Participants in the Occupy Wall Street movement are right to argue that the big banks have never properly been investigated for the mortgage-related shenanigans so central to the financial crisis—and to the loss of more than 8 million jobs. But, thanks to the efforts of New York Attorney General Eric Schneiderman and others, serious discussion has started in the United States about an out-of-court mortgage settlement between state attorneys general and prominent banks.
Talks among state officials, the Obama administration, and the banks are currently focused on reported abuses in servicing mortgages, foreclosing on homes, and evicting their residents. But leading banks are also accused of illegal behavior—inducing people to borrow, for example, by deceiving them about the interest rate that would actually be paid, while misrepresenting the resulting mortgage-backed securities to investors. If these charges are true, the bank executives involved may fear that civil lawsuits would uncover evidence that could be used in criminal prosecutions. In that case, their interest would naturally lie in seeking (as they now are) to keep that evidence from ever seeing the inside of a courtroom.
The scale and structure of any out-of-court mortgage settlement should address the damage inflicted by the alleged pattern of behavior. Many Americans now have too much debt. About 10 million mortgages are estimated to be “underwater” (the house is worth less than the loan). And, in key markets around the United States, four years into the housing slump, home prices continue to fall.
If these were commercial loans, creditors would consider restructuring them—extending the payment schedule and typically writing down principal. But this practice is less common in America’s home mortgage market. Banks do not want to have to initiate millions of negotiations, nor do they want to face the losses implied on their loan portfolio. As a result, households want to spend less and pay down their debts. To some extent, this is the natural aftermath of any credit boom. And household deleveraging will take a long time.
Policymakers can respond in three ways. The first option is to do nothing. This appears to be the preference of the Republican congressional leadership, which recently wrote to Fed Chairman Ben Bernanke to demand that he not try to stimulate the economy further. The second option is to continue to rely on conventional monetary and fiscal policy to pull the economy out of the doldrums. This approach is still preferred by the Obama administration, despite poor results thus far.
And the third choice is to adopt an alternative approach that directly reduces the value of underwater mortgages. At this point, any improvement in consumer balance sheets would directly stimulate the economy and create jobs.
Start with the proposal made by Martin Feldstein, who recommends a trade: The government should reduce the value of mortgages when they are sufficiently underwater, with the government and the banks splitting the losses; in exchange, the borrower must agree that the new loan becomes “full recourse.” That means that lenders could pursue borrowers’ other assets—not just the house—in case of default.
The key to this proposal is that banks and borrowers must agree. It is a voluntary debt restructuring, compelled by no legal authority. In principle, banks should be attracted to the proposal, because restructured loans are less likely to default. In practice, the banks have consistently dragged their feet on mortgage restructuring—and are laying off staff, rather than hiring people who could help them deal with an initiative of the required scale.