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Principal Reductions the Key to Sorting Out Mortgage Mess

Let me co-sign in the strongest possible terms to Felix Salmon’s little video about how to fix the mortgage mess. In two minutes he outlines a solution to the problem that would actually solve more than he thinks. Since you can’t embed it, I’ll transcribe some of his elegant solution, which many consumer advocates and state Attorneys General (and me) have echoed in recent weeks.

It involves a lot of work, it involves a lot of money, it won’t be easy and the banks are going to hate it… What you do is something you call principal reduction, where you take the old mortgage, the big mortgage, which is now as we know legally suspect… you take that slightly dodgy old mortgage, which in any case is very unlikely, statistically speaking, to ever get fully repaid, and you reconfigure it, you swap out for a new mortgage with a lower principal amount which is actually less than the total amount of the house so the homeowner has a strong incentive to continue paying that mortgage. And in doing so, because this is a brand new fresh mortgage, you know that this is legally watertight, and it’s going to be able to stand up to legal scrutiny.

This whole foreclosure fraud thing is a legal matter. In many cases, the banks and the servicers just don’t have the legal standing to foreclose. That’s not just because of the paperwork and the robo-signers, but because of improper mortgage assignments in the securitization process. The banks outsmarted themselves. They made it impossible to determine ownership in a vast number of cases.

It is similarly legal to refinance and reconfigure the mortgages – that has plenty of precedent in contract law. So this is a legal way to fix a problem of illegality. In this case, homeowners get the benefit of that process. I’m sure you’ll say “banks will never do this to themselves.” Not if they see an alternative of plowing through the system, yes. But if they see no recourse, if they envision a nightmare of taking bad sour mortgages and being unable to foreclose on borrowers in deficiency, it then becomes in their financial interest to engage in a mass workout. Judges are already shutting down alternative options for the banks, and the escape routes are getting closed off.

This is not without precedent: Wells Fargo agreed to mass principal reductions in a rolling settlement with Attorneys General throughout the country in the “Pick-a-Pay” loan scandal, and something similar happened in the Countrywide judgment. This is something that experienced prosecutors understand they can get (which is why it’s so important to keep the experienced ones on the job).

And if anything, Felix undersells this. This would resolve the problem of underwater mortgages, which is a feeder for foreclosures and strategic defaults. But it would also help spring the housing market back to life. Suddenly there would be less inventory available. Borrower foreclosures would slow to a reduced rate. The housing stock would tighten, albeit not by a huge amount. Prices may respond with increases. Moreover certainty would return to the housing market, and in this case, it’s crucial and not just an excuse. What the top title insurer did today is a sign that they have no confidence that foreclosures are occurring properly. Neither do potential REO buyers.

Less foreclosures mean less of a lead weight on the economy. Obviously there are other structural problems – the demand gap, the lack of investment, the trade deficit – but without the death spiral that is the housing market these days, the economy has a fighting chance to recover. And, principal reductions essentially fill some of that demand, as borrowers not dislocated by foreclosure and armed with a smaller monthly payment can spend their money elsewhere. Heck, the banks should want this, as it gives them a more secure set of payments, and the possibility to make up for the principal losses as the economy grows. And as I said, they have few alternatives at this point.

Principal reductions, simply put, are the key to unlock the economy. Each day we don’t do this is another day wasted.

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David Dayen

David Dayen