Tidal Wave of Foreclosures Will Force Bankruptcy Reform

Congress will be forced to give bankruptcy judges more power over mortgage lenders.

By Renuka Rayasam, Associate Editor, The Kiplinger Letter

October 10, 2008

A wave of foreclosures will crest next year, forcing the new Congress to take up bankruptcy reform in 2009. At issue is a provision that prohibits judges from ordering banks to renegotiate mortgage terms with homeowners when they file for protection from creditors under bankruptcy or reorganization law.

Consumer and banking lobby groups battled over modifying this bankruptcy law for years. Even amid the latest crisis on Wall Street when banks are more vulnerable than at any time in recent memory, efforts failed to include a provision in the financial market rescue plan that would have required banks to write down mortgage terms under certain conditions.

"[Legislators] clearly decided this is not a priority," at this time, says Ruth Susswein, deputy director of national priority at Consumer Action. "But we will continue to push for it, because it is the only plan that actually doesn't cost the taxpayers anything." Banking lobbyists argue that consumers end up paying higher interest rates that banks charge to offset the cost of writing down bad loans.

But the current housing market crisis is pushing Congress toward giving some additional options to up to 400,000 homeowners at risk of foreclosure. As of Oct. 1, homeowners struggling to make payments who meet certain criteria set out by the Federal Housing Authority (FHA) can ask their bank to write down the value of their mortgage to at least 90% of the home's market value and lower the interest rates on the mortgage. In exchange, the bank will get FHA backing, guaranteeing payment from the government if the homeowner defaults.

But consumer groups say the measure won't stem a coming flood of foreclosures. Bankruptcies will continue rising, and an increasing number of people will lose their homes to banks. In the first half of 2008, banks foreclosed on 1.2 million homes, and this is expected to rise even higher than the 2007 figure of 1.5 million homes as more and more homeowners lose jobs and become saddled with bills they can't pay.

"Soon we will discover that the bailout will do nothing to stop foreclosures," says Henry Summer, president of the National Association of Consumer Bankruptcy Attorneys. "Changing bankruptcy law is the only way to do that."

Congress might even take up the 2005 bankruptcy law and tackle consumer complaints that the process is on average 50% more expensive than it used to be. Reform advocates argue that the law creates unnecessary paperwork and forces people about to file for bankruptcy into pointless credit counseling sessions that often do little more than postpone the inevitable. "Certainly there are a lot of parts of that law that are not doing good for anyone," says Summer. "It was supposed to ferret out abuses, but it hasn't."

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