How to clear the way for both foreclosures and loan modifications.
As America's housing bubble has collapsed, it is clear that banks eager to foreclose quickly on defaulting homeowners have cut corners. In some cases, they have lied to courts and to the public. Banks have been foreclosing on homes whether or not they could prove that they had a legal right to do so.
The result has been to further destabilize housing markets, injecting increased uncertainty into home selling and buying. Distressed homeowners are looking for help to save their homes, or, if that isn't possible, to find a buyer. Would-be buyers or sellers of homes may not be willing to proceed without knowing more about the foreclosure situation.
Financial markets are destabilized as well. Existing stakeholders in mortgages -- including investors holding securities backed by home loans and stockholders in financial firms -- are having difficulty valuing their holdings. Potential investors are reluctant to buy except at very low prices.
If nothing is done, we could face continued sluggish and restricted investment in real estate and the broader economy if the titles to foreclosed properties are seen as tainted. We could even see a second financial implosion if the scope of the problem appears large enough and uncertain enough to potentially overwhelm fragile bank balance sheets.
One solution is to stop foreclosures until ownership records can be sorted out. But while we may not know precisely who the homeowners being foreclosed on owe money to, we know that they owe it to someone. Distressed homeowners should not be able to avoid foreclosure simply because the right party to foreclose cannot easily prove that it is the right party.
More important, we can find a better solution. We can provide an impetus for mutually beneficial loan modifications, thereby helping get the housing recovery back on track.
The new rescue for the financial industry would involve simplifying the proof required to foreclose on a property. If a bank could certify ownership based on electronic records, and if the property were listed for a reasonable period of time (e.g., 60 days) on an easily accessed public Internet site to allow for objections, the mere fact that the bank could not provide the usually required evidence of its claims would not prevent it from being able to foreclose.
The price banks would pay for these loosened procedures is that they would be required, in some cases, to modify homeowner loans. Temporary special courts would be created to administer standardized formulas for loan modifications. No foreclosure of owner-occupied residences could proceed until the new courts certified that the loan modification formula had been properly applied. This system could bring order, fairness and stability to real-estate markets in turmoil.
•Step one is the creation of a transparent formula for creating loan modifications. The formula not only would focus on interest rate reductions -- which is all that is commonly offered now -- but also would include reductions in the principal owed to reflect diminished home values. (The bank should, however, get a share of the home's future appreciation upon any sale of the home.) Our proposal would contain safeguards to discourage people from deliberately defaulting in order to require banks to modify their loans.
Enforceable rules for loan modifications would help a good many homeowners stay in their homes. This would reduce the supply of foreclosed homes on the market, which would help to stabilize home values and break the negative cycle of decreasing home prices leading to more foreclosures resulting in lower home prices, and on and on. If the borrower defaulted on the modified loan, the bank could foreclose after 60 days.
Transparent formulas would even benefit homeowners who don't qualify for loan modifications. These owners now have no idea whether they can stay in their homes and face bewildering and contradictory demands from foreclosing lenders. Certainty has value for everyone.
•Step two is establishing rules to limit liability when loan modifications occur. Mortgage servicers should receive guarantees that making loan modifications based on the formula offers protection from lawsuits by investors and, in most circumstances, other lien holders.
•Step three is the creation of specialized courts to administer the loan modifications and facilitate foreclosure when modification proves impossible.
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Actors in our current system face uncertainty that results in paralysis and resources spent fighting one another. Having clear rules swiftly administered is more fair and effective for everyone -- homeowners and markets alike.
It's the prudent thing to do, even if it means swallowing once again the bitter pill of saving banks from their own incompetence.
Claire Hill is a professor of law and the Solly Robins Distinguished Research Fellow at the University of Minnesota Law School. Prentiss Cox is a professor of clinical law at the same school and is a former Minnesota assistant attorney general who led cases against subprime mortgage lenders.
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