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How State Government Can Help Financially Distressed Homeowners

posted by Adam Levitin

Now that Congress has failed to act to stem the foreclosure crisis, it is up to states to try to protect their residents and economies. A few possibilities remain for state action, some of which states have either toyed with or started to do.

First, states have the ability to affect the (state-law) foreclosure process unlike Congress. States could take steps to slow down the foreclosure process. States are certainly free to make foreclosure more onerous for lenders. This could be done by putting up lots of procedural barriers to foreclosure, such as mandatory good faith negotiations with borrower; personal service requirements; longer notice periods; redemption rights; pre-sale appraisal requirements; banning deficiency judgments; minimum foreclosure sale bids based on appraisal value; and the requirement that servicers show the court their net present value calculation for foreclosure versus modification to the court as a condition of foreclosure. Delay discourages foreclosure and encourages modification because mortgage servicers have to advance payments to the securitization trust for a few months after a loan defaults, and these advances are only recoverable upon realization of the foreclosure sale. Delay increases time value costs to servicers, which starts to shift the modification versus foreclosure financial calculus for the servicer. These steps will not solve the foreclosure crisis, but they will buy some time. Maryland and California have both taken some steps in this direction.

Second, states could enact outright foreclosure moratoria. This was done by some 30 states during the Great Depression. The Supreme Court upheld Minnesota’s foreclosure moratorium law in the 1935 Blaisdell case against contracts clause and takings clause challenges. There might still be state constitutional issues, of course, but there does not appear to be a blanket nationwide obstacle to a foreclosure moratorium. This is an overly broad solution; there are some mortgagors that cannot be helped and foreclosures should happen in these cases. It might also reduce mortgage credit availability in states that adopt such a solution, at least for a while. But the social welfare gains of preventing foreclosures that should not occur (because modifications would be feasible and more efficient) likely outweigh the social welfare costs of some necessary foreclosures not happening. Minnesota considered, but failed to enact such legislation this time around.

Third, states could require lenders to consider state-sponsored refinancings before foreclosure. A state agency could offer to pay the lender say 80%-90% of newly appraised value of any qualifying property for which foreclosure proceedings have been initiated. Essentially, the state would be proposing a short sale to the lender. The state would then, upon purchasing the mortgage, modify it to a 30-year fixed at a reasonable rate. (Presumably, states should temper any relief like this with some eligibility requirements for homeowners, such as some showing that the homeowner has sufficient income/assets to make the modified mortgage payments.)

State refinancing programs would impose serious costs on states, which might be reluctant to act because of it. It would also fail to address second and third mortgage issues. Nonetheless, it would have several advantages on the HOPE for Homeowners program, not least that it would not make refinancing subject to a servicer-initiated modification. Modifications are expensive and non-reimburseable for subprime servicers. If the state did the modifications itself, the servicer would just have to take the inexpensive task of registering a short sale.

The key to a state refinancing program is conditioning foreclosure upon the servicer hearing a state refinancing offer and comparing that offer to its net present value calculation for the foreclosure sale. If a state offered 80%-90% of appraised value, it’s hard to believe that any servicer could get a NPV in foreclosure that was larger—foreclosure sale losses are running around 50% on average these days. Any servicer that turned down state offers would be facing suit by MBS holders. (States could ensure this by purchasing a few MBS themselves). This might get around the servicer incentive problem (servicers make more in foreclosure than in modifications) that HOPE for Homeowners does not consider. The key here is to remove servicer discretion and to only require a sale of a distressed mortgage--something that will not run into servicer pooling and servicing agreement restrictions or trigger REMIC problems. Again, this won't be silver bullet to the problem, but it will go much, much farther than anything Congress has authorized.

Fourth, states might actually hold the key to bankruptcy relief. The Bankruptcy Code, 11 USC 1322(b)(2), prohibits the modification of "a claim secured only by a security interest in real property that is the debtor's principal residence." As several Courts of Appeals have held, this means that if the security interest includes anything other than the debtor's principal residence, then the mortgage can be modified. Bankruptcy law looks to state law to determine property rights, as we know from Butner. So if the security interest covers a rental unit on the property or connected farmland or fixtures, then modification is possible. So states could redefine property rights to clarify that a mortgage that is secured by a debtor's principal residence is not secure solely by the debtor's principal residence if it includes a security interest in land (not just the house), or fixtures or rents, profits, etc. States might be able to make it possible for a large number of homeowners to file for Chapter 13 bankruptcy and modify the mortgage on their home simply by fine-tuning state property law.


I believe Adam has raised an important consideration and maybe intervention of State law and government may be a viable solution. Allowing Congress to fix the problem will be a mix of rain dancers because they are the only ones who believe the dance will change the weather. Every American is now faced with both Republican and Democrat decisions geared to getting votes so maybe they should remain in DC rather that returning to their home state.

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