OP-ED - Letting Judges Rewrite Loans Is Toxic Itself

OP-ED: Letting Judges Rewrite Loans Is Toxic Itself

Investors Business Daily, By Rep. Ed Royce (R-CA)

FEBRUARY 26, 2009

"At first blush it seems somewhat strange that the Bankruptcy Code should provide less protection to an individual's interest in retaining possession of his or her home than of other assets . . . (but) favorable treatment of residential mortgages was intended to encourage the flow of capital into the home lending market."

That was Supreme Court Justice John Paul Stevens in 1993. Yet today that sound reasoning is turned on its head with President Obama's proposal to allow bankruptcy judges to rewrite existing mortgage contracts.

Despite a vocal opposition to this "cram-down provision," it is being pushed through Congress by the administration and Democratic leadership and will likely be voted on in the House on Thursday.

Beyond the long-term damage this provision will have on our private mortgage market, the precedent this legislation will set risks permanently undermining the sanctity of private contracts upon which our country's economic model is based.

The consequences of the cram-down will likely be felt by homeowners for years to come in the form of tighter credit markets and higher interest rates. Because of the uncertainty that will result from bankruptcy judges abrogating private contracts, institutions will avoid investing in the private mortgage market.

As our capital markets struggle to recover, we should be looking for ways to encourage, not discourage, capital back into the system. The less capital in the system, the more expensive it will be to obtain a mortgage. Some economists predict that a 2% risk premium will be added to every mortgage should this proposal be implemented.

Credit cards and auto loans have typically seen higher interest rates because the ability of the lender to recover collateral, if any exists, is more difficult than with less-risky mortgage loans. With the implementation of the cram-down, however, mortgage debt will likely be treated more like credit card and auto loans because lenders' ability to recover collateral will be further restricted.

Advocates for the cram-down got a boost earlier this year when Citigroup had a change of heart and endorsed this proposal. After years of opposing cram-down, Citi's reversal is likely a reflection of influx of public sector dollars into the firm and the growing influence of regulators over day-to-day operations rather than any logical policy shift.

Citigroup believes this provision is "a temporary solution" that will be implemented for outstanding mortgages and then allowed to expire following this difficult period in our economy. Unfortunately, in Washington nothing is more permanent than a temporary solution.

Much of the past success of our country's capitalist system is based on a solid foundation of free and flexible markets and respect for the sanctity of contracts and the rule of law. As a member of the Foreign Affairs Committee in the House, I have seen the stark contrasts between societies that respect private contracts and those that opt to change the rules as they go. The bankruptcy cram-down has the potential to lead us down a path toward the latter.

Private mortgage foreclosure-mitigation efforts currently under way by the Hope Now Alliance and various financial institutions throughout the country are at risk of hitting a significant obstacle should the cram-down go into effect.

Almost 2.3 million foreclosure prevention workouts were completed in 2008 - all on a case-by-case basis. An effort to allow a third party to wipe out the interest rate and principal of the loan provides a perverse incentive for those borrowers that would otherwise work together with their lender to restructure the loan.

As Congress and the administration work to stabilize the housing market, we must avoid at all costs policies that will hinder the private sector's ability to recover. Enacting the bankruptcy cram-down legislation will restrict the flow of capital into the housing sector, make it more expensive for individuals to obtain a mortgage, hinder the broader housing sector's ability to fully recover and set a disturbing precedent of the government's treatment of private contracts.

It is critical that the administration and Democratic leaders in Congress understand the long-term consequences of this misguided policy before it is too late.

Royce, a Republican, represents California's 40th congressional district in northern Orange County