One solution the administration of President Barack Obama is seeking is a change to federal bankruptcy laws that would allow federal judges to restructure mortgages of struggling borrowers.

Senate Democrats are advancing legislation that would allow judges to reduce the principal or “cram down” the amount owed for the primary residences of borrowers who have sought Chapter 13 bankruptcy protection. Chapter 13 is a bankruptcy status that allows debtors to retain assets and pay back their debts over three to five years.

Judges can currently modify the terms of credit-card and other debt, including vacation homes, but haven’t been able to modify primary residences since 1979, when the U.S. bankruptcy code was enacted.

Giving judges the ability to restructure mortgages would help borrowers who have been unable to get their loans modified because the loans have been packaged into securities and sold to multiple investors, who won’t agree on a solution.

One sign that this may be inevitable: Giant lender Citigroup recently supported this bill, much to the dismay of rival lenders.

Rod Dubitsky, Credit Suisse managing director and lead housing analyst, also would like to see money from the government’s Troubled Asset Relief Program being used to buy up loan portfolios and modify them as part of a national government program.

“We have outsourced the housing recovery to loan servicers who are inadequately staffed and don’t have the freedom to do what is needed to minimize housing costs,” Dubitsky says.

Ron Faris, president of Ocwen Financial, a publicly traded servicer of subprime loans, says there is no financial incentive for most servicers to help strapped borrowers stay in their homes.

“Mostly it’s 50 basis points to the servicer whether (the borrower) is paying or not paying,” Faris says.

Writedowns and rewards for helpful servicers
That’s part of the reason why we’ve seen such a dismal success rate with loan modifications to-date, Faris says. The other reason is that many servicers lack the know-how or staff to carefully study a borrower’s total financial picture and tailor a solution.

Most of the loan modifications done to date, analysts say, do not involve reductions in principal, rate or term, but rather forestall the inevitable by rolling delinquent payments into a new and still unaffordable loan.

According to the comptroller of the currency, 52% of the loans modified in the first quarter of last year fell delinquent again in six months.

“Something is wrong if you are getting that kind of default rate,” Faris says.

With these kinds of inefficient solutions, and with prices continuing their downward slide, more borrowers are simply choosing to walk away from their homes, says Mark Zandi, chief economist of Moody’s Economy.com.

“Millions of homeowners are underwater, deeply underwater on their house and with any increase in expenses they are stepping away from their home,” Zandi says. “I think the only way to mitigate the surge in foreclosures is to have a government plan to have mortgage write-downs.

“It’s costly, but at the end of the day, not doing that and allowing these millions of dollars to go into foreclosure will cost more people their jobs.”

Faris, whose firm has received some attention for its successful foreclosure mitigation efforts for subprime loans, would like to see government get more involved in monitoring the performance of servicers and allocating work to those companies that are returning calls and helping borrowers keep their homes.

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