Posted on Wednesday, October 13, 2010
The foreclosure fraud scandal is a big deal (or a big "effin'" deal, as Joe Biden might say). But its real significance is an even bigger deal. Foreclosure fraud is one domino, and if it falls others will follow. The result could be an end to the "invisible bailout" -- the one you never hear about, the one that forces millions of people to subsidize bad lending practices in order to prop up Wall Street.
The invisible bailout is the reason why the government isn't pushing to freeze foreclosures. If the foreclosure process is halted and lending practices are thoroughly investigated, it might eventually force bankers to own up to their own lawlessness -- and write down billions of dollars in artificially inflated assets. How are they going to pay themselves record bonuses if that happens?
How much could that cost? One in four US homes is underwater, which means that proper accounting would require a writedown of enormous proportions. And, as the AP reported, "forecasters at John Burns Real Estate Consulting predicted that 41 percent of residential sales this year would be on distressed properties." The banks have been counting on that revenue.
Write down one mortgage in four? Halt nearly half of all home sales?
Now that's a big effin' deal.
To play the game, first place the blame
Ever wonder why so many pundits and politicians keep hammering underwater homeowners as morally reprehensible, while giving bankers a free pass for lending to them? It's because the ongoing success of the bank bailout depends in part on protecting banks from having to account for the billions of dollars in bad loans they generated. How do you do that? By convincing the public that borrowers are the ones who were irresponsible, if not downright criminal, and that they have a moral obligation to pay banks the full value of these loans.
That's the agenda that gets served by pieces like last year's "Homeowner Bailouts Reward Irresponsibility," which singled out real estate flippers and lambasted people who overspent for houses they couldn't afford. But flippers are a tiny percentage of the real estate market, and those people with houses they "can't afford" were told they could afford them... by the banks!
That's also why so many stories of mortgage fraud singled out homeowners who overstated their incomes or otherwise provided falsified information in obtaining a mortgage. But the FBI -- hardly a bastion of socialism -- estimated that 80% of mortgage fraud was performed by businesses ("Fraud for Profit") and not individuals ("Fraud for Housing"). Yet homeowners are being stigmatized in order to reduce political pressure to provide them with some form of mortgage relief.
As for the noncriminal loans, which presumably remain the majority of those outstanding, borrowers didn't take them out as part of a nationwide attempt to live beyond their means. These loans were aggressively marketed to homeowners by banks. A lot of people got rich giving out these loans. But our "invisible bailout" policy requires a public belief that homeowners are morally obligated to pay full value on loans written at inflated house prices.
That's where pieces like one written by Fareed Zakaria (and discussed here) were so important. For this argument to succeed, it was necessary to believe that the economic crisis was the result of their "bad habits" and their own native greed. "We... took out a massive mortgage and financed our fantasies," Zakaria writes.
But who fueled the fantasies? Who offered consumers these mortgages?
Catch-22 for Homeowners
Banks convinced people their homes were worth an inflated amount and persuaded them to borrow against that amount. The "invisible bailout" strategy relies on homeowners to pay them the full amount of that inflated loan, with no penalty to the bank for its role in that transaction. To help homeowners, the government's response has been to lower interest rates. But the banks won't lend money to someone whose collateral is worth less than the value of the loan! (Banks suddenly get religion about a home's real value when it's time to issue credit.)
That leaves homeowners in a catch-22. Who benefits? The banks, of course. They still collect against the inflated value of the house, and at older, higher interest rates -- while pocketing the zero-interest money the Fed is throwing their way.
That's the invisible bailout, and it's worked like a charm... until now.
Of course, when you're bleeding people like they're meat-locker inventory in a vampire delicatessen you're going to lose some of them. Foreclosures -- lots of them -- are the cost of doing business this way. But the banks must have decided that it's better to go through the foreclosure process than to write down their stated assets to a reasonable level.
But there's a problem with that. They had themselves quite a little party by swapping these inflated mortgages as securities, but now that the party's over it's getting messy. Nobody knows who owns what, exactly. That left them with a choice: Admit that they can't always trace the chain of ownership, or falsely claim that they had this information when they really didn't.
