To critics' dismay, Congress — and Obama — set to give judges power to modify home loans

WASHINGTON — Proponents call it the crucial missing tool needed to get us out of the national foreclosure morass.

Critics say it could be disastrous — pushing up interest rates on all future mortgages, even for people with excellent credit, and creating huge new losses for already-ailing banks.

Wherever you come down on the griddle-hot issue of home mortgage "cramdowns," the reality is this: Congress is poised to pass legislation empowering bankruptcy-court judges to reduce the loan balances of potentially large numbers of financially distressed owners to affordable levels, and to lower their interest rates and monthly payments. President Obama has promised to sign the legislation as soon as it hits his desk.

Cramdown may be an unpleasant- sounding word, but for decades it's been part of the bankruptcy lexicon for most types of debt. If you file for Chapter 13 bankruptcy — a court-supervised, multiyear workout plan designed to provide at least partial repayments to your creditors — judges can reduce what you owe on credit cards, auto, boat and student loans and even second-home mortgages. But under current law they cannot cut the mortgage debt you owe on your principal residence.

That, in turn, allows lenders to foreclose on delinquent homeowners to force quick recovery of what they're owed — part of the reason why foreclosures are so numerous.

According to the mortgage-industry data firm RealtyTrac, lenders filed for foreclosure on 2.3 million homes last year, up 81 percent from 2007 and 225 percent higher than the filing rate in 2006.

For the past two years, Democratic leaders in the House and Senate have been pushing for a change in the bankruptcy law to include principal-residence loans on the list of debts that can be "judicially modified" — crammed down — by the courts.

They argued that banks and mortgage companies too often have been unwilling to offer delinquent borrowers serious modifications on loans because they have the option to pull the plug and foreclose.

Lending-industry groups successfully blocked those bills by appealing to Republican allies, especially in the Senate. But in the wake of the November elections, Democratic majorities are now large enough to virtually guarantee passage of cramdown legislation, maybe as early as this month.

Though final details will depend on conference negotiations between the House and Senate, it's likely the legislation will provide that:

• Only mortgages closed before the date of enactment will be eligible for cramdown protection. In other words, the focus will be on helping current owners, rather than future borrowers who become delinquent.

• To be eligible, owners will need to inform their lender or loan servicer in advance of their intention to file for bankruptcy protection. That's intended to get the lender's immediate attention and prompt its best offer on a modification of the their loan terms, including principal reduction.

• Should the value of the borrowers' home increase, any appreciation would be shared with the lender under a preset formula.

Though banking groups predict that huge numbers of delinquent homeowners will opt for bankruptcy to avoid foreclosure, some consumer advocates say those fears are overblown.

"This is not going to be a cakewalk" for owners seeking protection of the courts, said David Berenbaum, executive vice president of the National Community Reinvestment Coalition.

Owners will need to hire a lawyer and petition for Chapter 13 bankruptcy. Then they'll be required to follow a detailed bankruptcy court-ordered household spending plan, monitored by a trustee, for a period of years.

Finally, their credit scores and ability to borrow will be severely affected for seven to 10 years.

"This should only be a last resort" for homeowners, said Berenbaum, not anybody's first choice.

Though resigned to the probability that some form of mortgage cramdown will be enacted, financial-industry leaders continue to warn of dire consequences.

Allowing "judges to unilaterally change mortgage contracts will increase costs for all future borrowers in the form of higher rates, greater fees and larger down-payment requirements," said Steve O'Connor, senior vice president of government affairs for the Mortgage Bankers Association.

Cramdown advocates answer that lenders are blowing smoke about rate increases, and that there is no statistical evidence that rates increase when consumers get the right to file for bankruptcy protection on a particular type of debt.

The best possible scenario coming out this whole controversy: that lenders and delinquent borrowers begin talking about serious modifications far earlier in the process than they've done so far.

That way fewer people have to file for bankruptcy, fewer lenders get crammed down and fewer people lose their houses.

Kenneth R. Harney: kenharney@earthlink.net