Home Foreclosure Moratorium: Survival of the Dumbest?

This week’s headlines screech about the "Foreclosure Crisis".  Several banks have imposed internal pauses to review their own foreclosure processes.  State attorneys general are mounting a coordinated investigation into chaotic foreclosure procedures; several Congressional representatives have called for a federally-mandated moratorium on all foreclosures.

There’s a lot of heat in this debate, but not a lot of light.   Let's try to remember a few of the basic facts about lending, mortgages, enforcement and prices.

In a perfect world, people would only borrow money they could repay ... and lenders would only lend money to folks who could repay it.  But we don't live in a perfect world.

For a few years, there, it seemed that there always was someone who would lend money to anyone who could fog a mirror, regardless of the borrower’s ability to pay.   Homeowners responded to rising home valuations by treating their homes like ATMs:  leveraging the maximum allowed by the lenders, and seemingly spending much of it on jet skis and vacations.  All of this easy money led to further inflation of home prices.  That bubble cycle made things tough for the poor devils who tried to live within their means, and also for the poor lenders who tried to compete for solvent borrowers without making irresponsible loans. 

No one, including regulators, wanted to be the adult who took away the punch bowl from that party.  Inevitably, eventually it crashed anyway.  

Now, we have several problems.

One is that a lot of folks are underwater on their home mortgages.  Many borrowed way too much, others just were unlucky.  Some have lost their homes. 

The housing and mortgage lending markets corrected to take that into account . . . partway.  Bank loan portfolios were re-assessed, and many were found inadequate.  The federal government bailed out a lot of banks, and closed a lot of banks, all on the taxpayer's dime.  The housing market probably has further to fall; so the banks that were strong enough to survive Round One probably aren't enthusiastic about having their remaining loan portfolios "marked to market".   That's economist lingo for "if you list on your books the price you'd get if you foreclose on all those loans right now, you might find out what they're really worth, and you might not like the answer."

That's the second problem.  There's probably still an artificially inflated portion of unknown size still included in home prices, and in the bank portfolios of loan secured by those homes.   This helps explain why many rescued banks, having been repaired by large infusions of no-strings federal money, do not seem terribly eager to re-lend it out again.    

Lately we're hearing about a third problem.  Remember that mad scramble to lend, and the decade of new-wave lending using securitized pools, before the crash?  A lot of the buzz back them was about how amazingly fast and cheap that process was, compared to old-fashioned bank loans.  

Turns out that it was cheap for a reason:  some of the high-volume processes used to generate those loans seem to have been sloppier, and full of more errors,  than the old-school approach used by Mom and Pop Bank.  My co-author and I raised that issue a decade ago (2001), in an article explaining securitized loans for Standard & Poor's Banking Review.   By unpacking the structure of loans into originators, sell-offs, servicers and investors, the system encouraged speed, and outsourcing, but may have tempted low-end originators to view their loan and documentation quality as some one else's problem.

Apparently this "high-speed" approach can screw up on the enforcement end, too.  In recent foreclosures, some lenders have used “robo-signers” -- lower level employees without underlying knowledge of the loans made -- to sign court affidavits required in some states.  That's a problem if they didn't really check the stuff that they swore (on penalty of perjury) that they knew.   Like, "the signed promissory note is in our safe", "we have a valid lien", or "the borrower still owes us $ X.".

These are genuine problems.   The thing is, we already have laws to deal with all of them.

There have been foolish borrowers, foolish lenders, and sloppy deals for a long time, as well as major economic downturns.   The Great Depression in the 1930's was chock full of all of the foregoing.  As a result, most states in the U.S. already have very specific statutes for handling them.  The thing about those statutes is:   they carefully distinguish valid deals, and good-faith parties, from the ones that need to be completely un-done because they're messed up or fraudulent.

 Every home mortgage involves someone who got a loan of money, usually to buy a house, and gave a promise to pay the money back or to give the house back if he or she could not repay the money: 

•  If the lender is required by law to give the borrower clear warnings or guidance about the loan, and failed to do so, that's the lender's problem.
• If the borrower fairly took out a loan for an amount that he agreed to at the time, but can't repay later, that's the borrower's problem. 
• If the lender messed up the loan documents so they are unenforceable, that's the lender's problem.

If this all plays out according to the usual laws. the folks who screwed up (whether bank or  borrower) will lose out and lose some rights;  and the ones who were more prudent will do fine.  The ones who cut corners and made poor decisions will (and should) bear the consequences of those decisions.

In fact, our whole system of capital formation and a market economy depends on just exactly that.   So major intervention from above -- trying to repeal Darwin's Law by saving the worst bad decisions by either lenders or borrowers and leaving the careful folks to fend for themselves (and to pay for bailouts through higher taxes) -- creates some grave problems of its own.  

Our laws presumes that both borrowers and lenders make generally rational economic decisions, are adults, and should be allowed to make those decisions, based on their own tolerance for risk.  This system of law is supposed to create justice:  if there’s a problem, each party to the loan is supposed to get the benefit of his bargain to the extent possible.   If a borrower can’t pay back the money it borrowed, it bears the cost -- it loses its equity in the property.  But the lender who made an irresponsible loan also bears the cost if the value of the property at foreclosure is less than the amount of the lender’s loan. 

In a rational world, that should incentivize both lenders and borrowers to try to only enter into  loans that are likely to be repaid.

[The law gets a little tricky if one of the parties acted in bad faith.  Generally, the borrower can’t block a foreclosure unless it was defrauded or tricked into taking out the loan, or has paid back the money it borrowed.   If the lender tricked the borrower into borrowing more than it should have, or lied about the terms of the loan, or engaged in other fraudulent acts in making the loan, the borrower can plead those acts as a defense, and may be able to stop the foreclosure.  If the lender’s acts hurt the borrower, the borrower might not have to pay back all or part of the borrowed money.  Again, that's been a reasonably fair set of solutions, for decades.]

