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Your Wealth Is in a Safe Place Now

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Last night, the House passed legislation permitting modification of mortgages on primary loans. Though the bill has been kicked around for over a year, the banking lobby only ratcheted up its campaign to shape the final legislation in the last several days.

Changes to the initial bill, then, obviously favor the financial industry. The first major change increased the amount lenders can recover from homeowners if their home's value appreciates after bankruptcy. In principle, such a recovery provision makes sense: mortgage holders take a hit when mortgage principle is reduced in bankruptcy. But the change merely ratchets up by 10% the amount the lender can recover from the borrower, suggesting that the New Democrats in favor of amending the legislation wanted to sweeten the deal for the banks. However, two quite obvious considerations mitigate how much of a "giveaway" this really is. First, home sales are way, way down (and will stay down). Second, home prices are way, way down (and will stay down). Because of this, the recapture provision functions less as a straight handout to banks and more as a disincentive for underwater homeowners to seek out bankruptcy in search of a principal write down and, thus, a chance at regaining equity.

The other major change limits the situations in which bankruptcy judges can reduce mortgage principal, among other measures explicitly permitting only interest rate reductions if such reductions make a mortgage affordable. Like the previous change, this alteration also seeks to prevent underwater homeowners from using bankruptcy as a means to recover equity in their homes.

While this concern is perhaps understandable, the narrow "affordability" provisions in the bill, which define affordability by monthly income, ignore the fact that until recently many middle-class homeowners relied on home equity to maintain a middle-class standard of living. As housing prices continue to plummet, these homeowners lose a significant source of wealth: poof, as the Federal Reserve said, went the 17% growth in median household wealth between 2004 and 2007. Principal reductions, in and out of bankruptcy, are the only means of restoring this wealth and are important to prevent foreclosures (and to incentive homeowners not to abandon their houses when they owe more than the house is worth).

The chatter about making mortgages "affordable" - in Obama's housing plan as well - is insufficient. Of course the housing crisis is a complex beast that requires imperfect solutions, as the bankruptcy bill and Obama's housing plan are. But we should remember that by avoiding principal write downs - and focusing on monthly mortgage payments - the burden of wealth destruction is being placed on homeowners, not on banks.