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Levitin Crystallizes AG Settlement Travesty

I wanted to give more space to Adam Levitin’s superlative take on the attempted foreclosure fraud settlement and the state of housing and the economy in general.

Basically his take is that the economy is weighed down by debt, particularly mortgage debt. A substantial chunk of homeowners owe more on their houses than they are worth. For those without a house, like the young, it’s cascading student loan debt that’s the problem. And this debt overhang has a serious impact on consumer spending, which is roughly 70% of the economy. So the lack of lending, lack of jobs, below-trend economic output can all go back to this negative equity.

The negative equity on mortgages actually acts as a bank subsidy at this point. If it weren’t for the negative equity, mortgage holders would refinance, costing the banks substantial amounts of money because rates are so low. So banks benefit from negative equity, even if they don’t benefit from the sluggish economy that accompanies it. It’s short-term versus long-term thinking.

And this negative equity is a direct result of financial institutions engaging in a pump-and-dump scheme, getting rich while selling anyone a loan and using government protection to insulate them from the fallout. As Levitin says, if they broke it, they ought to buy it:

There’s only one way to skin this cat. The negative equity has to be eliminated. Period. We hoped at first that we’d grow out of it. Fat chance. This is the anchor weighing down the ship. So now it’s just a question of whether we try to clear the market via foreclosure or whether someone pays to clear the market, meaning that the book values at which mortgages are carried are written down to market values or something close to it.

Who should pay? This is basic justice. Those who broke the economy should pay to fix it. You break it, you take it. We bailed out the banks because they are indispensible to the economy as a whole, but that doesn’t mean that they shouldn’t have to pay now. $20-25 billion is a fine price tag for robosigning. But this isn’t and shouldn’t be about robosigning. Robosigning was symptom of a much larger endeavor in reckless lending, in which corner cutting was the order of the day, from MERS to securitization paper work to no-doc loans. All of this was done to maximize profits and to enable a housing bubble that was hugely profitable to a limited number of financial institutions and with extraordinary collateral damage. Simply put, there needs to be accountability for blowing up the economy.

That includes paying to fix the economy by writing down the negative equity, and it means criminal prosecution for breaking the economy in the first place. The foreclosure fraud settlement was an opportunity to use this small area where the banks were truly caught with their hand in the cookie jar – on robo-signing – to force a massive rethink on the whole housing market, a market the banks shot through with fraud and needed to be responsible to repair. The current settlement, done without any investigation (an “abuse of the public trust” says Levitin) does nothing for the central issues.

And it goes without saying that the sweetener of refinancing on bank-owned, performing, underwater homes, a small sliver of the market, it kind of ridiculous. Never mind how small the reach of this would be, and how like most non-principal reduction payment mods it wouldn’t really save anyone’s home (the best you can say is that it would be a small stimulus at no cost). It’s a “penalty” on the banks for doing what they normally do.

It’s worth remembering, at this point, that mortgages are by their nature prepayable. When you write a fixed-rate mortgage, you make a general assumption that if mortgage rates fall substantially, the borrower is going to pay you off and refinance. The underwater questions we’re talking about here were written during the housing boom, when banks simply assumed that house prices always went up; those banks cared massively about prepayment risk at the time, and spent huge amounts of money and effort trying to hedge it.

As it happened, mortgage rates did fall substantially — with the result that the banks’ hedges paid off. But then the banks realized that they could make money on both legs of the deal — that they could collect on their mortgage-rate hedges, without having to worry about prepayment. Because now the borrowers are underwater, they’re not allowed to refinance. So the banks continue to cash above-market mortgage payments every month — something they never expected that they would be able to do.

This just rectifies that inequity. It’s not a penalty, it returns equilibrium to the market. And it’s completely arbitary, focusing on those homeowners lucky enough to not have their mortgage securitized. “I would think that California, for example, would come up short on this deal, even within the context of it being a bad deal in the first place,” Levitin writes, because so much business here was through mortgage brokers who securitized almost everything. Memo to Kamala Harris.

The bottom line is that the remaining AGs like Tom Miller and the Justice Department are trying to solve a problem of massive negative equity through criminal fraud with a tiny stimulus and a big release of liability. They ought to be ashamed of themselves.

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David Dayen

David Dayen