Barack Obama suffered a major setback yesterday on his economic policy, even though he had just expanded his majority in the Senate.  The “cramdown” policy that would allow bankruptcy judges to force lenders to adjust the principal on mortgages only got 45 votes, with 51 against.  Republicans argued that it would incentivize bankruptcy:

For the second time in two years, a provision to allow bankruptcy judges to modify mortgages died in the Senate today, handing the Obama administration a significant defeat in its plans for arresting the foreclosure crisis.

Supporters argued the measure would keep 1.7 million borrowers in their homes, but it ultimately foundered in the face of fierce financial industry and Republican opposition. The bankruptcy modification provision, which was offered an amendment to a broader housing bill, failed by a vote of 45 to 51.

“I’ll be back. I’m not going to quit on this,” said Senate Majority Whip Richard J. Durbin (D-Ill.), who sponsored the measure. He noted that estimated foreclosures during the housing crisis has ballooned from 2 million to 8 million since his campaign for the change to the bankruptcy code began. …

“Instead of encouraging homeowners who are at risk of foreclosure to file for bankruptcy, the federal government should continue to encourage lenders to work with owners to modify loans where it is economically viable for homeowners to remain in their homes,” Republican Whip Sen. Jon Kyl (R-Ariz.) said. “While it is regrettable that not all homeowners are eligible for a loan modification, Congress should not incentivize bankruptcy by making it the only means to save one’s home.”

Kyl’s point is well taken.  Homeowners who have gotten underwater might decide to take their chances on what amounts to mandatory government arbitration, not unlike that proposed in Card Check.  If bankruptcy judges can arbitrarily reset principal values, then it gives less incentive for people to honor the contract they willingly signed.

That is the bigger principle at stake.  We are supposed to be a nation of laws, and contract law is supposed to be binding.  No one signs a mortgage with a gun at their head.  Durbin and his allies want to end the notion that contracts mean what they say.  Instead of binding agreements on which people can rely, contracts will become much like the Constitution for the Left — meaning whatever seems expedient from moment to moment.

Suffice it to say that lenders cannot operate under those conditions in the long run.  That will mean they will have to get more particular about their borrowers, as they cannot rely on the contractual agreement to guarantee repayment.  They will be much less inclined to take risks, and many more people will find themselves locked out of mortgages in the future than will find themselves rescued by Durbin’s undermining of contract law.

Update: Who were the Democrats who voted against it?  Mostly the red-staters:

  • Max Baucus (MT)
  • Michael Bennett (CO)
  • Robert Byrd (WV)
  • Thomas Carper (DE)
  • Byron Dorgan (ND)
  • Tim Johnson (SD)
  • Mary Landrieu (LA)
  • Blanche Lincoln (AR)
  • Ben Nelson (NE)
  • Mark Pryor (AR)
  • Arlen Specter (PA)
  • Jon Tester (MT)

No Republicans voted for it, and Ted Kennedy and Jay Rockefeller missed the vote.  With only one exception, the dissenters came from states which will probably punish a yes vote on this measure.  Interestingly, Thomas Carper voted against it — but Delaware has a big constituency in credit and lending markets, despite their more liberal bent.

Update II: Oops, Carper isn’t Biden’s replacement — Kaufman is. I’ve changed the update.