Subprime Fall Out Battle In Full Swing

A bill that would provide greater bankruptcy protection for consumers facing foreclosure advanced yesterday despite protests by the Financial Services Roundtable, several large banks, and the White House. H.R. 3609, legislation co-sponsored by Reps. Brad Miller (D-N.C.) and Linda Sanchez (D-N.C.), was referred to the full Judiciary Committee today on a 5-4 vote. The legislation would, according to the WSJ, allow bankruptcy judges to adjust mortage interest rates and the length of mortgages to help borrowers avoid foreclosure. Judges could also possibly adjust the balance of the loan to reflect declining home values. For example, if $150,000 were owed on a house now worth $125,000, the judge could mark $25,000 to be "unsecured debt," making collection much more difficult.

This new law would naturally afford borrowers more protection than they enjoy under current law presumably at the expense of banks. Banks would have a more difficult time foreclosing on insolvent borrowers and would end up holding mortgages of lower value. David Kittle, the Chairman-Elect of the Mortgage Bankers Association (MBA) argued before the Subcommittee on Commercial and Administrative law that lenders would take into account this risk by increasing interest rates on mortgages by as much as 1.5-2%.

This legislation is interesting for two reasons. From an economic perspective, would it actually raise interest rates by 1.5-2%?Given that the source has an interest in killing this legislation, my guess would be no not now? But would this lead to some rise in the cost of obtaining a mortgage, either monetarily or administratively? It is definitely possible. Mr. Kittle is correct that risk should in theory be priced into the load. But considering that we have just come out of a period in which risk has been priced so badly, how much of this risk will be priced in for average buyers?

Much of the lending which fueled the bubble occured because risk was ignored. Mortgage originators did not end up holding risk at the end of the day so they originated as many loans as possible to maximize their fees. Meanwhile, borrowers and lenders alike anticipated (unrealistic in hindsight) ever-rising home prices so that borrowers could refinance. Now if this risk is better priced into the system (a good thing), we will expect interest rates to rise on their own. If interest rates are already rising will lenders be able to simply tack on another 1.5-2% when they are trying to bring borrowers back to the market?

From the political perspective, this legislation is interesting because a good deal of the subprime lending occured in Republican districts. This means it has potential of passing and could lead to some interesting defections.