Why foreclosure prevention plans aren’t working.

Even before the current “bail-out” bill passed, the government enacted a program (which took effect October first) to encourage lenders to “cram down” balances on mortgages (rather than foreclosing) by offering to have the FHA insure the new balance. The “bail-out” bill contains a fairly general and unclear instruction to the government to encourage such cram-downs on loans that back the bonds they buy.

But none of this is going to work, for a couple of reasons. One is that the lender that collects your money almost never “owns” the loan any more, so they really have no stake in the balance. They have probably split up the loan (interest payments and principle payments are one common way) and put the different parts of it into different bonds owned by different people or organizations.

It is very hard for the lender (now just the servicer, really) to find the owners of an individual loan (about a third of owners are foreign) and ask all of them for permission to do a cram-down.

Worse still, they have a strong incentive NOT to go through all that effort because the contracts they signed to service the loans generally call for them to get a fee if (and only if) they foreclose. Why should they go to extra trouble and get less money?

Finally, should the lender/servicer decide to do the right thing, no matter how much it might cost them, they expose themselves to suits from the bondholders who would say their contract had been violated.

That is why they should allow bankruptcy courts to create and supervise cram-downs within set limits. With the court in charge, a fair price will be settled on, the ability of the owner of the house to pay the mortgage will be checked, and lenders will be held harmless.

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