Fighting Over the American Home: Handcuffs versus Hope and Change
Over the past four years, we’ve watched as public officials pushed financial and legal power to the large banks – the latest episode in this saga was the mortgage settlement between state officials, Federal regulators, and the banks themselves. But there is also an undercurrent of resistance to this, resistance which could be growing stronger over time.
So what comes after the mortgage settlement? Will there be yet another multi-billion dollar transfer of wealth from taxpayers to banks in the near future? If I’m reading the tea leaves correctly, I suspect the answer is, yes. This time, it will flow through Fannie and Freddie, government entities that are responsible for trillions of dollars of mortgages. There’s been a deeply bitter fight over this giant pot of money, centering around Federal Housing Finance Agency (FHFA) acting head Ed DeMarco. DeMarco controls Fannie and Freddie, and so far, he has refused to write down principal for homeowners on GSE controlled mortgages. But Treasury has been attempting to get DeMarco to change his mind, using the prospect of simply paying off Fannie and Freddie with bailout funds.
Housing finance isn’t just a question of money, it involves the deep fabric of America – the home, savings, the rule law and the meaning of property, and the very space of the nation. It’s also a question of politics, and realigning interest groups that had been allies or opponents. With that in mind, it’s worth looking at how the last few years of bailouts and foreclosures have clarified factions in our politics.
There are two schools of thought on fixing the housing market. The first is the Tim Geithner school, which we’ll call the “hope and change” school. Hope and changers, who occupy most elite positions in the administration, in banks, at the Fed, in the economics establishment in Congress, at housing nonprofits like the Center for Responsible Lending, in regulatory agencies, believe that the housing market will come back when the economy returns. Foreclosure problems may be tragic, or overblown, or not, but ultimately are incidental to fundamentals, like matching housing supply to demand or increasing employment through boosts in aggregate demand. Warren Buffett is probably the most famous member of this school.
The second is the “law and order” or “handcuffs” school, which has (loosely) as members people like former FDIC chief Sheila Bair, former SIGTARP Neil Barofsky, iconoclastic investors such as Bill Frey, foreclosure fraud defense attorneys, Congressional actors like Maxine Waters, criminologists like Bill Black and various securitization experts and bloggers. The handcuffs believes that law and order is not incidental to the breakdown of the housing market, but is central to it.
Obviously these aren’t fast and hard divisions, they just represent the two major frames of thought around the housing crisis. It’s not a partisan breakdown – most people in both parties are part of the Hope and Change crowd, but a chunk of the left isn’t, and there are a few right-wingers like Chris Whalen and various right-wing investors who are outraged at the abrogation of property rights.
The handcuffs crowd sees accounting fraud and bank servicer abuses as driving a perverse incentive structure. There are significant incentive problems in the servicer model, with servicers having incentives to foreclose rather than modify or write down principal, even when that would make sense for the investor and the homeowner. There are suspicions of widespread fraud in the foreclosure process, such as fee harvesting, excess servicing charges, and misrepresentations to investors about what the trust actually holds. This is all leading to enormous pain for homeowners, and losses for investors.
Accounting fraud, according to the handcuffs crowd, is a major impediment to fixing the housing market. The generic logic is as follows. If regulators forced banks to write down mortgages on their books to their real world value, banks would lose a lot of money. Right now, if a borrower has a $100,000 mortgage, the bank is going to do anything it can to keep that loan on the books at $100,000. That debtor might only realistically be able to pay $70,000, and the house might only be worth $50,000 in foreclosure. But if the bank can keep that loan on the books at $100,000 for a few years, whether that loan is performing or not, whether that home is unoccupied and the copper wire is being stripped or not, the bank will.
According to the handcuffs school, this gap between accounting fiction and reality on the ground is causing needless foreclosures and massive blight across the country. Were banks required to write the loan down to, say, $60,000, then the bank would be perfectly willing to do a work-out with the homeowner at $70,000. The homeowner would be current, the bank wouldn’t have to foreclose, and value would be preserved all around. Executives, though, would show lower profits due to the accounting loss, and banks might have to retain more capital or do a capital raise. But the deflationary spiral, where foreclosures drive housing values down which causes more foreclosures, would end.
The hope and change crowd thinks this line of thought is foolish. To them, accounting fraud, or rather, regulatory forbearance as the case may be, is a useful tool to ward off chaos. They take the previous history of banking crises as their guide (as Vern McKinley details in his book Financing Failure). In the early 1980s, major American money center banks were insolvent, due to the recycling of petro-dollars to South American countries who couldn’t pay them back. Citigroup, for instance, made substantial loans to developing countries all around the world, and in a highly inflationary and low growth environment, these countries effectively defaulted. Rather than being taken over (and despite plans by the New York Fed to nationalize the banking system), these banks were allowed to earn their way out of the hole. They were undercapitalized, but that capital hole was gradually filled by profits over the next few years.
