Banks to Lose a Security Blanket

--Citi is backing legislation in Washington to allow judges to change the terms of mortgages, like slash outstanding principal --holdout banks argued that changes will weaken the legal link between the loan and underlying property value, leading to higher mortgage rates. By PETER EAVIS Think of Nixon going to China if you want to gauge the scale of Citigroup's about-face on mortgage bankruptcy. Citi is backing legislation in Washington to allow judges to change the terms of mortgages, like slash outstanding principal, for those who file for bankruptcy. Currently, courts can't amend the terms of first-home mortgages, and banks have fought to keep it that way. Mortgages are secured loans. Banks have argued that changes weakening the legal link between the loan and the underlying property would increase lending risks, potentially driving rates higher. They also say a change could act as an incentive to borrowers to file for bankruptcy, leading to higher credit losses. The opposing view is that banks have been too slow to cut the principal on mortgages as part of workout programs. Instead, they have tried cutting monthly payments and left borrowers with mortgages worth far more than their homes. It is instructive that Citi broke from the pack. Unlike peers, the bank has received two government bailouts, totaling $52 billion. And it also benefits from a loss-sharing agreement that caps losses on $306 billion of loans and securities. Skeptics suggest that if the bankruptcy change leads to higher credit losses, Citi could avoid the worst of it because of the loss-sharing agreement. Holdout banks may try to secure similar loss-sharing deals in return for falling in line with Citi, although there is no guarantee they would get that. If they did, they also might end up with another slug of preference shares that eat into profits for common shareholders and potentially increase government influence. Citi, for example, has issued government preference shares worth more than its market value. That level of government presence could be one reason why Citi appears to have caved. But it also might have seen the writing on the wall. With policy makers lining up behind the bill, it looks likely to happen. There are some bones for banks. The legislation, authored by Illinois Sen. Dick Durbin, will apply only to mortgages made before enactment, although bankers should assume it will be repeated if there is another foreclosure crisis. There also is language saying borrowers can get mortgage modification in bankruptcy only if they already have tried to renegotiate with lenders, who will be under pressure to strike a deal rather than leave it to a judge. The legislation is risky for banks because it messes with fundamentals of secured lending and is a blunt instrument. But it could help break the logjam in forcing modifications for loans in securitized pools. And with the threat of hefty new mortgage hits from the proposed legislation hanging over already-battered institutions, the administration might well be persuaded to soften the blow for banks. Write to Peter Eavis at peter.eavis@wsj.com