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Foreclosure Fraud Settlement: “Making Banks Money”

I liked that NBC Nightly News used Yves Smith to describe the foreclosure fraud settlement last night. And she’s right that the ultimate penalty here is tiny for the banks compared to the damage done. Moreover, as Felix Salmon explains in a post actually claiming that the settlement is a win-win for everyone (I’ll circle back to that, but why should a punishment be a win-win, exactly?), the banks have a financial opportunity in this deal.

Let’s say I lent you $350,000 to buy a house, and that house is now worth only $250,000. I’m holding that mortgage on my books at par, but if I sold it there’s no way I could get $350,000 for it, or even $250,000. I give you a principal reduction of $40,000, so that you now owe $310,000. That’s good for you — which is why the settlement is a welcome development. And it means that I have to take a $40,000 write-down on my balance sheet. But the mortgage is still being held on my books at $310,000, which is still more than I could have sold it for before the write-down.

In other words, what’s happening here is that the mortgage settlement is at heart largely just encouraging banks to bring their balance sheets closer to reality — which is something they’d have to do sooner or later in any case. Indeed, insofar as principal reductions can increase the value of a mortgage, this deal is actually making banks money, over the long term.

This becomes more magnified when you look at the possibility of the banks using write-downs on private-label MBS loans to “pay” the settlement off, which amounts to someone else’s money.

As for Felix’ point that the banks are only getting off the hook for robo-signing, and that substantial litigation risk remains (he later says that the banks got “significant immunity from prosecution” in the same post, so I’m not following), first of all that’s wrong. Servicer conduct, including fee pyramiding and a host of other deceptive practices are folded into the release. What’s more, robo-signing was the area where the banks were caught dead to rights. There are depositions with bank employees admitting to signing documents, thousands a day, without knowing anything about the underlying loans. There are register of deeds offices full of fraudulent documents. This is physical evidence that you’re giving away here, and ongoing criminal conduct.

What’s more, the American Bankers Association President Frank Keating believes that the settlement “addresses a distinct group of mortgages offered during a specific timeframe. It would be a mistake to regard the settlement as applying to mortgage practices industry wide.” Wow. That’s as big an announcement that the banks will basically keep doing what they want to do that I’ve seen.

If you want to read perhaps the best assessment of this, check out Georgetown law professor Adam Levitin at Credit Slips.

That $5 billion in hard cash is going to the state and federal government, only some of which will be given to borrowers. What about the other $20 billion? That’s to come in the form of $3 billion in refinancings and $17 billion in principal reductions, deeds in lieu, short sales, anti-blight measures, etc. The banks receive variable credit for these actions, depending on whether these measures are taken for loans owned by the banks or owned by others and serviced by the banks. Basically, it’s full credit if the bank owns the loan, and half credit if the bank merely services the loan. Because of this formulation, the $17 billion in principal reductions, DILs, short sales is anticipated to result in $32 billion in actual relief. In other words, it is expected that the banks will modify the loans owned by others rather than the loans they themselves own. And when a second lien loan owned by the bank is involved, it only has to be written down pari passu (at the same percentage) as the first lien loan. So from absolute to relative priority, which is a major handout to the big banks, which have large underwater second lien positions.

Or put differently, $32 billion of the settlement is being financed on the dime of MBS investors such as pension funds, 401(k) plans, insurance companies, and the like—parties that did not themselves engage in any of the wrong-doing covered by the settlement. This shouldn’t be a surprise—the state Attorneys General previously cut a similar deal with Bank of America, which promised to make up for its wrongdoing by modifying loans own by other parties.

But let’s get to the bigger problem. Whether this is a $25 billion or $40 billion settlement is really beside the point. It’s a drop in the bucket relative to the scale of the problem. There is approximately $700 billion in negative equity nationwide weighing down the housing market and the economy. Add to that legions of homeowners dealing with unemployment or underemployment and we’ve got a problem that absolutely dwarfs the settlement numbers. It’s Pollyannism to think that this settlement will have any impact on the national housing market. At best it makes some incremental improvements and helps a small number of homeowners. But at worst, it lets the banks off the hook for the largest financial crime in history.

In closing, I’m very happy to see Matt Taibbi actually reassess his position on this. The initial Taibbi story, where he was slightly happy about the imminent settlement, was used by a lot of people to “prove” that it was a good deal. Taibbi actually says “Shame on me for ever thinking that might be a good thing,” which is a brave thing for a well-known reporter to say.

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David Dayen

David Dayen

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