Non-Bankruptcy Solutions to Subprime Meltdown Won’t Be Enough

The mortgage industry and government are scrambling to find ways to stem the tide of subprime disaster. Some solutions will simply not work for enough people to matter and others are just passing the buck to future taxpayers. The best solution remains allowing consumers to modify their mortgages through the bankruptcy process.

Henry Paulson, the Secretary of the Treasury, changed course this week (again) in recognition of the deepening disaster. In a Wall Street Journal interview, he admitted that the potential home loan defaults “will be significantly higher” in 2008 than 2007. And he called on the mortgage industry to work collectively to set-up criteria for work-out deals that would allow consumers to stay in homes, when he had previously claimed the problem did not require an industry wide response.

So the Treasury Secretary expects an industry scramble to save its own life by consolidating, cutting costs (50,000 job cuts in a year!), filing Chapter 11, and trying to raise money anywhere it can to now drop those projects and create a super-work-out program which troubled homeowners can go through. I wonder if Mr. Paulson plans to pay for the staffing for this operation out of his own pocket. And how he proposes to convince all the investors in — the true owners of — the mortgage loans to all agree to this new scheme is anyone’s guess.

Along the same lines, Paulson is pushing for the Federal Housing Administration (FHA) to become more active in funding and backing loans, easing the criteria under which FHA will guarantee repayment of a mortgage. Such FHA guarantees are usually enough to get funding for a deal.

Although the Bush Administration and Democrats support the FHA proposal, it has opposition. In large part because such proposals put the government itself one-step closer to having to pay for the subprime bailout. If FHA backs a refinance mortgage which allows a consumer to only temporarily hang onto a house they can ill-afford, the old lender may get their money back but ultimately the loss on that loan will end up falling on the FHA — and American taxpayers. (And of course the fallout may come in the next Administration, when Mr. Paulson is no longer in charge of the Treasury.)

Mr. Paulson is also pushing for Fannie Mae and Freddie Mac to do more to bailout the mortgage industry, as I discussed in a companion piece on the Mortgage Law Network. Although Fannie and Freddie are not backed by the American taxpayer, everyone expects in fact that the government stands behind them. And the reality is that they are too large for the government to allow them to fail.

So the industry scrambles to just stay alive, the Administration tries to browbeat it into doing something more while trying to convince Congress to take more of the risk of a collapse onto the off-budget budget of the government and, in the meantime, foreclosures continue to come at a record pace.

There is of course a legislative solution. Change the bankruptcy law to allow a consumer to modify their mortgage enough to save their home, in Chapter 13. I discussed this in detail earlier this month. The taxpayer does not take on nearly so much risk this way. The industry gets a workout program supervised and managed by the bankruptcy court, trustees, and debtors attorneys. Many more homeowners keep their houses, communities keep their tax base, and neighborhoods are preserved.

As the industry and its friends in government continue to squirm and try to avoid reality, each day it becomes more and more obvious that the Chapter 13 mortgage modification proposal is the most cost-effective and immediate fix for the on-going meltdown.