Revolution, reform and the law of unintended consequences

February 14, 2011


In George Orwell’s classic book, 1984, the restriction of language and especially public discourse is a means of authoritarian control. The social explosion in Egypt illustrates an extreme reaction to years of silence enforced by the American puppet regime under Hosni Mubarak. Americans are just as constrained, just as oppressed as the people of Egypt. But in our case the repression is self-inflicted.

“While millions of ordinary Americans are struggling with unemployment and declining standards of living, the levers of real power have been all but completely commandeered by the financial and corporate elite,” Bob Herbert writes in the New York Times. “It doesn’t really matter what ordinary people want. The wealthy call the tune, and the politicians dance.”

The Obama Administration just rolled out the latest Orwellian diversions, two proposals for “reform” of the housing sector and federal spending. Most media commentators applaud the proposals as evidence of President Barack Obama moving “toward the center.” But the sad truth is, like most reform proposals coming from Washington, the latest White House initiatives simply enforce the status quo. And few Americans understand the difference.

In a review of The Mind’s Eye, the latest book by neurologist and writer Oliver Sacks, Sue Halpern writes that “Language is, perhaps, the second most obvious way that humans acquire knowledge after the sensory information that comes to us as a corollary of sentience.” Unfortunately most Americans are incapable of independently parsing reality from illusion in public policy. Bamboozled by complexity and ingenious lies emanating from Washington, fewer and fewer Americans accept statements from our elected officials as truthful.

Consider our inability to make some pretty obvious and rational decisions on housing finance since the crisis began in 2007 — some four years ago. This national inaction suggests that America is becoming a nuclear-armed version of Argentina. The residential housing sector is in a free fall — down six months in a row, according to Case-Shiller — yet members of Congress and the banking industry refuse to take real action. And when Congress does act, you can be sure that the “reform” will only be advantageous for the banks and certain privileged members of society.

Consider the Dodd-Frank financial reform legislation. The Obama Administration and its allies in Congress claim the law will end the tendency of Washington to bail out the largest banks and corporations. In fact, the law erects new protections around the largest banks and financial firms, effectively preventing even a group of creditors from forcing these entities into bankruptcy. Instead, we are told, the Secretary of the Treasury and the captive financial regulators will enforce market discipline. Don’t hold your breath.


The amusing part is that even with the corrupt control over America’s governing apparatus, the largest banks still manage to screw things up. Consider a much overlooked example that is very germane to the mortgage mess, namely bankruptcy reform. To better enslave American consumers in perpetual debt and penury, the big banks changed the bankruptcy laws in 2005 to make it more difficult to discharge debts and thus lower credit losses. But just the opposite has occurred.

A paper to be published by the Federal Reserve Bank of New York notes that the bankruptcy reform legislation had the effect of lowering default rates on credit cards and other types of unsecured debt, but boosted default rates on supposedly secured subprime mortgages. “Legal scholars and practitioners have long recognized how filing Chapter 7 and discharging unsecured debts can help avert foreclosure,” the paper notes. But all that the large banks have done is to shift the economic cost of default more heavily onto mortgage portfolios.

There is good reason to think that the large banks deliberately made the changes in the bankruptcy laws so that unsecured debts, which are typically retained in the banks’ portfolios, would see smaller losses. Mortgages, which are largely owned by investors and guaranteed by the federal government, are seeing far higher losses. If you think that such duplicity is beyond even the capabilities of the largest banks and the armies of lobbyists that serve them, think again.

“The banks negotiated a means by which they collect unsecured credit ahead of first mortgages and all mortgage losses go to the federal government,” notes a veteran attorney. “These losses will be funded by US taxpayers because the banks duped unsuspecting conservatives and liberals in Congress into thinking it is evil to let Bankruptcy Judges decide whether debtors can afford to pay their first mortgages.”

The US banking industry would have been far better off if they had allowed sane bankruptcy reform to be enacted with respect to restructuring of first mortgages. Over-burdened home owners could discharge unsecured debt and modify mortgage loans under the watchful eye of bankruptcy judges, who understand how to balance debtor and creditor rights.

Instead banks seeking foreclosure now face state court judges, who are elected by the people in their communities and not used to the intricacies of Wall Street finance. State courts are taking a much harsher line with banks than would federal bankruptcy judges. Banks seeking to conduct foreclosures are being met by a phalanx of judges that now say “show me the mortgage note and prove you are the one with the right to foreclose or I will not act on your pleadings.”

The cost to the bank of going back and rebuilding the document trail for a given mortgage note will likely exceed the entire proceeds of a successful foreclosure. For some banks, these “defective” notes are a significant part of the institution’s loan portfolio and securitizations. Once a lawyer has learned the “magical” questions to ask, he can stop even legitimate mortgagors that did not keep the right document trail in place.


Many analysts believe that the US banking industry is on the mend and, in general, this is true, but for some of the largest institutions who have a monopoly on mortgage servicing, the fun is only beginning. The bankruptcy reform legislation of a decade ago virtually ensures that bank losses on mortgages will continue at present levels for years. With many large banks crippled, GSE reform will be stifled and the federal government’s role in housing finance will continue indefinitely.

For example, if a bank put faith in ersatz title tracking systems such as the Mortgage Electronic Registration System and did not maintain the right “diligence” path, a debtor counsel will prevail in many courts. Some observers claim that 30-50% of all mortgages originated in the 2004-2007 time frame fall into that category.

Observers who believe that the worst of the mortgage crisis may be behind us are grossly underestimating the real “end-game” here. Over the next five years, a significant portion of the existing mortgages that cannot be cured in terms of the documentation of the note will be abandoned by the banks. Then we will get the same result as occurred in Holland about five years after the tulip bubble burst in the 17th Century, namely “general forgiveness.” And debt forgiveness will happen, as my friend Yves Smith at Naked Capitalism has predicted, because the bankers will realize eventually that seeking collection is futile.

So next time you hear President Obama or a member of Congress talk about financial reform, ask them first what harm their proposal will do compared to doing nothing. This is not an argument for inaction in the face of the accelerating real estate implosion in the US, but Americans must start to subject political claims regarding reform to the same level of scrutiny that state court judges are giving to bank foreclosure petitions. As the people of Egypt will confirm, gaining and maintaining freedom is hard work.

Photos;Top:A worker searches for sick and infected tulip bulbs in his flower fields just outside the northern Dutch town of Noordwijkerhout April 19, 2010. REUTERS/Jerry Lampen

Middle: A sign on a foreclosed home is seen in Los Angeles, California, October 25, 2010. U.S. banking regulators will issue a report next month on foreclosure practices at large financial institutions, following allegations that lenders cut corners to illegally evict homeowners, Federal Reserve Chairman Ben Bernanke said on Monday. REUTERS/Lucy Nicholson

Bottom: A pile of clothes and a sofa sit outside a foreclosed home in Los Angeles, California, October 25, 2010. U.S. banking regulators will issue a report next month on foreclosure practices at large financial institutions, following allegations that lenders cut corners to illegally evict homeowners, Federal Reserve Chairman Ben Bernanke said on Monday. REUTERS/Lucy Nicholson

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