The positive mortgage settlement

By Felix Salmon
February 9, 2012
looks like a good one.

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The long-awaited mortgage settlement is here! And it looks like a good one. The biggest worry was that the attorneys general would give away the shop in return for big headlines. While in fact they seem to have been quite successful at limiting the immunity that the five banks (Bank of America, JPMorgan Chase, Wells Fargo, Citigroup and Ally Financial) are going to receive:

In the agreement’s expected final form, the releases are mostly limited to the foreclosure process, like the eviction of homeowners after only a cursory examination of documents, a practice known as robo-signing.

The prosecutors and regulators still have the right to investigate other elements that contributed to the housing bubble, like the assembly of risky mortgages into securities that were sold to investors and later soured, as well as insurance and tax fraud.

Officials will also be able to pursue any allegations of criminal wrongdoing. In addition, a lawsuit Mr. Schneiderman filed Friday against MERS, an electronic mortgage registry responsible for much of the robo-signing that has marred the foreclosure process nationwide, and three banks, Bank of America, JPMorgan Chase and Wells Fargo, will also go forward.

Along with how broad the releases would be, California’s attorney general, Kamala Harris, also pushed for her state to be able to use the state’s False Claims Act. That would enable state officials and huge pension funds like Calpers to collect sizable monetary damages from the banks if officials could prove mortgages were improperly packaged into securities that later dropped in value.

If you’re a bank shareholder breathing a sigh of relief, then, don’t. The only thing you’re protected against, now, is lawsuits over robosigning. Were those likely to cost $25 billion if they had gone to court? It seems unlikely to me that they could have raised that much. Other big-money lawsuits over securitization can and almost certainly will still be brought — which means that the big banks all still have significant litigation risk hanging over their heads.

So why did they do this deal? Well, for one thing, it’s not nearly as expensive as it might look at first glance. It’s not like they’re paying out $25 billion and getting nothing but a bit of immunity in return. A huge chunk of the money will go towards principal reductions on underwater mortgages — which means that it’s not really a cash outlay at all.

Let’s say I lent you $350,000 to buy a house, and that house is now worth only $250,000. I’m holding that mortgage on my books at par, but if I sold it there’s no way I could get $350,000 for it, or even $250,000. I give you a principal reduction of $40,000, so that you now owe $310,000. That’s good for you — which is why the settlement is a welcome development. And it means that I have to take a $40,000 write-down on my balance sheet. But the mortgage is still being held on my books at $310,000, which is still more than I could have sold it for before the write-down.

In other words, what’s happening here is that the mortgage settlement is at heart largely just encouraging banks to bring their balance sheets closer to reality — which is something they’d have to do sooner or later in any case. Indeed, insofar as principal reductions can increase the value of a mortgage, this deal is actually making banks money, over the long term.

So think of this as that rarest of settlements, one which really is a win for all sides. The attorneys general get a big deal, homeowners who got foreclosed upon get $2,000 apiece, and the banks get to do the kind of principal reductions they probably have wanted to do for a while, but while getting significant immunity from prosecution at the same time.

Now, I guess, we just wait and see what happens with all the other possible prosecutions and lawsuits, especially in New York and California. And, of course, from the FHFA.

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