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Why The Failure Of The "cram Down" Legislation Hurts Everyone

Why the Failure of the "Cram Down" Legislation Hurts Everyone

Last April, the United States Senate voted against legislation that would let bankruptcy court judges modify home mortgages in bankruptcy.   The failure of this legislation is a significant loss to home-owners, neighbors of homes on the verge of foreclosure, and ironically, to lenders.

First and foremost, home owners facing foreclosure bear the immediate brunt of the economic crisis.  In the first instance, they have seen cash reserves plummet as payments readjust, or as interest only "step up" loans cause higher monthly payments.  Once savings are exhausted, the homeowners face the possibility of foreclosure and losing their home.  This is a bad result for many reasons, including the personal loss to the buyer, the possibility of increased need to turn to social services, or a greater burden on friends or family.

In addition to the injury to the home owner, the foreclosure is bad for everyone in the neighborhood.  Homes in financial distress are less likely to be maintained, deferred maintenance goes undone, and damage unrepaired.  This lowers home values for the entire neighborhood.  Once a home goes into foreclosure, it lowers the overall intrinsic value of surrounding properties.  It also acts as unfair competition against other homes being sold in the same market, and ultimately reduces sale prices further as a comparable or "comp" in the appraisal process.

Even the banks may be damaged by a foreclosure.  In addition to losing the monthly payment, they incur the cost of repossessing, foreclosing, and reselling.  There may be expenses in making the house sellable, including repairing damage, paying back taxes, and complying with code issues.  Having additional foreclosures on the books can cause further damage to a lender's overall financial picture by adding to liabilities and throwing off the assets and liabilities.

Many of the homes purchased during the housing boom of the mid-2000s were made with zero-down mortgages.  Consequently, where borrowers paid less than 20% down, lenders required the borrowers to obtain Private Mortgage Insurance (PMI).  If a borrower defaults on a mortgage covered by PMI, the lender can recoup its loss from the insurance company.  In some loans, the mortgage can be further insured by the government, such as Federal Housing Administration (FHA) or Veterans Administration (VA) insured loans.

This short sighted decision by lenders to hedge their bets based upon PMI may prove ultimately detrimental to both borrowers and lenders.  Just as we witnessed dramatic financial upheaval as a result of the failure of AIG and its leveraged backing of derivatives, asset backed securities, credit default swaps, and other complex financial instruments, the failure of major PMI insurers may be see lenders again thrown into turmoil.  In the long run, the continued travails of the housing sector can result in weak consumer confidence and reduced purchases in an already troubled market.

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