The Feds' Next Step After Rescuing Banks

Protesters in Philadelphia call for more action on the subprime crisis Adam Nadel/Polaris

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

So far, attempts to slow the foreclosure epidemic at the center of the crisis have had little impact. Despite "voluntary" industrywide efforts to rework troubled mortgages—efforts that Treasury Secretary Henry Paulson jawboned 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 (CS). He thinks 3.6 million more foreclosures could pile up through 2012.

Both Presidential candidates now want the federal government to take a more active role in buying up troubled 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 woes that have stymied mortgage workouts so far. The government may have to find a more extreme legal solution to get mass workouts going.

The reason: 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 reworked, 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 nullify or supersede 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 leeway to modify mortgages.

Those tactics could spark enormous litigation, however. Uncle Sam might also have to reimburse investors for lost value. That's why many argue it would be better for Congress to change the bankruptcy laws. Currently, homeowners who go belly-up cannot renegotiate their mortgages in court. Democrats have tried to alter the law so bankruptcy judges can trim interest or principal. "It gets around the biggest impediment to workouts without costing taxpayers a penny," says Jaret Seiberg, an analyst for the Stanford Group brokerage.

Republicans have blocked the effort, arguing that if courts were granted these new powers, lenders would see their losses soar and pass the cost on through pricier mortgages. But should foreclosures continue to skyrocket—and should Barack Obama, who backs the bankruptcy measure, be elected President—mortgage holders could find themselves on the losing end of the battle.