If you want a sign the financial world is changing fast, look no farther than Thursday’s announcement that Citigroup would back legislation allowing judges to modify mortgage terms in bankruptcy.
The bill, championed for more than a year by Sen. Richard Durbin (D-Ill.) — and backed by many Democrats, including President-elect Barack Obama and Sen. Chuck Schumer (D-NY) — has been anathema to the financial-services industry for just as long. The industry successfully fought it off several times over the last 18 months, most recently in this fall’s negotiation over the Emergency Economic Stabilization Act. And as recently as December, industry officials were promising an ugly fight, and saying they might still be able to head off the measure entirely.
No longer. Citigroup’s announcement comes even as the same officials acknowledge that a compromise is likely — though perhaps not this compromise. “I think the politics, the substance, the economics, the tax angle all work against the industry on this one,” a financial-services industry official said in an interview Wednesday night, before the Citigroup agreement was public.
That doesn’t mean the deal is done. Much of the industry still opposes the measure — and some even argue that Citigroup’s support can be explained by its own self-interest: the bill could hurt its competitors more than Citigroup.
As it stands, Durbin's bill (SB 61) would essentially give judges the authority to rewrite the terms of a home mortgage -- a so-called "cramdown," something possible already for every other kind of debt, mortgages on vacation homes and any real-estate other than a primary residence. It would also extend Truth in Lending Act protections to bankruptcy court, meaning predatory loans -- made in violation of TILA -- would be wiped out.
To get Citigroup's support, Durbin agreed to three minor modifications. First, it would apply only to mortgages in existence when the bill passes, not future loans; lenders have argued that applying it prospectively would drive up the cost of borrowing for all homebuyers. Second, to qualify for a modification, homeowners would have to contact their lender at least 10 days before filing or bankruptcy, to give it a chance to offer a voluntary workout. And minor violations of TILA wouldn't wipe out a debt, but would instead incur a fine, bringing it into line with how the statute already operates outside bankruptcy court.
That's not enough for much of the industry. The Financial Services Roundtable, a trade group that represents a hundred banks, insurers and other big institutions, put out a statement opposing the compromise, calling the revised bill "a first step," but "still far too broad" and "a serious risk to the mortgage markets."
The industry's main objections: the bankruptcy-modification provisions would apply to all existing mortgages, even million-dollar homes or those where the homeowner hasn't fallen behind on payments, and there's no time-limit, meaning lenders could still be dealing with bankruptcy modifications for current mortgages 30 years from now. Moreover, that truth-in-lending provision means a mortgage can be wiped out. "You get that house for free," FSR's Scott Talbott said in an interview.
Supporters dismiss the industry's complaints. Unless they're at risk of foreclosure, most homeowners wouldn't qualify for bankruptcy, notes one Democratic Senate aide, and the truth-in-lending provision just mirrors the penalty outside bankruptcy court for abusive lending practices. As for putting a time-limit on seeking a modification in bankruptcy, "there's no good policy justification for that at all," the aide says.
So given the bulk of the industry's opposition, why does Citigroup support the bill? In a letter to lawmakers, Citi CEO Vikram Pandit says it "will serve as an additional tool" to help homeowners at risk of foreclosure. "Given today's exception economic environment, we support its swift passage," he wrote.
But some see a more sinister motive: Changing the bankruptcy law could force lenders and mortgage-backed security holders to take write-downs, under accounting rules that require companies to recognize hits to asset values once they become likely. (Since some homeowners will surely file for bankruptcy, and then receive mortgage modifications under the new law, some losses are likely.)
But the federal government has twice come to Citi's aid, plowing $45 billion into the company to keep it stable. The second time, the government guaranteed the company against big losses on $306 billion of real-estate loans and securities. (See the Treasury's press release and the term sheet.)
Does that government guarantee protect Citigroup against losses from bankruptcy modifications, or from write-downs the company would otherwise have to take if the bill passed? Some in the industry worry that it does, giving Citi an edge over its competitors. If so, what harm to Citi to support the measure, ingratiate itself with lawmakers and look like the white knight?
A Citigroup spokesman declined to comment late Thursday. The Senate aide dismisses the argument, saying it makes sense only if the legislation were likely to drive a lot of viable mortgages into bankruptcy court, where they would be modified to the lender's detriment. In fact, the aide says, if homeowners can pay their mortgage, they're not likely to qualify for bankruptcy reorganization; most of the people helped by the bill would likely face foreclosure otherwise -- and in foreclosure, lenders stand to get a lot less than they would from a court modification.
"This actually helps all those firms that hold garbage on their balance-sheets," the aide says. "They would be hurt less badly than if these loans went through foreclosure."
Kurt Eggert, a Chapman University law professor, notes that Citi and other financial firms have other reasons to support the bill as well: Most have taken billions of dollars in federal aid, any may be hoping for more. "It’s harder for them to just say no to something that will obviously help homeowners," Eggert says.
Eggert says he worries that the 10-day notice requirement will hurt homeowners who don't know about the provision and file for bankruptcy to head off foreclosure. He also thinks applying it to future mortgages could make sense. "Having bankruptcy cramdowns is a way of instilling discipline to subprime lenders," he says. Investors ould be more vigilant because they "aren’t going to want to buy bad loans where there’s going to be a cramdown."
Update: One person familiar with Citi's federal guarantees points out that the company is responsible for the first losses on the guaranteed portfolio, meaning total losses would have to be large before the company had an advantage over its competitors.