Cramdown legislation faces opposition

Obama's proposed "cramdown" legislation is facing opposition among moderate Democrats in Congress:

President Obama is in danger of losing the biggest stick in his foreclosure prevention arsenal.

The administration's plan to stem the housing crisis depends on Congress amending the bankruptcy laws to allow judges to modify mortgages, in particular by reducing principal to make monthly payments more affordable.

The so-called cramdown provision could put pressure on loan servicers to modify mortgages before borrowers file for bankruptcy.

A major critique of the voluntary modification programs is that servicers aren't doing enough to help struggling borrowers. But servicers will likely be more aggressive in working with homeowners if they know that the borrowers can turn to judges for relief. ...

But congressional Democrats, who first introduced a bill broadening judges' power two years ago, are running into trouble gathering the support needed to pass the legislation. The House postponed a vote on the measure until early this week after a group of centrist Democrats voiced concerns. And its future in the Senate remains in doubt with many powerful Republicans strongly opposed to the legislation.

This legislation will allow judges to basically say, "I'm sorry you owe $400,000 on a house that today is only worth $200,000. Presto! Now you only owe $200,000." Of course, someone has to take the loss. It will be the banks, and they will pass much of the loss on to future borrowers (i.e. current renters).

This legislation will likely lead to higher mortgage rates in the future. A mortgage interest rate is composed of two components: the risk-free rate and the risk premium. The risk-free rate is basically just the rate of return on Treasury bills. The risk premium is an additional rate of return to compensate the lender for the risk of issuing the mortgage. The risk premium currently covers two significant risks: interest rate risk, the risk that interest rates will increase in the future, and default risk, the risk that the borrower won't repay the loan. This cramdown legislation will let banks know that in the future they will also need to account for a third risk: legal/legislative risk, the risk that politicians will change the law to modify existing contracts. This added risk will mean a higher risk premium, and thus higher mortgage rates.

President Obama's cramdown legislation is an example of irresponsible existing homeowners getting a bailout at the expense of future homeowners.

Update: The problem is not the specific cramdowns that Obama is proposing, nor cramdowns in the past. The risk is the precedent that is being set by having politicians coming in and modifying existing contracts. Banks now have to worry more that any of the terms of a mortgage that they issue may be changed, at the whims of politicians, in favor of the borrower.