Foreclosures are key element missing in plan

Under the plan, the government is promising to work with companies collecting mortgage payments to encourage them to accept lower payments from troubled homeowners. Treasury officials say they think they can use the leverage the government will gain once it owns troubled mortgage-backed securities. But that promise may be fundamentally flawed.

The government's basic plan is to buy just the worst securities in huge mortgage pools, which won't give the Treasury control over all the mortgages in that pool.

The problem that has stalled foreclosure relief efforts to date is rooted in how these mortgage-backed investments are structured. By pooling hundreds of mortgages in a separate entity, and then using the payment stream to back multiple classes — or tranches — of investments, Wall Street’s alchemy turned risky subprime borrowers into Triple-A rated safe investments.

To do so, Wall Street bankers assigned different prices, and different levels of risk, to those tranches, creating a so-called "waterfall.” The current mortgage default rate of about 9 percent means only the investors at the bottom of the waterfall are getting wiped out. The problem is that until the mortgage default rate begins to fall, no one knows how far up the waterfall investors will be hurt.

For investors higher up the ladder, there is no incentive to accept lower interest rates.

Treasury officials Sunday night said they expect the bailout fund may be used to buy up mortgages directly, or buy entire pools of mortgages. But after nearly a year of prodding lenders and services to rewrite loan terms voluntarily, it remains to be seen how effective the Treasury will be in its efforts to — in the legislation language — “encourage” loan servicers to “minimize foreclosures.”

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For the past year, many House Democrats have been urging that the process of rewriting unsustainable loans be turned over to bankruptcy judges. That proposal was hotly debated again during the whirlwind negotiations of the past week.

Opponents — including The White House and some Republicans — argued that forcing lenders and investors to accept such bankruptcy “cramdowns” would only make matters worse. They argue that lenders would be leery of extending new credit if borrowers could go to court to have terms changed. That would make mortgages more costly and more difficult to get, worsening the housing crisis, say opponents.

Supporters of the bankruptcy law change argue that voluntary efforts to work out affordable loan terms — including the White House’s highly touted Hope Now Alliance — just haven’t worked. They also note that the bankruptcy process applies to other forms of debt that are still in relatively good supply.

In any case, unless anticipated future loan “resets” to unaffordable payments can be diffused, the pace of mortgage defaults and home foreclosures likely will be difficult to contain.

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