would allow bankruptcy judges to modify mortgage contracts. In fact, some of the rumored provisions only apply to second homes and investment properties. There are some serious issues with this sort of idea.



The concept is that lenders are reluctant to write down the principal of mortgages that are in default. If you are a bank that lent say $200,000 on a mortgage and the buyer stopped paying while the value of the home is now say $180,000, you obviously lost money. In normal times, the borrower still owes you $200,000, but obviously can't pay. The property gets foreclosed and the bank sells the home at a loss, recouping as much as possible. In such a case, the bank propbably will lose over $30,000 on a $200,000 investment. However, before foreclosing, the bank could have decided to refinance the loan into a) a longer maturity, b) a lower rate and/or c) knocked the loan balance down to say $190,000 in acknowledgement that losing $10,000 is better than losing $30,000, provided the new terms make the home affordable for the homeowner. Sort of a win-win where both the lender and buyer get something by cutting their losses.

Lenders are reluctant to reduce the loan amount for obvious reasons though: the buyer signed a contract where they can't keep up their end of the bargain, so why should the bank set a precedent of leniency? If you lent $1000 to your 20 year old child and they come back and say "you know, I really just can't pay right now because my car needs brakes", do you say "that's ok, not only will I let you pay me back in a few months even though you promised it would only be one month, but just give me back $800 and we'll call it even"? I don't think so. The financial system uses other peoples money, it is not the Bank of Mom/Dad. Doing such a thing would encourage people to default after they borrowed and spent the money. Just like the 20-year old would try that trick over and over.

Also consider that in the U.S. a mortgage is a non-recourse collaterized obligation. That means the loan is secured by the property- don't pay and you turn over the keys. But it is also non-recourse meaning that in the example above, the bank can't come after you to recoup its losses. The bank gets the house, that's it. The lender takes the risk in exchange for the property, no more, no less. Pretty darn fair, actually.

So, Congress is trying to pass legislation that effectively says, if you can't make your payments and file for bankruptcy, the judge has the power to modify the mortgage and lower the amount you owe. Remember, the mortgage is a contract with no recourse unlike credit card debt. If you owe on a credit card and can't pay, the interest starts racking up at 15, 20, 25 even 30%. The card company has no collateral and so can come after you for the full amount even if you can only pay say 80% of the balance. Bankruptcy judges protect the borrower from this by being able to write off some of that debt.

It is the non-recourse collaterized feature that makes mortgages carry such low interest. But if the contract can be re-written after the fact despite the protections for borrowers, who is going to make a loan? Think about it: what good is a contract if the contract can be rewritten unilaterally without negotiation? The collateral is no good, since the contract doesn't uphold the right to that collateral.

Let's flip the coin to illustrate. Say you deposit $275,000 into a bank paying you interest. Effectively you loan the bank money. Now the bank comes to you and says "we can't pay you back, so we are going to file bankrupcy where the judge can decide how much you get back." You tell them the FDIC guaranteed your deposit up to $250,000 (collateral), so at least give you$250,000. The bank says "yeah, but Congress decided to change that guarantee after you made the deposit, so you'll have to wait over a year for the judge to decide what you get." "But I need the money" Too bad. Would you lend to a bank anymore? How much interest would they have to pay you to make the risk worthwhile? Outrageous!

Congress is unilaterally taking away the protections that make the loans so inexpensive for borrowers. In finance, risk is "priced" by the expected return: A higher risk of default or the less safe an investment is, the more the investor demands in compensation for taking that risk. Make a loan to someone less likely to pay and the interest rate is going to be higher. If mortgages are effectively no longer bound to the terms of the contract, they become much, much riskier and the rate will climb to compensate the lender for that risk and/or only the most credit worthy will be offered loans (another way to reduce risk is to make safer loans). Is tighter credit and higher rates what we need?

Even more puzzling, I have heard but can't confirm, is that Congress is targeting these measures on second homes and investment properties. This makes no sense to me. Why protect an investor who speculated? Last I checked, second homes and investment properties (like that lake or ski rental your neighbor owns) is not part of the American Dream of owning a home to live in. Why is a Democratic Congress trying to protect such luxuries?

To be sure, modification of loan terms is an appropriate tool when done fairly (primarily through lower interest rates and longer maturities- this drops the payments considerably without giving away principal). Lenders and the government have programs to help refinance existing loans. To date, they have been a failure- such programs have modified far fewer loans than planned and out of those loans modified, over 50% have defaulted anyway.

I have a hunch this action is Congressional retribution against lenders (i.e. punishment or threat of) and not intelligent policy making intended to help the situation. No one said Congress is rational.