New Obama Bailout Will Reduce Principal Owed on Some Mortgages

By Matt Cover | February 18, 2009 | 7:27 PM EST

A row of vacant, new homes in Gilbert, Ariz. With one of the highest foreclosure rates in the country, Arizona is the chosen backdrop for President Barack Obama's new housing program, to be unveiled Wednesday. (AP Photo/Matt York)

( - President Barack Obama announced a mortgage assistance plan on Wednesday that contains provisions allowing bankruptcy judges to reduce the value of mortgages, known as a cram-down, and gives participants up to $1,000 a year if they make their mortgage payments on time.
According to a fact sheet released by the Treasury Department, the plan “will provide a monthly balance reduction payment that goes straight towards reducing the principal balance on the mortgage loan.”
“As long as the borrower stays current on his or her payments, he or she can get up to $1000 each year for five years.”
This means that the government will pay down the principle on a mortgage, up to $1,000 per year for five years, if the homeowner stays current on his renegotiated payments during that time.
The plan also includes a one-time $1,500 payment to mortgage holders who modify loans for borrowers who are still current on their payments, if the borrowers are determined to be “at risk of imminent default.”
Financial institutions also will receive an up-front $1,000 payment for each modification they perform, with an added $1,000 yearly bonus for three years for every borrower who stays current on their new mortgage.
In the event that modifications are impossible, the plan includes provisions such as seizures of deeds or short sales to further prevent foreclosures. Short selling is when someone buys a home for less than the value of the mortgage and is often used by investors looking to “flip” the property when prices go higher.
The plan is aimed at both the 7 percent of borrowers currently behind on their mortgages and the millions more who are estimated to be ‘underwater,’ those whose mortgage debt is more than the value of their homes. The plan will pay financial institutions “dollar-for-dollar” for reducing mortgage payments below 38 percent of a borrower’s income, if a lender assumes the losses for getting the payment down to 38 percent.
The plan also includes a controversial provision that would allow a bankruptcy judge to re-write mortgages in the event borrowers and lenders cannot come to an agreement. Known as ‘cram-down’ this proposal met with stiff resistance in Congress last year when it was proposed by congressional Democrats because lenders say it will cause interest rates to rise on new loans, as lenders take the risk of judges forcing cram-downs on them into effect.
Cram-downs are opposed by mortgage lenders because they reduce the principle value of the home, devaluing the mortgage and causing the lender to lose money. Currently, bankruptcy laws exempt mortgage debt from being restructured by judges, which acts to keep mortgage financing less expensive than other forms of debt.
If enacted, the Obama administration’s proposal would remove this exemption and allow cram-downs for people who enter bankruptcy.
The plan is optional for all lenders, even previous bailout recipients. Only those banks who take bailout funds from this point forward are required to participate in Obama’s plan.
The total cost of the plan is $75 billion and is separate from the $50 billion foreclosure relief effort announced by Treasury Secretary Timothy Geithner last week. It also is separate from the bailout passed by Congress last year, meaning the $75 billion comes on top of the hundreds of billions already spent on solving the nation’s financial crisis.
The plan is only available to an estimated 7 to 9 million people whose mortgages are owned or serviced by Fannie Mae and Freddie Mac, the government sponsored enterprises (GSE) largely blamed for instigating the financial crisis.
One problem facing Obama’s plan is the high rate of re-default for re-worked mortgages. Mortgage Metrics, a study conducted by the Office of Thrift Supervision and the Office of the Comptroller of the Currency, found that the rate of re-default after six months for renegotiated loans was 53 percent; after eight months, the rate rose to 58 percent.
Under Obama’s plan, both borrowers and lenders are locked into renegotiated mortgages for five years.
These figures suggest that re-working mortgages may not be enough to keep people in their homes, especially if housing prices continue to decline and unemployment continues to rise.