Opinion

The Great Debate

Occupy the mortgage lenders

By Simon Johnson
October 21, 2011

By Simon Johnson
The opinions expressed are his own.

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.

This piece came from Project Syndicate.

Comments
9 comments so far | RSS Comments RSS

The mortgage system needs to be fixed, or it will lead to another crisis.

In the UK, the mortgage borrower carries all of the risk (which creates major problems for labour mobility in a down-housing market turn).

In the USA, the bank carries all of the risk (which creates major problems with fraudulent mortgage applications, and elective debt default.)

US and UK mortgage law is both flawed. The only solution is to balance the risk between bank and borrower, as per “Islamic finance”. (I’m not a Muslim, never have been and never will be; but this principle offers an obvious and principled solution.)

Posted by matthewslyman | Report as abusive
 

What happened in the mortgage and mortgage backed CDO market was purely and simply criminal.

To deter systemic crime, cultural crime, repeated and knowing crime by bankers, the responsible individuals must be indicted for what they actually did. This means that the highest raking bank employees who knew of and either approved of or did not disapprove of these frauds need to be indicted on Federal bank fraud charges. This will result in high ranking financial officials facing tens of thousands of charges for even more financial crimes. Thousands of them must end up in prison or this will be done again.

Currently, given the pathetic state of corporate governance laws in the USA, shareholders who had no information about those policies and who had no practical control over the relevant Boards of Directors will be hit with huge fines while the criminals who did all this damage continue to be employed as bankers! This is a gross, gross miscarriage of justice and will destroy banks in the USA. Does the Government think investors are fools? If we wanted a Libyan style banking system, we would have bought stock in Libyan banks! Time to end corruption and self-dealing in the US Government.

Posted by txgadfly | Report as abusive
 

Occupy the home buyers that lied about their incomes to gamble with our futures on a home miles above their means! Real easy to check too-W2s please for the year you borrowed! If ya didn’t lie you’ve got nothin to hide! If you did lie, you should get no help and get stuck with a good portion of the loss! Seen bank stock prices lately-looks like they’re paying for their lyin/cheatin & stealin! Hpow many home buyers/gamblers have been prosecuted? That’s what I thought! It’s a Fed Offense to lie on a Fed/Tax payer back loan FYI! Start in Nevada-bet ya find 10s of thousands that cheated the rest of us and I haven’t heard a peep about it! Now they’re talking cash for cons-more bailout for flakes! Sorry to those that had good intent/were honest-the flakes stold your bailout money we don’t have now too!

Posted by DrJJJJ | Report as abusive
 

“…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.”

If this is done, there will be a violent revolution in this country. This is an incredibly pernicious ploy to further socialize the costs of the bubble upon taxpayers and to permit the banks to pursue their equity outside of the original collateral. This HURTS taxpayers and homeowners, it does NOT help them! For someone who has already lost their home, it saddles them with additional taxes and no recourse whatsoever. For a struggling homeowner, it marginally assists them, but the assistance is offset by increased taxes and the danger of losing other assets not originally used to collateralize the mortgage. This is a purely pro-banks proposal.

You want to see incensed Americans? Pull this garbage and you will see more outrage than you ever imagined.

Posted by BowMtnSpirit | Report as abusive
 

Ya, don’t expect us to pay for our poor decisions-it’s not our fault-it’s somebody elses, get “them” to pay for it! Classical transference- a mental disorder!!

Posted by DrJJJJ | Report as abusive
 

DrJJJJ: talk about transference. You must support irresponsibility, un-accountability, and fraud. Which means you are either a crook yourself, or a banker – oops… that’s the same thing…
You should change your handle to DrFailure_To_Accept_Responsibility

Posted by edgyinchina | Report as abusive
 

It’s an interesting idea for lenders to be invited to forgo a year’s profits, and surely not too onerous if spread over a number of years.

But. As the economic and financial crisis worsens, house prices drop further and more jobs go, the problem will surely get worse.

So the logical thing to do would be to step in now and pree-empt the spiral of decline by converting all mortgage lending to a not-for-profit arrangement.

UK building societies provide an excellent model.

Posted by goldelux | Report as abusive
 

I watch McMansion after Mcmansion being built in our neighborhoods for years by those that had to keep up with the Jones and now I’m watching them walk away after they borrowed every dime the banks would lend them and no, I have nothing to do with banking-they haven’t been any better, but I haven’t heard of one home gambler being called on a lie-they just tranferrred the loss to taxpayers! When I was down in Vegas for a business trip, I heard of waiters and waitresses that had bought several expensive homes on false income claims only because they were appreciating assets and they were only bought to flip/gamble with! What’s wrong with this picture? 3 sides to every story, 2 sides and the truth!

Posted by DrJJJJ | Report as abusive
 

“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.”

You don’t really believe that the “profits” recently reported by the big banks were real, do you? It was all accounting gimmicks, manipulated to make it look to investors like they weren’t in such bad shape.

These guys have managed their businesses into the ground. It might be worth it to help neither the housing market nor the financial industry…just to see the big banks implode under the weight of their own greed and stupidity. Especially if the Justice dept would actually do their job and prosecute these white collar criminals. At least then folks might perceive that there’s some amount of fairness in our political/economic/justice system.

Posted by NedStark | Report as abusive
 

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