Published: December 5, 2007

Editorial: Helping borrowers will help neighborhoods

Nearly 2 million American homeowners are carrying subprime mortgages with low interest rates that will shoot up over the next two years, which could swamp some neighborhoods and the economy. The government is right to try to fashion some sort of lifeline.

But the voluntary industry rescue organized by Treasury Secretary Henry Paulson is inadequate. The Hope Now Alliance may do some good, but it won't reach enough foundering borrowers.

A better idea: Change federal bankruptcy law to allow judges to modify mortgage terms. This simple tweak could keep more than 600,000 people in their homes, according to the Center for Responsible Lending, an advocacy group that has worked to curb predatory lending.

No matter what is done, foreclosures will rise over the coming months as a string of bad decisions by borrowers, lenders and investors ripples through the economy. Not everybody deserves help, of course, especially speculators who bought homes with the intent to flip them for quick profits. Only borrowers living in their homes should qualify.

And the government should not use taxpayer money to bail out anyone. That includes homeowners in over their heads and investors who had unfortunate adventures in mortgage-backed securities.

But some help short of that is warranted for battered neighborhoods in places like Milwaukee and Detroit. The Paulson plan doesn't go far enough. A change in the bankruptcy code also is needed.

Foreclosures at record highs

The number of homes going into foreclosure jumped in the third quarter to the highest level since the Mortgage Bankers Association started tracking the number more than 30 years ago. In Wisconsin, foreclosures rose 28.7% through November, ForeclosuresWI.com reported last week. Foreclosures rose 53.5% in Milwaukee County during November compared with the same month in 2006. There have been more than 5,000 foreclosures in the county so far this year.

The Federal Reserve lowered short-term interest rates last week by a quarter-point, noting that "economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending."

Paulson's plan sorts the 1.8 million most vulnerable loans into three piles that could be labeled - "No Way," "Close, But Not Close Enough" and "Maybe."

About 600,000 of these loans are held by borrowers already in over their heads who, in Paulson's words, will "become renters."

The government believes the second group either will be able to afford the higher monthly payments or to refinance their mortgages.

The third group - the "maybes" - might get relief. Some would qualify for a five-year extension of their introductory teaser rates. Industry experts claim they don't know how many subprime borrowers would ultimately qualify; independent estimates range between 145,000 to 360,000 loans.

Far more could be helped by the proposed change in bankruptcy laws, which is part of several bills moving through Congress.

Under current law, bankruptcy judges cannot modify terms of a home loan, even though, strangely, they can make modifications for investment properties, vacation homes and boats. Changing the law costs the federal government nothing, targets people who need help the most and places the decision in the hands of impartial referees.

Credit and credibility

The lending industry argues that there could be a flood of bankruptcy filings and that the change would drive up costs and lead to tighter credit.

Bankruptcy filings may grow, but it is unlikely that they would mushroom. Bankruptcy remains an unpalatable option for most borrowers, a stain on a credit record that takes years to wash out. As for the argument that a change in the law would distort lending markets, history suggests otherwise. There was little evidence that either the cost or the availability of credit was affected when bankruptcy laws allowed loan modification on primary residences between 1978 and 1993. Keep in mind, loans in foreclosure represent only a fraction of all loans outstanding. The numbers aren't large enough to have the effect the industry claims.

Furthermore, during the 1980s farm crisis, the bankruptcy code was modified so that farm loans would be adjusted, which created a model for lenders and borrowers to use outside bankruptcy court, according to Jacqueline P. Cox, an Illinois bankruptcy judge. "They were often able to modify mortgage obligations on their own, without the bankruptcy court's involvement," she told the Senate Judiciary Committee earlier this month.

The credibility score of some lenders is nearly as low as the credit scores of many of their customers. As Henry J. Sommer, president of the National Association of Consumer Bankruptcy Attorneys, told the Senate committee:

"These are the people who created this mess and are now suffering billions of dollars of losses, not because of any bankruptcy laws but rather because of their poor predictive abilities."

Borrowers should be the focus, and many of them deserve a lifeline. Modifying the federal bankruptcy code would give them one.