Why the Government is Not Going to Force Banks to Write Down Your Mortgage Principal

On Monday, I saw a lot of disappointment over the Obama administration's new housing plan, because it didn't do principal reduction.  Felix Salmon made one of the better cases, I think:

The best that Dudley can bring himself to say about HARP II is basically that it's a start. Most importantly, it doesn't do principal reductions -- if you're underwater when you get your HARP refinance, you'll be underwater afterwards, too. The FHFA itself, in its press release, helpfully points out that for someone with a loan worth 25% more than their house, they won't start building equity in their home for ten years if they refinance into a 30-year fixed-rate mortgage.

But the sad fact is that anything more substantive than this is likely to require Congressional approval, and therefore be a political non-starter between now and November 2012. The government's done almost nothing to address the housing mess, and will continue to do almost nothing for the foreseeable future. Which, as Dudley says, bodes very ill for the economy as a whole.

The drumbeat for principal reductions is understandable: underwater homeowners are more likely to default, and of course, the ones that don't are shoveling a whole lot of disposable income into closing their negative equity.  It's a policy that seems win-win at first glance, since foreclosures are very costly to the bank.

But of course as the Atlanta Fed has pointed out (and, cough, some bloggers), only a minority of underwater homeowners are going to default, and the banks have no reliable way of distinguishing those people from the underwater mortgagees who won't default.  That means it's not win-win, it's win-lose, because if the banks offer reductions to everyone who's underwater, most of the people who are underwater are probably going to take them.  They'd far rather offer "principal reductions" in the form of short sales, which have a cost to the homeowner as well as the bank.

Okay, so they won't do it voluntarily.  Maybe the social benefits are large enough that the government should force banks to offer those principal reductions: after all, there would not just be benefits from falling foreclosures, but from freeing up all that cash flow.  (Well, sort of.  You've also impaired bank capital and investment assets, which presumably means you spend less.)

That is, I take it, the argument that a lot of people like Felix are making.

I never thought it was going to happen, and after emailing with some lawyers, I'm now certain of it.  Here's why:

The government will have to pay nearly the full cost of any principal reduction it mandates.

Obviously, this holds for Fannie and Freddie, because the government owns them.  But it also holds for private banks.  According to the expert I heard from "Contract interests are property for purposes of the Takings Clause." So the government can mandate that banks write the mortgages down.  But eventually, a judge will order them to pay those banks back.  Yes, they will, even if those banks are full of bad, irresponsible people who gambled with money that wasn't theirs.

I take it this is in fact broadly true of interest rate reductions as well.

Last I heard, there was about three quarters of a trillion dollars worth of negative equity in American homes.  There is not anything close to $750 billion available to spend on writing  And even if there were, there's reasonable debate over whether that's how you'd spend the money.

That's why all of these programs are functionally voluntary for the banks: if they're not voluntary, the government is going to eat the full bill. And the government is out of money.

There are ways around this, of course--as the expert who emailed me said, "The devil is in the details".  You can offer some sort of quid-pro-quo and say that you returned fair value but a) this is expensive, and b) the banks will probably litigate and there's a chance that you'll lose, plus maybe even suffer a political black eye over your "unconstitutional" program.

You can also extract promises to write down these loans as part of a deal with the banks over things like robo-signing.  Problem: not all mortgage securities are actually owned by banks, and not all banks are implicated in robo-signing or similar.

Plus, there are limits to what you can extract in a settlement--you cannot force banks to offer more than they will likely lose in a suit.  And when assessing how much that might be, it is helpful to keep in mind that even Rudy Giuliani and Eliot Spitzer lost most of the high-profile securities cases they took to trial. The banks certainly will, when you're claiming that they need to do this to save themselves from a trillion dollar verdict.  It would take a lot of record jury awards to get to $750 billion.

Then you have to consider that bank capital impairment.  If you hit the banks too hard, some of them will go under, and then the FDIC will have to pay off their depositors.  The FDIC is already a mite overstretched at the moment.

In other words, there simply is never going to be what I think a lot of pundits are envisioning: a broad based, mandatory program in which banks are forced to "do what's right for the country" and write down all that horrid underwater principal.  Legally it can't be done except at enormous cost to the government.

There is one thing that has been proposed that you could do: principal write-downs on mortgages in bankruptcy.  Adam Levitin wants a special "Chapter M" that would efficiently just strip mortgage debt.  He's a legal expert and I'm not, so I'll defer to him on the question of whether we can create a whole chapter of the bankruptcy code that only deals with one creditor, rather than fairly allocating the debtor's assets or income between all of them.

But even if we do this, it's at best a very limited solution.  Bankruptcy drops an atom bomb on your credit (and makes your personal finances public record).  It requires hiring a lawyer.  The number of people who would avail themselves of this is going to be far lower than the number of people with underwater mortgages.

So I'll go back to what I said above: there is not going to be broad-based mortgage equity relief, because your neighbors do not want to pay $750 billion to relieve you of that burden.  HARP isn't a panacea, but it will actually do some limited good, which is probably about all we can expect.