A foreclosure fix: More bankruptcies

By Liz Pulliam Weston

The big surge in bankruptcies will get worse if some lawmakers have their way.

Let's hope they do.

Legislation that would allow bankruptcy judges to modify the terms of residential mortgages is finally gaining steam in Congress. The idea has the support of key congressional Democrats, President-elect Barack Obama and an impressive array of consumer advocates, from the AARP to Consumers Union, the publisher of Consumer Reports.

This is the fourth time in the past year that Sen. Dick Durbin, D-Ill., has tried to convince his colleagues that a small, temporary change in the bankruptcy law could prevent hundreds of thousands of foreclosures with no expense to taxpayers.

It's an approach I advocated in a May 2008 column, "A bailout that wouldn't cost you a dime," but it's one that mortgage bankers hate and have managed to kill the previous three times.

• Talk back: Is this a good move to help slow foreclosures?

I warned you back then that a foreclosure tsunami was coming that could devastate property values and local economies. I said that if Congress didn't act to stem the crisis, we'd all pay the price.

It didn't, and we are.

Averting more devastation to economy

If we don't slow the pace of foreclosures, they'll continue to devastate the economy. But most lenders haven't been willing to do the one thing that would actually help keep homeowners in their homes, which is to reduce the mortgage principal to the current fair market value of the home.

It's not that lenders are stupid. They know that:

• Home values have dropped, leaving many troubled borrowers owing far more on their properties than they're worth.

• Many of the mortgages made no sense in the first place, because the payments quickly became unaffordable.

• A foreclosure will cost lenders far more than a loan modification, since the foreclosure process is expensive and typically nets significantly less than the home's fair market value.

But lenders are still resisting lowering the principal owed on the loans. Part of the problem is that they're understaffed, but they're also worried about being sued by the investors that hold various pieces of these loans.

So they continue to foreclose. And because of the widespread use of derivatives based on these bad loans, the effect of each foreclosure is magnified throughout the economy.

A rush on bankruptcy courts

Giving bankruptcy courts the power to do what lenders won't, or can't, makes sense. Bankruptcy court is the place where contracts of all kinds can be modified. Furthermore, bankruptcy judges already have the power to alter mortgages on rentals and vacation homes; extending this authority to mortgages on primary residences is long overdue.

The inevitable result of making this change will be another land rush on the bankruptcy courts, which are already plenty busy.

Continued: Why you should care

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