Jim Gogek

Cram-down: A court-ordered reduction of the secured balance due on a home mortgage loan, granted to a homeowner who has filed for personal bankruptcy…

We will have a tough time getting out of the recession and mortgage crises as long as the following dire statistic remains true: More than one in six U.S. homeowners are underwater. They owe more than their home is worth. And, since their primary home is usually their biggest investment, that means their liabilities are greater than their assets. In essence, they’re bankrupt.

And, it’s greater than one in six in many parts of the country, particularly those places that experienced the real estate bubble-on-steroids earlier this decade. Probably, most people who bought homes in Southern California from 2003-2007 are underwater. That includes a certain blogger.

Loan modifications for homeowners in trouble aren’t enough, because too many people bought their homes at wildly inflated prices. Continuing the “underwater” motif, loan modifications for these people are like rearranging the deck chairs on the Titanic. If your liabilities are far greater than your assets, it doesn’t matter a whole lot how you finance your liabilities. Proof is that more than 50 percent of loans modified this year were delinquent again within six months.

More and more people are saying that reducing debt principal is necessary to keep people in their homes. One of those people is Barack Obama. The President-elect’s senatorial colleague from Illinois, Dick Durbin, has introduced legislation that that would allow judges to modify the terms of distressed mortgages, including the principal. Obama is said to approve of this approach; Durbin wouldn’t otherwise have repeatedly introduced it as federal legislation.

…In a cram-down, the bankruptcy court splits the outstanding mortgage balance into two parts. The amount of debt equal to the current appraised value of the home is treated as a secured claim, which the borrower must continue to pay. The amount of debt in excess of the current property’s value becomes an unsecured claim, which is usually not repaid in full…

Mortgage bankers hate the idea, of course. Investors do, too. If a judge simply reduces the current value of a home by reducing the mortgage balance, somebody’s gotta take it on the chin.That somebody will be your friendly neighborhood mortgage originator.

…In areas where home prices have depreciated, cramdowns can result in significant mortgage reductions. In some cases, the judge may order the remaining secured debt amortized over the remaining life of the loan term, thus lowering monthly payments. In other cases, monthly payments remain the same as before the cram-down, and the secured mortgage is simply paid off faster…

But all of this brings up the question of fairness. If my neighbor declares bankruptcy and a judge lowers the principal of his mortgage and therefore the value of his home, where does that leave me? So, one of the ideas is doing cram-downs as public policy, with big groups of mortgages, rather than just individually in bankruptcy court.

The problem with cram-downs is that mortgages have been sold to Wall Street, which in turn sold them around the world; it’s the poisonous mortgage-backed securities we’ve all been hearing about. So if you cram down the value of mortgages, you’re harming investors from CALPIRS to China and other large and small government investment funds from Indiana to Italy. Judges’ decisions could put a hard bottom on mortgage-backed securities. Their low value would be revealed and that could put added strain on the markets by showing how much trouble companies that hold them are really in.

One solution is for the US government to foot the bill for a portion of the cram-down. But what that would cost and how much more debt the US government would have to issue is anybody’s guess.

Somehow, though, government has to get the leverage out of the economy. It’s killing us. That’s what the Bush Treasury Department has been trying to do, unsuccessfully, with its bank bailout money. As long as so many Americans owe more on their homes than their homes are worth, the foreclosures and economic squeeze will continue.

Remember the word: Cram-down. Coming soon to a neighborhood near you.