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New Citigroup Cramdown Deal - Will it Stem the Rising Tide of Foreclosures?

Democratic lawmakers have reached a deal with Citigroup Inc. on a plan to let bankruptcy courts reduce mortgage rates for at-risk borrowers by allowing bankruptcy judges to alter home loans. The deal was drafted in an effort to prevent foreclosures and urged other lenders to follow suit.

The compromise between Citigroup and Sens. Richard Durbin of Illinois, Charles Schumer and Christopher Dodd of Connecticut, would be limited to loans made before the bill is signed. Obama has said he backs the concept.

"This legislation would represent an important step forward," Citigroup Chief Executive Officer Vikram Pandit said in a letter to the Senate released by Durbin and reported by Bloomberg. "It will serve as an additional tool to the extensive home retention programs currently in place to help at-risk borrowers."

Democrats have backed the "cramdown" proposal over the past year as a potential solution to the foreclosure crisis. Consumer advocates and Democrats say it would prod the lending industry to be more aggressive about modifying loans because of the looming threat of having a bankruptcy judge involved. To qualify, borrowers would need to demonstrate that they have asked their lender for a loan modification before filing for bankruptcy.

Currently, a 1993 Supreme Court decision bars judges from altering first mortgages on primary homes, though such changes are allowed on loans for vacation homes, motorcycles, boats and other kinds of property.

"Any sort of arrangement that can stave off foreclosure and modify existing mortgages, all of those things will help to get to the bottom of the housing market decline. And only then can we see a real turnaround in the economy," said Randy Frederick, director of trading and derivatives at Charles Schwab.

Other attempts by the government to deal with the surge in foreclosures over the past two years haven't made much of a dent in the problem. The federal program, Hope for Homeowners, was intended to let 400,000 troubled homeowners swap risky loans for Federal Housing Administration (FHA) 30-year fixed-rate loans with lower rates. But the early results have been disappointing, with fewer than 400 applications since the program's launch on October 1.

The agreement between Citigroup and Sens. Richard Durbin, Charles Schumer and Christopher Dodd raised hopes that the steep downturn in the housing market that has badly hurt consumer spending and the overall economy could be halted. The lending industry until now had fought the concept, saying it would force lenders to raise mortgage rates.

The U.S. government late Sunday offered $20 billion for Citi preferred stock, on top of the $25 billion it has already given the bank. But this time, the government also said it will assume 90% of losses from Citi's $306 billion portfolio of loans related to bad mortgages if the losses exceed $29 billion, in return for another $7 billion in Citi preferred stock.

Analysts say the backstop was essential to calm investors worried that the values of U.S. bank portfolios have been getting worse each passing month. "Persistent downward pressure on valuations of residential mortgage assets are being compounded by falling valuations of commercial real estate and other assets," says Brian Bethune at IHS Global Insight. Any bank with similar toxic assets in their portfolio now has a chance to ask the government for similar cover.

For the government, this latest bailout and cramdown deal is a way to stretch the fast-dwindling cash available from the $700 billion bailout fund. "It enables the government to leverage taxpayers' money better," says Keith Davis, financial analyst at Farr Miller & Washington. "This way, you can avoid buying up bad assets, and hopefully not have to bear losses unless the situation worsens."

For the banks, analysts say, this could calm investors by putting a floor on losses from the bad assets. Also, it's like an insurance policy, which the banks might never need to access, Bethune says.

The news boosted Citi shares 58% to $5.95, helped lift other battered financial stocks and triggered a broad market rally Monday in which the Dow Jones industrials surged 397 points to 8443. Lennar Corp. rose 85 cents, or 8 percent, to $11.42, while Toll Brothers Inc. ended up $1.01, or 4.9 percent, at $21.70.

Obama promised to rewrite financial regulations and pledged to launch "a sweeping effort to address the foreclosure crisis so that we can keep responsible families in their homes."

Sources: Associated Press & USAToday.

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