But bad circumstances tempt politicians to make bad laws.  As a result of the current drop in housing values, and other recession problems, the number of "problem" home loans has skyrocketed.  About 1/3 of California homeowners are currently late in paying their mortgages.    This may even include people who can afford it -- but they've figured out that "extend and pretend" patterns to postpone enforcement let them get away with it, for a while.  The federal government's signals encourage that.  Also, the feds gave a large and well-publicized bailout to several of the biggest financial institutions, with few strings.  Presumably some Wall Street and pension funds are delighted that their stock portfolio was helped by this.  But the only results Joe Homeowner has read about?  (1) The banks got the money but still haven't started lending again, and (2) some of them loudly paid huge bonuses to the executives who ran the ship into the sand:   at about the same time many Americans became unemployed.  Maybe a meltdown was averted ... but these actions have turned Wall Street into new favorite villains for Main Street.

Now we have this latest report:   some of them may be committing fraud when they do foreclose, too, with those false robo-affidavits.   This is not a smart thing to do in court (it’s a great strategy to irritate a judge), nor is it helping their PR situation. 

Still, “Foreclosure-gate” is being overblown in the press.  The real “robo-signer” problem is fairly easy to fix.  All it takes is to have someone review the loan and foreclosure files to confirm the information, prior to submitting the needed affidavit.  This takes time and costs money -- taking the steps now that should have been taken when the loans were made -- but it's simply not that hard.   Several banks have announced that they are temporarily stopping their foreclosures to review and if necessary fix their foreclosure processes.  That's completely appropriate, and probably will only have a minor and temporary effect on their foreclosures.

If the “robo-signers” have committed perjury on behalf of their lender employers, then that’s a matter for the attorneys general to decide to prosecute or not.  In making a decision to prosecute, a prosecutor has some discretion to decide to prosecute such an action at all (if, for example, others would be deterred by seeing such prosecutions), and also whether to prosecute the employee who signed the documents, or its employer.  We have prosecutors whom we’ve hired to decide whether it makes sense to prosecute in cases like this:  we should let them do their jobs.  If we don’t like how they do it, we can vote them out.  Judges, too, should make sure that all parties to a foreclosure action follow the existing rules, so that lenders who seek to foreclose prove that they have rights to do so, and borrowers alleging fraud or other bad acts have the opportunity and responsibility to prove up their allegations. 

But the bad PR is leading to an outcry for bad legislation.  While it's entirely appropriate both for the affected banks to proceed carefully, and for borrowers to require that banks prove up their cases against them, it might be a disaster for Congress to impose a moratorium on foreclosures.  Predictability -- the ability to determine in advance what the worst case will be -- is vital to any lender’s willingness to make a loan.  If a lender cannot rely on the existing law to enforce its valid deals, it will simply make far fewer loans, and will charge much more for them.  (Which is pretty much what's happening right now.)

This past week, a number of these banks’ stocks went down in value:  and it’s acceptable for Mr. Market to scold those banks that way.  Ultimately if they fix their processes, they should be able to proceed with their legitimate foreclosures.  After all, they lent out the money -- and their investors and shareholders need them to collect on their collateral.  And Mr. Market will notice that too -- particularly, he will notice which ones clean up their act.  Also a good thing.

 Hernando De Soto, in The Mystery of Capital, argues persuasively that one of the key reasons that capitalism works in the West, but not as much of the rest of the world, is that the rule of law in the West allows parties to make contracts that allow them to allocate risk and do business with people they don’t know.  In the third world, that doesn’t happen so much:  because the legal system is not well developed in many third world countries, folks can only do business with others with whom they have informal ties because there’s no way to enforce contractual promises effectively and systematically in nonexistent or corrupt court systems.

In other words, our system creates business opportunity because we enforce business contracts.  This is true elsewhere, as well.  When China got serious about inbound foreign investment in the late 1980s, eyeing Hong Kong's success, the first thing it did was set up special economic zones on the mainland in Guangdong and Shenzhen with . . . guess what?  Commercial courts, well-defined arbitration rules and contract law.

But well-meaning members of Congress are talking about legislative steps to abrogate mortgage rights and bar some foreclosures.  Popular talk in an election year recession, probably.  However, when we suspend gravity to rescue the worst deals, we are enforcing what Darwin might have called "Survival of the Dumbest".  Often this leaves the "fittest" twisting in the wind.  

If a bunch of those mortgage loans are malformed or were fraudulently made, then even with no moratorium, they won't be enforced.  The way laws deal with that may include class actions, against any proven patterns of fraudulent foreclosing practices, and securities lawsuits, against arrangers and raters who made misrepresentations in securitized loan pools.   

Working those disputes out in that conventional way would allow the marketplace to continue honoring the large portfolio of nonfraudulent home loans, where everyone's behaving and things are working out.  Because ultimately what we need is a viable home and mortgage marketplace that takes a hit, revalues, and moves on.  Not to stop the patient's heart before starting surgery.

For the government to intervene, instead, and magically make all foreclosures go away for a while, risks much.  For one thing, wouldn't barring all banks from routine mortgage enforcement make the stock of both good banks and bad ones go down?   I'm pretty sure that I would not invest in a bookstore if the federal government outlawed paying for books.   Or even introduced a six month "moratorium" on book selling, and let everyone go loot the local bookstores temporarily.  Because, you know, they really need books.

 If contract-suspending interventions keep postponing marketplace reactions, without creating any jobs or letting any property values re-set, it's all just going to get worse, not better.