Why the Banks Should Welcome Any Settlement That Finally Resolves the Mortgage Mess

Commentaries on economics and technology.
Oct. 20 2011 1:02 PM

Settling Up

Why the banks should welcome any settlement that finally resolves the mortgage mess.

(Continued from Page 1)

Feldstein calculates that the one-time cost of principal reduction would be around $350 billion. Of course, in our current fiscal environment, it will be hard to find additional resources from the budget. But $350 billion is roughly what the financial sector as a whole earned in an average quarter during the credit boom—and profit levels in recent quarters have reached or exceeded those levels. So, if the entire write-down cost were covered by banks, most of them would lose the equivalent of no more than a year’s profits—spread over several years.

Those boom-time profits were in any case overstated, because they were not adjusted for risk. And when the downside risks materialized, the losses were largely socialized, which is the primary reason why U.S. public debt has soared in recent years. Asking shareholders and management to pay a relatively small amount is entirely fair and appropriate under these circumstances.

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Some in the financial sector would, of course, threaten dire consequences. In fact, bank stock prices might drop, and it is entirely possible that compensation and bonuses would be curtailed, at least in the short term. On the other hand, a large-scale settlement that legitimately and finally removed the threat of future legal action would lift an enormous cloud that hangs over some of the largest lenders, including Bank of America, and creates significant risks for the rest of the financial system.

If the banks were ever really held accountable for the social costs of their behavior, the bill would far exceed $300 billion to $400 billion. Realistically assessed, the full downside legal risks to financial institutions are in excess of $1 trillion—particularly if it can be demonstrated that the “mortgage-backed securities” sold to investors were not backed by mortgages at all, because the proper legal paperwork was never done.

Any settlement should also include the banks’ explicit agreement that they will support modifying America’s bankruptcy law to enable inclusion of mortgages in the usual court-run processes. If the Occupy Wall Street movement tells us anything, it is that the last thing the U.S.  economy needs is more households overwhelmed by debt.

This article comes from Project Syndicate.

Simon Johnson is a professor at MIT’s Sloan School of Management and the co-author of White House Burning: The Founding Fathers, Our National Debt, And Why It Matters To You.

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