The Feds' Next Move After Rescuing Banks

The financial system, perhaps, has been rescued. Now, what about homeowners?

So far, attempts to slow the foreclosure epidemic at the center of the crisis have had little effect. Despite "voluntary" industry wide efforts to rework troubled mortgages—efforts that Treasury Secretary Henry Paulson banks and mortgage servicers into undertaking last fall—the numbers continue to soar. In 2008 some 1.69 million homeowners will lose their houses—double the rate of two years ago, says Rod Dubitsky, managing director for asset-backed securities at Credit Suisse . He thinks 3.6 million more foreclosures could increase through 2012.

Both Presidential candidates now want the federal government to take a more active role in buying up struggling mortgages and helping homeowners refinance with more affordable loans. Congress has also insisted the Treasury do more. But many of the proposals, which are based on the Depression-era Home Owners' Loan Corp., are likely to run into the same legal problems that have blocked mortgage workouts so far. The government may have to find a more extreme legal solution to get mass workouts going.

No solution in untying Gordian knot

The reason is that no one has figured out how to untie the Gordian knot created by the mass securitization of mortgage loans. Hundreds of investors may own an interest in the trust that holds any given mortgage. If a loan is worked, some of those investors would lose more than others. In many cases, mortgage servicers are prohibited from modifying a pool of loans without the consent of two-thirds of the investors; often, the servicers also earn more in foreclosure than in reworking a loan. "The servicer or the lender needs more flexibility to reach a rational economic decision," says John L. Douglas, chair of the banking and financial institutions group at law firm Paul, Hastings, Janofsky & Walker.

What might that mean? Douglas thinks servicers need protection from investor lawsuits. But others say the government may have to invalidate some of their obligations or investors' rights. To give securities holders more incentive to loosen the trust rules that govern them, Georgetown University Law Center associate professor Adam Levitin argues that Congress could reduce the favorable tax status for trusts that don't go along. Or, he says, what's known as the Gold Clause could be invoked. Under this New Deal-era legal precedent, the government, citing the need to preserve gold because of the economic emergency, abrogated private contracts that required payment in bullion. Washington could use the Gold Clause to give trusts incentives to modify mortgages.