The Foreclosure Lawsuits Show Why Everybody Hates Bailouts

The Obama administration will have a tough time keeping the banking system stable without angering the Americans people

600 bailout REUTERS Shannon Stapleton.jpg

For politicians in Washington, doing the right thing can be hard: sometimes it isn't even clear what is meant by "the right thing." Although elected representatives are put in power to carry out what their constituents want, what happens if policymakers know that the action being called for will result in more harm than good? Right now, the Obama administration finds itself in such a pickle. Will it choose anger to Americans and go easy on the banks despite their foreclosure misdeeds for the sake of financial stability?

The Foreclosuregate Dilemma

As you probably know, the state attorneys general in conjunction with the Justice Department have sued a number of big banks in conjunction with their allegedly flawed foreclosure practices. This case must end in a settlement, because it's a logistical nightmare to deal with each mortgage lawsuit separately. To create a settlement, however, the states, the federal government, and the banks all have to come to an agreement. That is proving to be a challenge.

At this point, the banks can be pretty sure they'll end up having to pay something. Obviously, they want to keep the amount of damages as small as possible. But perhaps more importantly, they want to ensure that their liability is limited as a part of the settlement: they don't want to face additional lawsuits in connection with these botched foreclosures.

But several state attorneys general are aggressively pursuing damages and don't want to extend this courtesy to banks. They believe banks have harmed a large number of people through flawed procedures and want the banks to pay for their mistakes. Many Americans agree.

The Obama administration may agree too. Unfortunately, its decision to go after the banks isn't as simple as it sounds: a painful settlement for banks could endanger financial stability. So does the administration push for an aggressive settlement or go easy for the sake of the U.S. economy?

Really, this is a no-win situation for the administration. Americans will not be pleased if banks get off with a little tap on the behind. They want justice. The president's progressive base feels particularly strongly about the need to make banks pay. Politico reports that the left is outraged that the administration is said to be pushing for a milder settlement. So going too easy might alienate voters.

In the meantime unemployment is 9.1%. A great deal of uncertainty continues to plague the banking industry due to its foreclosure problems. Providing a limit to their liability here could go a long way in calming investors that at least one aspect of legal action is behind the banks. To make matters worse, a banking crisis may be brewing in Europe, which could spread to the U.S. Now is probably not the best time to beat down the banks.

What actually should be done in a perfect world? The banks should face a penalty that fits whatever mistakes they made. While the magnitude of that penalty is probably somewhat subjective, it certainly could be larger than what would be ideal for ensuring economic stability under the current circumstances.

An Effective Bailout?

You can probably see why the Obama administration is in such a rough spot. Their ultimate goal at this time must be to keep the recovery as strong as possible and to prevent the U.S. from sliding into a double dip. So it must push for a result here is both unpopular and possibly unjust. It needs healthy banks, even if they deserve punishment.

Does this remind you of anything? It sounds a lot like the same problem that the government faces when it considers providing bailouts during a time of economic stress. If you think of Lehman Brothers, for example, the firm probably deserved to fail. And the government allowed it to do so. The results weren't pretty: it triggered a financial crisis and a massive bank bailout followed anyway.

If the Obama administration goes easy on the banks in foreclosuregate settlement talks, it would be providing a sort of bailout-lite. And its reasoning would be the same as that of the Bush administration back in the fall of 2008. The government would need to take a vastly unpopular action for the sake of the very people who it will anger.

Why Everybody Hates Bailouts

If bailouts are sometimes seemingly necessary, then why are people so against them? Is it because they don't understand the consequences of allowing a systemically relevant firm to fail? That might be part of it, but it's more because they seem unjust. If a firm deserves to fail, then it ought to fail.

This point is bipartisan. The Tea Party movement actually began in response to the bailouts. Libertarian-leaning Americans were angry that the government was becoming so involved in the private sector, so they began to protest.

On the other side of the aisle, progressives hate most bailouts too. Although they don't mind the government having heavy involvement in the private sector, they are particularly disgusted by the bank bailouts. They see it as the government handing out taxpayer money to Wall Street fat cats.

So what should the government do? Should it ignore the will of the people and take action that it believes will make them better off? Or should it heed their words and allow the nation to face the consequences of a less stable banking industry? There's no good answer to this question, but the Obama administration must choose one option or the other.

Image Credit: REUTERS/Shannon Stapleton