The nation faces a foreclosure crisis of historic proportions, and there is an understandable desire on the part of the federal government to "do something" to help. House Judiciary Chairman John Conyers's bill, which is moving swiftly through Congress (and companion legislation introduced by Sen. Richard Durbin) would allow bankruptcy judges to modify home mortgages by reducing both the interest rate and principal amount on the loan. This would be a profound mistake.
Mortgage modification would indeed provide a windfall for some troubled homeowners -- but its costs will be borne by aspiring future homeowners, and by any American who uses credit of any kind, from car loans to credit cards. The ripple effects could further roil America's consumer credit markets.
In the first place, mortgage costs will rise. If bankruptcy judges can rewrite mortgage loans after they are made, it will increase the risk of mortgage lending at the time they are made. Increased risk increases the overall cost of lending, which in turn will require future borrowers to pay higher interest rates and upfront costs, such as higher down payments and points. This is illustrated by a recent example: In 2005, Congress eliminated the power of bankruptcy judges to modify auto loans. A recent staff report by the Federal Reserve Bank of New York estimated a 265 basis-point reduction on average in auto loan terms as a result of the reform.
Allowing mortgage modification in bankruptcy also could unleash a torrent of bankruptcies. To gain a sense of the potential size of the problem, consider that about 800,000 American families filed for bankruptcy in 2007. Rising unemployment and the weakening economy pushed the number near one million in 2008. But by recent count, some five million homeowners are currently delinquent on their mortgages and some 12 million to 15 million homeowners owe more on their mortgages than the home is worth. If even a fraction of those homeowners file for bankruptcy to reduce their interest rates or strip down their principal amounts to the value of their homes, we could see an unprecedented surge in filings, overwhelming the bankruptcy system.
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