Occupy the mortgage lenders
A sign sits in the front yard of a home being offered for sale January 25, 2010 in Pleasant Prairie, Wisconsin. (Getty Images)
October 20th, 2011
01:15 PM ET

Occupy the mortgage lenders

Editor's Note: Simon Johnson, a former chief economist of the IMF, is co-founder of a leading economics blog, BaselineScenario.com, a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-author, with James Kwak, of 13 Bankers. For more, visit Project Syndicate or follow it on Facebook and Twitter.

By Simon JohnsonProject Syndicate

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.

The views expressed in this article are solely those of Simon Johnson. Copyright: Project Syndicate.

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Topics: Business • Protests

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soundoff (17 Responses)
  1. brian

    RT @beewalks: time to move from #occupywallstreet to #occupyDC

    October 20, 2011 at 2:28 pm | Reply
  2. Greg Gilbert

    "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" It's called a shake down because popular opinion is against the banks. When actual evidence pops up rather than here-say I'm sure there will be an investigation, which is how crime should be fought in America and not based on the populations anger and prejudice.

    October 20, 2011 at 10:03 pm | Reply
  3. lloydblack

    Mortgage rates are historically low you can easily refinance these days your mortgage to 3%. It is the best way to save money. Search online for 123 Refi they did 3.54% refinance and free analysis of my current mortgage. Learn the refi secrets there.

    October 21, 2011 at 4:31 am | Reply
  4. j. von hettlingen

    Low interest rates and the dream of owning a house proved to be many's undoing.

    October 21, 2011 at 8:10 am | Reply
  5. EricKuma

    These people took advantage of others seeking the American Dream and destroyed it for everyone.
    They need to be investigated.
    However history says that white collar criminals are rarely investigated or convicted of any crimes.
    I don't expect anything different this time around.
    Much talk, no walk.

    October 21, 2011 at 8:48 am | Reply
  6. FoodCartel

    Why just 'upside-down' mortgages? I've sacrificed everything to be able to make my mortgage payments for the last 15 years. A bankruptcy and 4 years of unemployment scattered over that time means refinancing is impossible. Now I've got 80k in equity that can't be touched, 8-5/8% interest rate and no real chance of selling my home. Meanwhile there have been no vacations, health insurance, new cars, clothes, furniture... nothing.

    I would have been much better off just walking away 10 years ago. Instead I stuck it out, and when the help comes none of it helps me. I'd love to help stimulate the general economy by purchasing needed items, but all my money has gone into the pockets of the Banks instead. For me, 'Help' would entail a reduction in my principal and interest rate – something I deserve for sacrificing all so some Banker can buy his daughter a Pony.

    October 21, 2011 at 10:47 am | Reply
  7. JamieDouglas

    And the government will pocket the hundreds of millions of $$$$$ instead of making these funds available for the victims. What is the point? The firms should be punished with measures such a being forced to sign of on the fraudulent paper. But not in the corporate states of America! Why not just have the fines payable to the banks themselves?.

    October 21, 2011 at 11:11 am | Reply
  8. carole lane

    everybody relies on banks, we think it's okay or unavoidable for this day and age, even though charging interest has ultimately never, ever caused anything but grief in the world. It is ironic that the followers of religions that most clearly condemn banking (charging interest and usury) are banking's best supporters! Banking creates poverty, then throws a few bones to those from whom it stole, giving the appearance it is helping them. I wager that poverty would end if most everyone practiced their own religion and agreed to never use a bank again. That means default on mortgages and loans and, instead, be truly responsible and pay what we owe back to those who actually need it. Yes, there probably will be chaos first, but everything good and worthwhile must "have a falling away first." A seed begins by falling to the ground and dying. What do your prophets say? "Babylon is fallen, is fallen."

    October 21, 2011 at 5:41 pm | Reply

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