By John W. Schoen Senior producer
msnbc.com
updated 12/12/2008 11:25:57 AM ET 2008-12-12T16:25:57

Last year, when Courtney Scott went looking for a house in the Atlanta area, she signed up for a home buying class with a local community group. That’s where Scott, a retired nurse living on a disability payment, learned about a state-sponsored homeownership program for low-income households.

She applied for the program and was told she qualified. After finding a home for $95,000, she applied for a mortgage with one of the program’s lenders, Bank of America. Based on her 34 percent down payment, some additional savings and her monthly Social Security income of $865, the bank approved the $65,000 loan.

But although the bank approved the loan, the monthly payment of $602, including insurance and property taxes, ate up some 70 percent of her income. By March, with her budget stretched to the limit, Scott began to try to get her loan modified to more affordable terms.

It hasn’t been easy.

One bank representative told her she didn’t qualify for a modified loan because she was not yet behind in her payments, she said. After she eventually fell behind, she was told she had to be in her house for a year to qualify for a new loan. After 12 months in her home, she said she was told she didn’t qualify for a new loan because she hadn’t made 12 consecutive, on-time payments.

“Every time I talk to someone, with what looks like an option, they come up with a reason why it doesn’t work,” said Scott, 60.

A spokeswoman for Bank of America, citing privacy reasons, said the bank couldn’t comment on individual customers’ financial details.

Scott is one of hundreds of msnbc.com readers who have reported serious problems wading through the thicket of red tape surrounding any efforts to modify troubled mortgages. Their experience puts a spotlight on roadblocks preventing a broader approach to cleaning up the nation's mortgage mess.

Despite the trillions of dollars in federal money advanced or committed to shore up the nation's financial system, efforts by lenders and government agencies have failed to halt the relentless rise in foreclosures. Relatively little has been spent directly to help head off home foreclosures, in part because of opposition from some lawmakers and Bush administration officials who fear rewarding bad decisions by borrowers.

President-elect Barack Obama has signaled that his administration would take more aggressive steps to stem the tide of foreclosures, which threatens to toss millions more Americans out of their homes, prolong the slide in house prices and deepen the global recession.

"We've got to start helping homeowners in a serious way to help prevent foreclosures," Obama told reporters this month. “Deteriorating assets in the financial markets are rooted in the deterioration of people being able to pay their mortgages and stay in their homes."

Other government agencies and regulators — from the Federal Reserve to the Office of the Comptroller of the Currency — have echoed that call in recent weeks.

But those efforts will face the same legal and financial hurdle that so far have stymied more aggressive housing relief efforts. After a year of gridlock in Washington, some foreclosure relief advocates are renewing calls for more radical reforms that could include a change in bankruptcy laws that would allow judges to modify mortgage terms — a move the lending industry has strongly opposed.

Who's to blame?

After this fall’s $700 billion rescue package and recent debate about the auto industry bailout, Congress also faces pressure to move more aggressively and spend taxpayer funds to try to break the financial and legal logjam that threatens to send millions more homeowners into foreclosure next year.

“I do think we’re going to come to a point early next year when it becomes obvious that the foreclosure problem is so severe that we’re going to have to take a shot a something like this,” said Moody’s Economy.com chief economist Mark Zandi.

Workouts that don't work
Efforts to reverse the rise in foreclosures began in earnest in October 2007, when the White House unveiled the HOPE NOW Alliance, a voluntary industry effort to help homeowners work out unaffordable loans. Since July 2007, lenders working with the HOPE NOW Alliance have reworked some 2.7 million mortgages, according to the group’s data. Roughly 1.7 million of those involved repayment plans, which typically increase the monthly mortgage bill to make up for missed payments.

Many homeowners find the new payment even harder to keep up with, a big reason the “redefault” rate, the number of loan workouts that later fail, is rising. More than half of all homeowners who had their loans modified in the first half of the year are already in default again, according to the Comptroller of the Currency.

A second option is to lower the monthly payment by stretching out the term of the loan, resetting interest payments to current market rates or forgiving some of the principal. Since July 2007, just under a million mortgages were modified to change the terms of the loan, according to HOPE NOW data.

“Within the world of workouts, we are seeing a lot of repayment plans and not a lot of modifications,” said Adam Levitin, a Georgetown University law professor who recently wrote a paper on the problems servicers are having modifying loans.

As a result, the foreclosure rate continues to rise. Though hundreds of thousands of homeowners have been helped, millions more have lost their homes. Without aggressive new efforts, another 3.6 million homeowners will likely lose their homes over the next two years, according to Moody’s Economy.com.

That number is expected to swell as homeowners with so-called ‘pay option’ adjustable-rate mortgages see their monthly payments begin rising by an average 63 percent, according to a recent research report by Fitch Ratings. That wave of resets is not expected to crest until 2010 and could double the delinquency rate unless aggressive prevention measures are taken, the report said.

“The impact of the option-ARM defaults is already under way," said William Longbrake, the retired vice chairman of Washington Mutual, a failed bank that was one of the biggest originators of pay-option ARMs. "Already the option-ARM defaults are rising quite rapidly.”

After a year of debate, Congress and the White House approved a housing relief bill in July, but only after President Bush repeatedly threatened to veto tougher measures, including a provision that would have required lenders to cut the principal balances of borrowers at risk of default.

But the political landscape has shifted since mid-September as the Treasury and Federal Reserve have announced trillions of dollars in cash infusions, buybacks of bad mortgage-related assets and loan guarantees to lenders. Despite that massive investment, the pace of new defaults and foreclosures shows no signs of letting up. That has highlighted the need to provide more direct assistance to homeowners facing foreclosure.

