Tuesday, October 21, 2014
1

Occupy the Mortgage Lenders

WASHINGTON, DC – Participants in the Occupy Wall Street movement are right to argue that the big banks have never properly been investigated for the mortgage origination, aggregation, and securitization behavior that was central to the financial crisis – and to the loss of more than eight million jobs. But, thanks to the efforts of New York’s attorney general, Eric Schneiderman, and others, serious discussion has started in the United States about an out-of court mortgage settlement between state attorney generals and prominent financial-sector firms.

Talks among state officials, the Obama administration, and the banks are currently focused on reported abuses in servicing mortgages, foreclosing on homes, and evicting their residents. But leading banks are also accused of illegal behavior – inducing people to borrow, for example, by deceiving them about the interest rate that would actually be paid, while misrepresenting the resulting mortgage-backed securities to investors.

If these charges are true, the bank executives involved may fear that civil lawsuits would uncover evidence that could be used in criminal prosecutions. In that case, their interest would naturally lie in seeking – as they now are – to keep that evidence from ever seeing the inside of a courtroom.

The scale and structure of any out-of-court mortgage settlement should address the damage inflicted by the alleged pattern of behavior. Many Americans now have too much debt. About 10 million mortgages are estimated to be “underwater” (the house is worth less than the loan). And, in key markets around the US, four years into the housing slump, home prices continue to fall.

If these were commercial loans, creditors would consider restructuring them – extending the payment schedule and typically writing down principal. But, in America’s home mortgage market, this is much less common. Banks want neither millions of negotiations nor, most importantly, the need to face the losses implied on their loan portfolio.

As a result, households want to spend less and pay down their debts. To some extent, this is the natural aftermath of any credit boom. And household deleveraging in the US will take a long time.

Policymakers can respond in three ways. First, they could do nothing – apparently the preference of the Republican congressional leadership, which recently wrote to Fed Chairman Ben Bernanke to demand that he not try to stimulate the economy further.

Second, they could continue to rely on conventional monetary and fiscal policy to pull the economy out of the doldrums. This is the approach still preferred by the Obama administration, despite its poor performance.

Third, we could adopt an alternative approach that directly reduces the value of underwater mortgages. At this point, any improvement in consumer balance sheets would directly stimulate the economy and create jobs.

Start with the proposal made by Martin Feldstein, who recommends a trade: the government should reduce the value of mortgages when they are sufficiently underwater, with the government and the banks splitting the losses; in exchange, the borrower must agree that the new loan becomes “full recourse.” That means that lenders could pursue borrowers’ other assets – not just the house – in case of default.

The key to this proposal is that banks must agree; it is a voluntary debt restructuring, compelled by no legal authority. In principle, banks should be attracted to the proposal, because restructured loans are less likely to default. In practice, the banks have consistently dragged their feet on mortgage restructuring – and are laying off staff, rather than hiring people who could help them deal with an initiative of the required scale.

Feldstein calculates that the one-time cost of principal reduction would be around $350 billion. Of course, in our current fiscal environment, it will be hard to find additional resources from the budget.

But $350 billion is roughly what the financial sector as a whole earned in an average quarter during the credit boom – and profit levels in recent quarters have reached or exceeded those levels. So, if the entire write-down cost were covered by banks, most of them would lose the equivalent of no more than one year’s profits – spread over several years.

Those boom-time profits were in any case overstated, because they were not adjusted for risk. And when the downside risks materialized, the losses were largely socialized – the primary reason why US public debt has soared in recent years. Asking shareholders and management to pay a relatively small amount is entirely fair and appropriate under these circumstances.

Some in the financial sector would, of course, threaten dire consequences. In fact, bank stock prices might drop, and it is entirely possible that compensation and bonuses would be curtailed, at least in the short term. On the other hand, a large-scale settlement that legitimately and finally removed the threat of future legal action would lift an enormous cloud that hangs over some of the largest lenders, including Bank of America, and creates significant risks for the rest of the financial system.

If the banks were ever really held accountable for the social costs of their behavior, the bill would far exceed $300-400 billion. Realistically assessed, the full downside legal risks to financial institutions are in excess of $1 trillion – particularly if it can be demonstrated that the “mortgage-backed securities” sold to investors were not backed by mortgages at all, because the proper legal paperwork was never done.

Any settlement should also include the banks’ explicit agreement that they will support modifying America’s bankruptcy law to enable inclusion of mortgages in the usual court-run processes. If the Occupy Wall Street movement tells us anything, it is that the last thing the US economy needs is more households overwhelmed by debt.

Read more from our "The Big Bank Battle" Focal Point.

Hide Comments Hide Comments Read Comments (1)

Please login or register to post a comment

  1. CommentedRobert Mullen


    A better analysis: There is no entity capable of deciding the value of houses or mortgages, or when they are "sufficiently underwater". Nor any one capable of deciding if the owner, the lender, or other circumstances caused the problem or who deserves to benefit from the solution.
    The best solution: The home owner has the option now of mailing in the keys -- they should determine if that is in their interest and do it, rather than throwing good money after bad. The government should allow them (via guarantees), on the same basis as anyone else, to get loans for new housing if they have enough income, when they have a down payment, and if they are a good risk (ignoring for this purpose the fact that they defaulted on their previous mortgage.)
    This will have the effect of putting more homes on the market, but also more buyers. The banks will be faced with well deserved losses on the loans they never should have made -- the more risky the loan, the bigger their loss. The homeowners will lose also, but in proportion to the excess size of the house they "bought" -- in short they may well wind up in a smaller house, or renting. The banks will have the opportunity to lend wisely to the new buyers in the market.
    Note this plan requires no voluntary action by the bankers, only the homeowners and the government need to act.
    The worthy public policy objective is to put folks in a home they can afford, if they can afford one. It should not be to keep everyone in the specific home they were in when the "music stopped". If most of the homeowners that are underwater mail in their keys, many will wind up in a very similar home across the street or down the block from the home they currently occupy.
    And the market will have cleared.

    The proposed transition to "full recourse loans" is a trick, a trap. It will be the final nail in the coffin for the middle class, ensuring that homeowners pay the full cost of the whole fiasco. If there is a movement to full-recourse, you can bet it will be followed by a long gradual deflation, squeezing every ounce of savings out of the middle class.

Featured