Maurna Desmond and Daniel Fisher, 03.17.09, 11:30 AM EDT
Hiding in Obama's foreclosure bill are provisions to protect big investors from bankruptcy cramdowns.

Washington is finally realizing that there are two types of mortgage investors and you usually can't help one without hurting the other.

A last-second addition to the Helping Families Save Their Homes Act of 2009 would make it so that senior mortgage investors--often pension funds, foreign banks and life insurance firms--would fare better with a court-ordered loan modification than a voluntary one involving taxpayer subsidies.


Reducing a loan amount in bankruptcy court is called a "cramdown" and it's popular with spread-the-wealth types who argue home loans are the only ones that can't be adjusted in court. It's also gotten support from Citigroup--after the troubled bank got a bailout from the government--and now from certain investors who were previously terrified at the idea.



The legislative fix was imperative, says Frank Keating, president of the American Council of Life Insurers, in a late February letter to Congress. "Without clarifying language, top-tier mortgage-backed securities could be downgraded significantly, resulting in increased capital requirements for life insurers and a need to raise additional capital in a hostile environment," he wrote. "This issue by itself is of extreme importance to life insurers."

Here's the problem: Most so-called pooling and servicing agreements, or PSAs, currently say all losses in the event of a "cramdown" are shared pari passu, or equally among all investors. Here's how the House fixed it: Representatives voted to invalidate that part of the securities contracts, restoring the "waterfall" structure that insures top-ranked securities are paid in full before lower-level paper gets anything.

The contract language legislators found so offensive was designed to protect all investors against a very rare occurrence, since it was illegal for bankruptcy judges to cram down single-family mortgages, says Adam J. Levitin of the Georgetown University Law Center. As lawmakers were drawing up the anti-foreclosure bill, Levitin says, bankers and other holders of AAA paper realized that clause could bite them hard if millions more homeowners elected to go bankrupt instead of going through foreclosure.

A proponent of bankruptcy cramdowns, Levitin isn't exactly brimming over with sympathy for his beneficiaries, who he says should have predicted what would happen to their gold-plated investments if bankruptcy judges got the power to trim mortgage balances.

"This is a bullet (senior bondholders) have seen coming for over a year," Levitin says. "But the nature of doing bailouts means rewarding some people who shouldn't be rewarded and vice versa."

About $200 billion in mortgage-backed securities could be impacted by court-ordered loan modifications, according to Economy.com's Mark Zandi. If passed, the provision will protect the 401(k)s of countless Americans, but it will inevitably have intended consequences. "It's counter to what some politicians intended ... It will reduce the incentive for Triple-A security owners to go along with loan modifications under President Obama's plan," Zandi says.

At the same time, the bill tries to encourage servicers to keep borrowers out of bankruptcy court by modifying their loans first. (See "Loan Modification Plan Gets Sweeter.") That would benefit holders of riskier securities backed by lower-quality mortgages and second liens. Commercial banks, for example, sold many of the first liens they originated and have kept an estimated $400 billion of second mortgages on their books, equal to their entire capital base.

Jeff Gundlach, chief investment officer of TCW, a Los Angeles-based money manager, says that restoring the waterfall structure in court with juniors taking a hit is only fair. "They signed up for the first-loss risk," he says. "They should get it."

While sweetening cramdowns for senior investors might make the idea easier to sell, it still catches plenty of pushback. The measure would undermine the value of hundreds of billions of dollars in mortgage-backed securities by making it almost impossible for investors to predict what those mortgages will be worth if borrowers elect to file for bankruptcy instead of going through foreclosure.

The Mortgage Bankers Association says passage would tack an additional two percentage points onto borrowing costs for consumers and Barclay's estimates that cramdown legislation would double or triple the number of Chapter 13 bankruptcies filed in the U.S. as borrowers figure they will do better in bankruptcy than foreclosure.

Still, even if the cramdowns are bad for lending and bad for banking, don't expect too much bellyaching from Wall Street--at least not in public. Hedge funds and investment banks that bought up the junior debt are among the nation's most disliked institutions these days and they'd be flayed for grumbling about unfair treatment.

"It's a very interesting fact that we are not hearing complaints about this," says Zandi.


Forbes