The new Administration is seriously considering a revision to the bankruptcy law that will allow Judges to “cram down” mortgages on residential properties.

Actually bankruptcy judges already have the power to modify mortgages on vacation homes – just not primary residences.

Consumer advocates argue that by giving bankruptcy courts the power to cram down mortgage debt, we will stave off a lot of foreclosures because:

(1) Any homeowner entering the bankruptcy process (Chapter 13) will have the ability to argue for a lowering of his mortgage principal. The bankruptcy judge can then determine, based on the debtor’s reasonably anticipated income, what amount of mortgage debt the homeowner can afford … and wipe out any debt above that amount. In other words, a homeowner could enter bankruptcy court with a $250,000 mortgage and leave with a $125,000 mortgage.

(2) Lots of other homeowners, who are not in bankruptcy but may or may not be considering it, will gain a lot of leverage with their lender. If a borrower can threaten the cram down process, it is anticipated that he or she will have a lot more sway in negotiations with his/her mortgage lender.

Lenders hate the cram down proposal. For one, they feel it violates the sanctity of contract law. The lender – borrower relationship is contractual. The lender loans $X and expects to be repaid that amount. Lenders feel that by giving a judge the right to ignore the specifics of this contract (i.e. changing $X to a lesser amount), the law is essentially usurping a lender’s private property (capital).

What’s more, lenders argue that if the cram down law is passed, they will have to be much more cautious about who they lend to, making mortgages harder to get. In addition, they claim that they will need to charge higher interest rates to compensate for the increased risk of a cram down.

How you feel about this issue may come down to how you feel about the foreclosure crisis. I have seen estimates that as many as five million homeowners could lose their homes to foreclosure in the next few years. That will continue to drive down housing prices, which impacts everyone.

On the other hand, you may feel that foreclosures, while unfortunately painful to people and the system, are a necessity to clean out the excesses of the last five years – collateral damage of the crazy lending and borrowing that went on.

President Obama has indicated he favors changing the bankruptcy law. Given political pressures to address the housing crisis, my guess is that we will soon see a new law permitting residential cram downs.