Should Foreclosure-Gate Spur More Modifications?

Banks screwed up. Their shoddy documentation and flawed procedures surrounding their mortgage business has led to many halting foreclosures while they clean up the mess. Should they consequently offer additional, more aggressive mortgage modifications as a result? That's the growing call from progressive circles. Yet there's no logical connection here: banks may have been negligent in their bookkeeping, but that doesn't suddenly mean defaulted homeowners are suddenly reincarnated as creditworthy borrowers who can now afford their houses.

This flawed concept is coming from a few different directions. Out of Congress, Rep. Maxine Waters (D-CA) is using the new crisis as support for a bill that would require all banks to offer borrowers modifications before foreclosure. Separately, blogger Tim Fernholz of the American Prospect says that if there's a new bank bailout needed due to this mess, then modifications should ramp up:

But, to borrow a phrase from a certain former White House official, in every crisis there is opportunity. The revelation of this negligence offers the Obama administration and Congress an opportunity to capitalize on the lessons of TARP. Namely, if the public once again steps up to bail out the banks, we will get something -- something big -- in return.

Ezra Klein of the Washington posts echoes this call in the introduction to his daily (and quite good) Wonkbook newsletter today. He thinks cramdowns, where bankruptcy judges reduce mortgage principal to keep defaulted borrowers in their homes, would be a particularly good response. He also suggests ramping up rent-to-own programs.

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But let's step back for a moment. Imagine the worst-case scenario occurs, where banks find themselves in a lot of trouble and again need many billions of dollars of capital from the government. That cost will again fall on the shoulders of taxpayers. And, of course, the vast majority of taxpayers are not the ones being foreclosed on; indeed, more than 30% of Americans don't even own a home, and only a small fraction of homeowners face foreclosure.

So you've got a new bailout being paid almost entirely by renters and homeowners who don't face foreclosure. Now think about who modifications help -- the several million Americans that are facing foreclosure, who almost certainly makes up less than 5% of the population. They're the ones who would get "something big." And who would be paying for that something big? Not the banks -- they already can't afford to survive on their own in this scenario, which is why they'd need a bailout. Instead, that other 95% or more of taxpayers would be paying for the modifications too.

In other words, you would have Americans who aren't facing foreclosure paying to ensure the banks' survival and then separately paying for more aggressive modifications, which probably include principal write-downs. More modifications wouldn't stick it to the banks; they would stick it to the taxpayers who are dutifully paying their bills.

Now maybe under some scheme you could design a bailout to require that banks pay back far more than they're provided in capital, amounting to the cost of these new aggressive modifications. But you would still have a very small segment of taxpayers benefiting -- those who face foreclosure, while the risk of the banks not being able to pay back the government is placed almost entirely on the shoulders of everybody else. And of course, if you make the bailout repayment requirement too punitive, then banks might balk and prefer to go through bankruptcy instead.

If the big mess had something to do with why millions of Americans were facing foreclosure -- like if the banks mistakenly raised interest rates on these borrowers or something -- then that might be different. Then, it would make sense to argue that banks' mistakes should lead to modifications by those borrowers who they would have wronged. But that's not what's happening here.

All of the struggling homeowners who face foreclosure got there by not paying their bills. Now maybe that's because they got laid off or didn't fully understand a mortgage product that they were signing up for some years ago. Those situations are lamentable, but they have nothing to do with the document irregularities that have caused banks to halt foreclosures and examine their procedures and documentation. The two situations are unrelated, and any attempt to connect them is nonsensical.