Remember, if banks admit that they can't prove ownership, then they have to write down a lot of assets. If their lack of information had become known, they might have had to negotiate with homeowners... for the actual, current value of the home! That's exactly what they don't want to do.
Blackmail on the Books
So the banks bluffed it out instead and hoped they'd get away with it. That's a reasonable enough assumption. After all, they've gotten away with so much already. As "Synthetic Assets" points out: "Over the past half century the financial industry has not treated the law as a bedrock institution that constrains... its activities, but rather as a set of rules that can be forced to adapt to the industry's needs and desires."
As long as a financial collapse threatens the entire economy, these bankers understand that the government will retrofit the law to fit their behavior. The alternative would be an economic crisis. (That's why we need to break up the big banks.)
Bankers. Aren't they supposed to know something about managing money?
Mortgage fraud was a huge business in the 2000's, leading to more than a billion dollars in restitutions in 2003-2005 alone (and identified cases were a tiny fraction of the total). Bank assets are loaded down with fraudulently written loans which, if acknowledged, would hit them hard (and make it more difficult for bankers to pay themselves record bonuses again this year).
Then there are the legally obtained but still highly overpriced assets, mostly real estate that's worth much less than what's on the books.
And consider this: We have a massive problem with homes under foreclosure because bank haste and greed have left them with no clear title. That means it's not clear who owns these houses. We only learned about it through the foreclosure process, but the same title problems must exist for homes that aren't going through foreclosure. We could be looking at millions of homes whose ownership is unclear. No wonder bankers tried to hide the problem with fraudulent affidavits.
The IMF estimated that banks worldwide still needed to write down $550 billion in bad debt -- and that was before this problem arose.
Investors hate banks right now, and no wonder. Non-interest revenue has fallen by more than $10 billion since 2007, while this kind of problem will cause their expenses to rise. Banks are trading below book value on the open market, which should be (but won't be) celebrated by the right as an instance of an informed market making a wise decision. (Only 8% of banks traded below their book value in 2001, and by 2008 that was up to 60%.)
As the IMF says, bankers are running a "very fragile" business. Even with a license to break the law, profits are down and they can't dig their way out of the hole they made. That suggests they're not very good at their jobs. What's the right set of incentives for that kind of record? Record bonuses, of course -- even if it means taking a bigger percentage of their reduced profits to do it.
But what they must do at all cost to protect those bonuses is pretend everything's fine. They're not even writing down second liens on homes, which are notoriously over-borrowed. (Did I mention that these guys are giving themselves record bonuses?)
Nobel prizewinner Joseph Stiglitz, who also bears the distinction of having been correct about the housing bubble, thinks it's time for the banks to write down the excess value of these loans. As Stiglitz observes, that will be painful for the banks in the short term, although it would be "nothing in comparison to the suffering they have inflicted on people throughout the rest of the global economy."
But the administration's reluctant to do that. That's why we heard such tepid remarks from the White House about the foreclosure fraud scandal over the weekend. If the foreclosure fraud issue is pursued too aggressively, it throws 41% of all expected housing sales into question. It raises even more questions about the ownership of millions of loans in good standing, potentially giving homeowners leverage to renegotiate based on the actual market value of their homes. And it reopens the issue of "writedowns."
Illegal submission of foreclosure documents was part of a larger cover-up. People need to be arrested for it -- but that, of course, would open up a larger can of worms. The legal process could very well reveal the extent of the title problem, as well as other potentially widespread criminal practices.
Still, that's no reason not to cuff 'em and book 'em. If you can't do the time, don't do the crime...
Foreclosure fraud is the first domino. If it's tipped over, the "invisible bailout" would end. Banks would no longer be subsidized by American homeowners. Know what that means? Bye-bye, bonuses. Hello, increase in discretionary spending for American consumers. And hello there, new jobs.
Anyone for a game of dominoes?
Richard (RJ) Eskow,WSJ