The next foreclosure wave
One of the proposals to break the logjam has come from Sheila Bair, chairwoman of the Federal Deposit Insurance Corp., who has been using her agency's takeover of failed IndyMac bank to develop ways to speed up loan modifications and reverse the rise in foreclosures.

"We are clearly falling behind the curve,” Bair told a congressional panel last month. “Much more aggressive intervention is needed if we are to curb the damage to our neighborhoods and broader economic health."

One of the reasons existing solutions haven’t worked, according to lenders, loan servicers, community and housing groups and government regulators, is that they haven’t adequately addressed the scale and complexity of problems created by rogue lending that swamped the mortgage market during the height of the boom.

For most  homeowners facing default and foreclosure, reworking a mortgage means navigating the financial thicket created when their mortgage was bundled with hundreds of other loans and resold to investors. Since the credit bubble has collapsed, the lending industry has consolidated, creating an often impenetrable maze of legal and regulatory roadblocks for homeowners and lenders trying to prevent a foreclosure.

In seven months trying to work out more affordable loan terms to keep her home, Scott, the retired Atlanta nurse, has amassed a thick paper trail and a meticulous log of dozens of correspondences and conversations with the White House, her congressman, the Hope Now Alliance, consumer groups, housing and banking regulators and several different Bank of America representatives.

Scott finally wrote the Department of Housing and Urban Development for help. This month, she got a letter back from HUD saying that it had contacted Bank of America, which said it had denied her application for a modified loan because their records showed her monthly income was only $286.21 — not enough to cover a $64,000 loan.

“I don’t know where they’re coming up with these figures,” she said. “Evidently, Bank of America has been communicating with HUD about me, without communicating with me.”

The Bailout Debate
This fall, as the growing number of mortgage caused serious cracks in the global financial system and panic in financial markets, pressure began building for federal action. The Bush administration rolled out the $700 billion Troubled Asset Relief Program to buy up bad mortgage-related securities and rework the underlying loans to more affordable payments.

But the plan quickly faced a major hurdle. Unless the Treasury bought up a majority stake in entire pools of mortgages, it had no legal standing to require investors to agree to settle for less than their expected return.

In mid-November, Treasury Secretary Henry Paulson stunned Congress and Wall Street by announcing that the department had suspended plans to buy up troubled mortgage-backed investments. Paulson said the money would be better deployed to shore up bank assets. But critics say the plan was unworkable from the beginning.

“What the Treasury secretary and the other regulators thought was, ‘Hey, we’re the government: We’re going to tell these investors they’ve got to cooperate and do this,” said John Taylor, president of the National Community Reinvestment Coalition, which has been working on foreclosure relief efforts for the past year. “Well guess who blinked first? It was the government. Because the investors said, ‘The heck with you. We’ll wait until we get a better offer.”

Last month, the FDIC floated a plan modify some 2.2 million loans by sharing losses with mortgage companies that agree to refinance home loans. Bair estimates the plan would cost about $25 billion, to be paid from the Treasury's $700 billion bailout fund. Paulson has opposed the plan — the two sparred last month at a Congressional hearing — on the grounds that Bair’s plan would use bailout funds as a “subsidy, or spending, program."

"The TARP was investment, not spending," Paulson said.

Bair’s plan also would pay mortgage servicers $1,000 for each loan they modify, overcoming another roadblock to loan modification. In some cases, loan servicers are paid more to manage a mortgage in foreclosure than they get for collecting payments from a performing loan.

But it remains to be seen how quickly Bair’s plan could be implemented and how wide an impact it would have. Some housing advocates believe Congress should reconsider a more sweeping proposal that was voted down in early versions of this summer’s housing relief bill — a change in the bankruptcy law to allow judges to modify loans from the bench.

Under current bankruptcy law, a mortgage on a primary residence is the only form of debt off limits to a bankruptcy judge; the terms of car loan or the mortgage on a second home, for example, can be modified as part of a personal bankruptcy filing.

Proponents of the letting bankruptcy judges modify mortgages say it would bring immediate results. Because lenders and servicers would have more incentive to renegotiate new mortgage terms, homeowners might not even have to file for bankruptcy. Just the threat of a filing could speed up loan modifications, they say.

The lending industry, with strong support on Capitol Hill, has vigorously opposed what it has described as a “cramdown” provision. Lenders argue that the risk of a bankruptcy filing would increase the credit risk of writing new mortgages, making them more costly and difficult to win approval from underwriters.

But proponents argue that lenders are already dealing with that risk and pricing it into the cost of new loans. And if they aren’t taking that credit risk into account, they should be, according to Georgetown University law professor Adam Levitin, who specializes in bankruptcy law.

“Had that been the case, we never would have gotten into this mess,” he said. “Bankruptcy has a strange effect. When creditors have to take into account bankruptcy risk they have to take into account credit risk. When they think there’s no bankruptcy risk, they stop paying attention to credit risk. This can help correct against that.”

Doing the math
The debate over direct government aid to homeowners and more aggressive measures like bankruptcy cramdowns will likely get a boost from growing evidence that a continued rise in foreclosures would likely prolong and deepen the ongoing recession.

“The cost to the taxpayer and to the economy may be greater if you don’t do something,” said Mark Zandi, chief economist at Moody’s Economy.com. “If I spend $40 billion and give it to the homeowners, am I going to save more than $40 billion in tax revenue because of the benefit to the economy?”

That kind of math will likely frame the debate when Obama is inaugurated and the 111th Congress returns after its holiday recess. Proponents of more comprehensive homeowner relief note that these efforts may continue to face opposition.But some are hopeful that new programs could begin to turn the tide on foreclosures and help stabilize the housing market and the economy.

“It’s not rocket science at this point; we all know what the hurdles are,” said Taylor. “We can all lose more money together, or we can try to resolve this.”

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