New Effort to Prevent a Million Foreclosures Takes Shape

Last week, we learned that the Obama administration is considering other alternatives to stop foreclosures. Today, we have some color on what one of these efforts might look like. It would encourage servicers to reduce struggling borrowers' mortgage balance. Although banks have fought such efforts in the past, it seems that the program could benefit everyone involved. And the best part: it wouldn't take any taxpayer dollars.

How is this possible you ask? Rich Miller at Bloomberg explains:

Of the residential mortgage-backed securities outstanding, about $1.3 trillion are so-called private label notes that were issued by banks and other financial institutions, according to data from the Securities Industry and Financial Markets Association. "That's where a lot of the trouble is sitting," Lockhart said.

Many contracts governing such securities cap the percentage of loans that can be modified or prohibit reductions of principal, according to the paper by Dorchuck, Lockhart and Mills, managing director of Mortgage Banking Initiatives Inc. in Alexandria, Va.

To get around that, they want the Treasury to help clear the way for sales of delinquent or defaulted loans out of the securities at a discount to outside investors.

Because they would buy the loans at less than face value, these investors would be more willing to renegotiate the terms, including writing down principal, the plan's backers say.

No government money would be needed, Dorchuck said. The Treasury would have to provide the banks servicing the loans with legal cover against lawsuits by designating short-sales as "qualified loss-mitigation activity" under legislation passed in 2009.

For those wondering, James Lockhart is a former regulator of Fannie and Freddie, Jordan Dorchuck is an executive at a major mortgage servicer, and Pete mills is a housing consultant. The assertion lying beneath this explanation is that the only thing standing in the way of as many as one million principal reductions -- and foreclosures prevented -- is a tiny legal barrier.

Supposedly, if servicers could just sell bad mortgages to distressed debt investors, then everybody would benefit. Banks would get more money than they would through foreclosure, borrowers would have their principal reduced and remain in their home, and the new investor-owner would have a good deal on a loan that is more likely to perform.

Why, then, the need for legal cover? The investors in these deals could just get together and amend their agreements. But presumably some of the investors who own these loans would not be thrilled if they were sold to new investors for a loss. Which is likely the kink that has to be worked out. The sale price must satisfy the initial investors as well as the subsequent investors.

This could end up being more thank a small issue. Usually, when something sounds too good to be true, it usually is. Someone must lose here, and it could very likely be the initial mortgage investor.

If this plan works, the article notes that it could prevent a million foreclosures. That's significant, but it's really just a fraction of the millions of Americans facing default. That's in part because this proposal only applies to so-called "private label" mortgages. Those are the ones not guaranteed by the federal government, for which the market dried up after the housing bubble burst. Fannie Mae and Freddie Mac do not allow principal reductions, because they believe doing so would reduce the value of the mortgages, according to the article.

Read the full story at Bloomberg.