Should the bankrtupcy laws be changed to include homes?

An idea floated lately in various circles to deal with increasing foreclosures is to 'tweak' the bankruptcy codes so it will include homes, thus forcing lenders to re-write loan terms and prevent them from foreclosing. But what are the long-term ramifications of this happening, given that homes are usually the only collateral lenders can repossess to help pay back the loan?

In today's Los Angeles Times, Paul Leonard, the director of the California office of the Center for Responsible Lending and Christopher Thornberg, a founding partner with Beacon Economics, debate the topic.

First, from Paul Leonard (pro-tweak):

The heart of the mortgage market's problems were and remain sub-prime loans. In California, data from the Mortgage Bankers Assn. show that while sub-prime loans make up 14% of total mortgages, they are responsible for about 60% of all foreclosures. Sub-prime loans -- many of which had stated-income requirements without verification, low teaser rates, no down payments and aggressive marketing tactics by brokers who had strong financial incentives to close loans -- increase chances of foreclosure. Reckless lending with little regulatory oversight helped get us into this mess.

Foreclosure spillover has much broader consequences -- for neighbors, local government services and our state and national economies. The Center for Responsible Lending recently estimated that 356,000 foreclosures will occur in California in 2008-09. With each foreclosure reducing surrounding home values by nearly 1%, we estimate that 7.5 million owners who live near foreclosed properties will lose a total of $107 billion of wealth in their homes. Possible municipal bankruptcies and deep local government program cuts, combined with historic levels of state budget deficits and the looming national recession, are all byproducts of the highest foreclosure levels since the Great Depression....

Given industry apathy toward voluntary loan modifications, the only way to achieve meaningful relief on a larger scale is to tweak bankruptcy laws. Courts should be allowed to restructure mortgages on family's homes. Most loan modifications would occur voluntarily outside of court with no cost to taxpayers. Bills in the House (H.R. 3609) and the Senate (Sen. Richard Durbin's bill, S 2636, included as Title IV of the Foreclosure Prevention Act) would give judges the authority to modify harmful sub-prime mortgages to provide families with one last chance to save their homes. These bills would help some 600,000 families avoid foreclosure.

Next, from Chris Thornberg (anti-tweak):

The mortgage loan modification plans put forward by the governor and, at various times and in various forms, by the U.S. Treasury Department all failed to fix the problems in the housing markets. Why? They pretended that the problem is the structures of the mortgages used to buy houses -- in other words, fix the interest rate and you fix the problem. Make the loan "fair" and everything will be fine.

Nothing could be further from the truth. The real issue in today's housing markets is that prices currently sit at levels that are unaffordable given income levels in our state...

Prices are going to fall one way or another; it's only a function of time. They simply aren't sustainable at their current levels.

So what caused prices to go so high? Home bubbles are nothing new. We had one in the late 1980s, another in the late '70s and certainly many others before then. The bubbles are characterized by people buying an asset, in this case a home, and thinking they can sell it at a higher price regardless of the fact that the price being paid is completely out of whack relative to fundamentals such as income. At their root, all bubbles are driven by individual greed -- the desire to make money...

People make mistakes. We give them a second chance by allowing them to bankrupt themselves out of debt they couldn't afford even if they arrived in this situation because they made an error. We pay for this right through high interest-rate premiums on consumer loans. Years ago, in an effort to make buying homes cheaper, the home asset was opted out of the bankruptcy system. Because the home is a secured asset that could be repossessed in the event of a lack of payment, we all have enjoyed lower interest rates. But the game is simple -- if you can't make the payment, you lose the house. To change the game now is to violate this simple rule; that violation will lead to high costs of capital in the long run for anyone playing in the housing market. In other words, changing bankruptcy laws as they relate to mortgages would punish those who made the prudent decision to stay on the sidelines and not buy something they couldn't afford.