Sources indicate that the settlement may benefit almost everybody -- not just homeowners facing foreclosure

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Here's something nobody expected: the state attorneys general lawsuit against the big banks over their flawed foreclosure practices may produce a huge net benefit for the U.S. economy. Although talks are still ongoing, sources have revealed that some progress has been made and that a deal might be struck by month's end. How good is the possible solution? It could eliminate a big chunk of the mortgage litigation risk banks face, limit the impact of the related losses, and also help alleviate some pressure on underwater borrowers. 

A Solution Everyone Can Live With?

Aruna Viswanatha at Reuters revealed the news on the settlement talks late Tuesday:

Under the proposed terms of the settlement -- which could total $25 billion -- banks would get broad legal immunity from state lawsuits in exchange for refinancing underwater loans, those mortgages where borrowers owe more than their homes are worth, the sources said.

But the article goes on to explain a very important clarification: those underwater borrowers that banks would agree to provide refinancing to would have to be current. In other words, anyone delinquent or defaulted and facing foreclosure would not benefit from this new aspect of the settlement.

Great for the Banks

Understanding why banks are embracing this approach is easy. They already know that they're going to have to concede more here, so they might as well try to limit their losses. The might like the agreement above for a couple of reasons. 

First, if their additional settlement cash provided more aggressive mortgage modifications for delinquent borrowers, then their subsequent losses would continue to pile up in later years. Mortgage modifications have a very high rate of re-default. Banks want to foreclose on as many borrowers as possible whose default they see as inevitable.

Second, this move will actually make the borrowers who can pay much less likely to strategically default. Imagine you've got a 6% interest rate on a $250,000 mortgage on a home that is now only worth $200,000. If the bank forgave that $50,000 in excess principal, your mortgage payment would be reduced from about $1,500 per month to about $1,200 per month. If it refinances your $250,000 loan at 4%, however, then your payment still becomes around $1,200 per month. Psychologically, underwater borrowers won't feel so bad about their mortgages once they're able to take advantage of refinancing at the prevailing, very low interest rates.

Then, there's the really huge potential advantage for banks. For any of these refinanced mortgages that they're holding on their balance sheets, they won't face a loss. Because the principal for these loans would remain intact, they would book the new loan for the same amount. So it would create no capital hole like mortgage principle write downs would. Loans they hold as securities, however, would decline in value, since their prepayments would rise due to the refinancing boom. This means the big losers under the plan would be investors, Fannie Mae, and Freddie Mac.

Great for the Economy

While there are certainly those who would like to see the banks suffer as much as possible for their misdeeds surrounding foreclosure, the U.S. economy is much better off if its banking system is healthy. By providing banks with broad legal immunity, a huge portion of their mortgage litigation risk suddenly disappears. Investors will see this as a significant step forward in ensuring the financial system's stability. As bank stock prices begin to recover and certainty on potential litigation related losses improves, banks will also be more willing to lend to businesses that want to create jobs.

Those homeowners who obtain refinancing will also clearly benefit. As mentioned, many will see their mortgage payments decline by a few hundred dollars or more per month. That's real money -- money that can now be spent to stimulate the economy or pay down their debt. That spending should help to create jobs, as firms that sense more demand will ramp up hiring. But Americans' debt deleveraging will also help: the sooner Americans feel comfortable with their finances, the sooner they'll feel they can spend more freely.

For the next nine months, the opportunity for more Americans to refinance is particularly important. Over this period, the Federal Reserve is taking extraordinary measures to ensure that long term interest rates -- which include those on mortgages -- are kept very low. At this time, however, few Americans appear to actually be qualifying for these ultra-low mortgage rates. By banks relaxing their standards on loan-to-value, the Fed's stimulus has a shot at being effective.

How big an impact could refinancing have at this time? More than one-quarter of mortgage borrowers are underwater or barely above the surface, according to real estate analytics firm CoreLogic. Some of them may be delinquent, but a huge percentage is current. The firm also reports that 75% of underwater borrowers have interest rates above 5.1%. In other words, this settlement has the potential to impact millions of Americans.

But What About the Real Victims?

There is one strange aspect to this new part of the settlement, however. It isn't really an answer to the question posed: how will banks make it up to the Americans who suffered or face foreclosure due to their mistakes? Imagine if a big tobacco's legal settlement for misleading smokers paid Americans who had never smoked. While Americans that remain current on their loans could sort of be considered victims in the broader housing bubble debacle, their suffering is not directly related to foreclosure.

Meanwhile, those who have suffered or face foreclosure appear to obtain no benefit from this part of the settlement. They will reportedly benefit from other provisions previously leaked, however, like additional mortgage modifications for delinquent borrowers to prevent foreclosures. 

It is a little bit surprising to see the state attorneys general accept this carrot the banks have offered, since it does nothing to help those who suffered through or still face foreclosure. They certainly appeared to be fighting on behalf of those Americans when the lawsuit began. But perhaps they're also looking out for the greater good. This settlement provision would help to prevent many underwater borrowers who are current from falling behind on their payments.

A Few Caveats

While this reported settlement provision sounds like relatively favorable concession from the perspective of banks and underwater borrowers who are current on their mortgages, we'll have to wait and see if it really holds up. It seems like every few weeks we get another report that the banks and state attorneys general are near settlement with x, y, or z terms. This report certainly passes the sniff test in terms of banks' willingness to agree compared to other possible concessions we could imagine. We'll have to wait and see if it holds up.

Of course, if this is a part of the final settlement, it won't be the whole story. As mentioned, banks will be subject to other measures under a final agreement. For example, they might still ultimately have to agree to forgive some principal to modify mortgage of borrowers facing foreclosure. So banks might not get off too easy, and foreclosure victims might get some assistance. Time will tell.

Image Credit: REUTERS/Rebecca Cook