In May, the House passed a bill authored by Rep. Barney Frank, D-Mass, which would, in summary, create a bail-out refinance program through FHA for borrowers who owe more than their home is worth. The bill, if passed by the Senate and not vetoed by the President, would require lenders to write-down (ie: forgive) approximately 15% of the amount of a loan secured by the borrower’s home. In exchange, the FHA will insure the refinancing of the home under a loan that meets FHA standards. The bill would also provide the borrower with up to 10% equity in the home upon refinancing, even though that home has decreased in value. And, the only thing that the borrower has to do is pay certain financing and disposition fees to the lender and to FHA.

Meanwhile, in April, U.S. Representative Maxine Waters introduced a bill that has received far less attention but that attempts to achieve the same goal as Mr. Frank’s bill: halting the growing rate of foreclosures in this country. Ms. Water’s bill, titled the Foreclosure Prevention and Sound Mortgage Servicing Act of 2008, would amend the Real Estate Settlement Procedure Act by, among other things, requiring loan servicers to make certain loss mitigation efforts on defaulted home loans before pursuing a trust deed sale or foreclosure sale. More specifically, the Foreclosure Prevention and Sound Mortgage Servicing Act, if passed, would require lenders to pursue loan modifications, forbearance schedules, short sale approvals, or modified repayment approvals before the lender can pursue a foreclosure.

The bills offered by Ms. Waters and Mr. Frank each appear to be good faith efforts aimed at protecting the best interest of the American consumer while reducing the rate of foreclosures and they should each be commended for their respective efforts. But let’s take a step back for a moment and imagine what the “big picture” would look like if each of the aforementioned bills were passed without revision.

The reality is that borrowers would be able to sign promissory notes, mortgages and/or deeds of trust whereby they obtain hundreds of thousands of dollars from a bank and promise to repay that bank the principal amount plus interest over a specific period of time. However, if the borrower decides, after the fact, that he can no longer comfortably make his loan payments according to the agreement (ie the note, deed of trust and/or mortgage) that he presumably read, understood and signed, he can enter into a new agreement backed by the FHA, and, by the way, he can build equity doing so. Recall that Mr. Frank’s plan would give the borrower approximately 10% equity in the home, even if the home’s value has decreased.

Then, if the borrower still cannot comfortably make his loan payments, he need not fret because the lender will have an affirmative duty to try to modify the borrower’s loan payments to an amount that suits the borrower. If the lender does not take certain loss mitigation measures to try to either modify payments, approve the borrower’s desired short sale, or approve some other form of debt forgiveness, the lender cannot foreclose on the borrower’s home.

If passed, the bills offered by Mr. Frank and Ms Waters would (i) reward borrowers with equity and alternative financing if they made a poor decision regarding the home loan they obtained and (ii) protect borrowers from foreclosure if they make poor financial decisions during the term of their home loan. In short, these bills incentivize borrower fiscal irresponsibility by encouraging borrowers to obtain home loans without first weighing the risks, because, ultimately these bills would almost eliminate borrower’s risks.

Does anyone think that more restrictive underwriting standards will make it easier for borrowers to purchase a home? In the long term we should expect that, if the aforementioned bills are passed, borrowers will pay even less attention to the loans they are agreeing to be bound by and lenders will become decreasingly willing to loan the money. Because these bills would greatly increase the potential that banks will suffer losses on their home loans, banks will have to tighten-up their underwriting standards even more than they have done in recent months.

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Attorney Tyler F. Belong is a partner at the San Diego law firm of Hogue & Belong. Mr. Belong is also a founder of the Mortgage Accountability Association.

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