Attorneys general from all 50 states launched a joint investigation last week into allegations that mortgage-servicing companies submitted fraudulent documents and broke laws in foreclosure proceedings. Some lawmakers are calling for a national moratorium on foreclosures. In response, major mortgage servicers have announced a freeze on all foreclosures until internal investigations are completed.
While any fraudulent activity should of course be addressed, a comprehensive moratorium on all foreclosures will do more harm than good. For starters, it won't address the underlying issue-that thousands of homeowners can't make their mortgage payments. Postponing the resolution of these debts will actually prevent consumers from extricating themselves from loans they can't afford. Worse, a national foreclosure moratorium will exacerbate the housing-market crisis by increasing uncertainty and preventing supply and demand from reaching equilibrium.
A foreclosure moratorium effectively abrogates the contract between the borrower and the lender-sticking the investor with a larger loss and preventing the housing market from fixing itself. Investors aren't the only ones harmed by this vicious cycle-average homeowners also suffer. A ballooning foreclosure backlog prevents the market from clearing, thus dragging all home prices down further.
Just look at what happened when the federal government set up a similar market-distorting program last year, the Home Affordable Modification Program (HAMP). Under HAMP, investors with first-tier claims on delinquent mortgages have been forced to take a back seat to holders of second mortgages and other consumer obligations like credit-card debt. In essence, primary mortgage contracts-which promised investors that they'd be paid back first if a borrower defaulted-are being invalidated and investors are being sent to the back of the collection line.
The primary beneficiaries of HAMP have been holders of unsecured consumer debt (credit cards, car loans, etc.) that have benefited from borrowers' reduced debt burden, despite the dismal reality that half of all borrowers emerge from HAMP with a total debt-to-income ratio greater than 63.5%, according to the most recent Treasury data.
So what's the answer to this mess? Bankruptcy reform. A special chapter of bankruptcy should be created to fix the mortgage crisis and hasten a housing recovery, while protecting borrowers and investors alike. Regulators would identify an affordable total debt-to-income ratio for overburdened borrowers. Qualified individuals could then file for this special bankruptcy by presenting all their debts-mortgages, credit-card bills, car loans, and the like-to a court (or an arbitrator). No debts would be excluded, so the borrower's entire balance sheet could be addressed.
The court would then rank those debts so that a borrower's debt would be reduced or eliminated in order of seniority. If the court and the borrower could not settle on a sustainable payment plan, then foreclosure and liquidation proceedings could commence.
To relieve banks from having to absorb all the losses associated with borrowers' bankruptcy plans at once, regulators could allow losses on home-equity loans and credit cards to be spread over an extended period. They might also include a "sunset clause" so that these special bankruptcy rules expire once the mortgage crisis is resolved.
Any resolution of the housing crisis needs to respect the rights of everyone-investors, borrowers, lenders and taxpayers. Foreclosure moratoriums, failed mortgage modifications, and principal forgiveness programs delay resolution. Worse, they create more losses for investors, homeowners and taxpayers, yet fail to keep delinquent borrowers in their homes.