Citigroup and Dick Durbin rewrite bankruptcy law—but won’t the investors be mad?

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Mortgage servicers (who in many cases are also the original lenders) have long been saying they can’t simply cut interest rates or reduce principal balances on loans to help people avoid foreclosure, because they’ll get sued by investors in mortgage-related securities. I find it interesting that this argument has been largely absent from the conversation about Citigroup signing on to Illinois Democrat Dick Durbin’s effort to give bankruptcy judges the power to rewrite the terms of mortgages.

I guess that might be because if bankruptcy judges make those changes it won’t be the servicers’ doing. But I’m also wondering if it might be an indication that we’re finally past the point of blaming investors for the hang-up.

The other day I was talking to one such investor at a big commercial bank, and he was saying how annoying it’s been to hear servicers in Washington blame investors when the need for more aggressive loan modifications is overwhelmingly apparent to people like him. Safe to say his firm isn’t looking to sue anyone on that count.

I asked him why then more hasn’t been done, and he said that he thought servicers simply don’t have the economic incentive to modify loans on a mass scale. He said foreclosure is an easy process—one long-established—but going through a portfolio loan by loan and figuring out which are likely to be more valuable with a modification, and what sort of modification would be best, is hard work. Foreclosure is a mechanical process, he said; determining that a modification is the best economic outcome is subjective.

So everyone sits on their hands and waits. I asked him what he thought about Fannie and Freddie paying servicers $800 for each loan they modify, and Sheila Bair wanting to hand out $1,000, and he said he thought such efforts were directionally correct—but that to really spark modifications, the amount would have to be much more. He was just guessing, but after thinking a bit about typical servicing fees, he said probably at least $2,500.

You might be asking why I’m still talking about this if we’re headed toward rewriting bankruptcy law to let courts handle the issue. Well, that’s exactly why I’m still talking about this. Maybe I’m being a bleeding heart, but I don’t think we should create a system where a family has to declare bankruptcy in order to get a loan modification. The whole point is that there are broad forces at work in our economy that no one saw coming. I get that plenty of people made unwise decisions and that they need to take responsibility. Bankruptcy, though, is a horrific process that wrecks not only a person’s finances but often their relationships, too.

Fine, let’s redo the bankruptcy law. I’m good with that. But I don’t think it should be the end of the conversation.