The hope and changers believe that this is what is happening with the big bank servicers – the housing market will eventually come back, as the extra houses built during the boom are sopped up by new household formation. That’s Warren Buffett’s famous “hormones” will fix the housing crisis argument. Buffett is of course highly conflicted, owning stakes in Wells, Moody’s, Bank of America, and profiting mightily from TARP directly through his position in Goldman and indirectly through his other positions. Many of the hope and changers are so conflicted, but this doesn’t mean that there isn’t a policy logic behind their ideas.
To these people, restructuring the banks, or even forcing them to take write-downs, is a pointless political conflict with a powerful and important constituency. Geithner famously represented this view when he talked about “air in the marks” in Lehman’s book, as detailed in the Valukas Bankruptcy Report. On a moral level, the hope and changers basically believe in the foundational myths of Wall Street, as described by Karen Ho in her ethnographic analysis of the investment banking industry Liquidated. This myth is that people on Wall Street are the best of the best, and naturally deserve to be in charge of capital allocation because of their smarts and willingness to take charge.
These two schools tangle, repeatedly, and the hope and changers routinely win. From the Housing and Economic Recovery Act (HERA) nationalizing Fannie and Freddie to TARP to killing judicial modification of mortgages in bankruptcy (ie. a write-down of debt) to HAMP to Dodd-Frank to the mortgage settlement, the hope and changers push their agenda of regulatory and legal forbearance for the banks. Katie Porter documented, as early as the spring of 2008, that these banks break the law to foreclose on homeowners, and most of the regulatory agencies, particularly the Fed and the OCC, help them do so. No one has been punished for these violations, except the victims. Still, the courts are full of litigation from investors and homeowners are getting savvier about fighting foreclosures. Moreover, the banks aren’t necessarily earning their way out of the hole as quickly as they need to be, considering they are attempting to reduce capital levels through dividends, bonuses, and buybacks. And they are being stymied by the housing market itself, which hasn’t yet come back. Banks have swollen inventories of properties in the foreclosure pipeline, which will depress prices when/if they come on the market. There’s also the chain of title problem, where people are leery of purchasing homes out of foreclosure for fear that they will not have clean title to the property.
There are many proposed “solutions” to housing market woes, from the hope and changers. They all boil down to, well, buying time and distracting the public until the housing market recovers naturally. Some might call it PR, others might call it “confidence”. The most recently proposed plan is the purchase of properties in bulk by private equity investors, who will then hire management companies to rent them out. It probably isn’t a very smart strategy – PE firms will end up with a difficult low margin business and clouded title on their properties. Over the course of a few years, these firms will plan to exit the business with a modest profit, but this can only happen if the housing recovery actually happens and if they can scale the property management business. Moreover, most suburbs just aren’t built to be particularly profitable rental prospects, and it’s not going to be easy to buy the right mix of properties to manage with tangled ownership of these homes by various trusts. It’s not to say rentals can’t be profitable given the right rental price, but it’s unclear if it’s possible to get that necessary revenue. Besides, given the lack of law enforcement in the mortgage market, high value foreclosed properties are probably being bought up by connected local real estate insiders.
Another proposed strategy is the “fire DeMarco” line of attack. This strategy is about getting rid of FHFA acting head Ed DeMarco, or forcing him to pillage Fannie and Freddie to write down principal. Largely the pressure for this attack is coming from the administration (through groups like Obama White House alumni Van Jones’s Rebuild the Dream and various administration aesthetically leftwing surrogates) and ex-Goldman Sachs executive William Dudley of the New York Fed, who are trying to force write-downs of debt without damaging the bank servicers. The intended outcome of this strategy is to get Fannie and Freddie, who are exposed to a few trillion dollars of first mortgages, to write down debt on homeowners. This will saddle the taxpayer with losses, which is probably illegal according to the FHFA’s mandate to maximize assets for taxpayers. It will help certain homeowners by reducing negative equity, (while possibly slapping them with a big tax bill). It will also aid the big banks, because these banks have over $300 billion of home equity lines of credit and second mortgages on their books, loans that probably won’t be paid off unless the first mortgage is reduced. Right now, these banks seem to be pretending that these loans are worth at least 93 cents on the dollar (that’s BofA’s number), and regulators at the Fed, the OCC, and the FDIC are allowing them to go along with these inaccurate numbers as part of the overall multi-year forbearance strategy.
There isn’t great public data on second mortgages and home equity lines of credit. As just one example, the Government Accountability Office blamed a bad data system run by Lender Processing Services for Treasury’s failed second lien modification program. The handcuffs crowd generally believes that these second liens are causing massive distortions in the market, because they are kept on the books at excessively high values. Rep. Brad Miller calls this the “bezzle” (a term first coined by John Kenneth Galbraith), describing in February, 2009 how second mortgages were systematically overvalued by financial institutions as a form of embezzlement. They perceive pressure by the New York Fed’s William Dudley and the Obama White House as attempts to aid the big bank servicers by helping them increase the value of their second lien books, or simple PR antics to ward off blame for the housing crisis by blaming DeMarco. DeMarco isn’t blameless at all – Fannie and Freddie are still giving charitable donations, overpaying their executives, committing routine foreclose fraud, etc. Dave Dayen is worth reading on this. Yet, the pressure to put pressure on DeMarco to force write-downs is intense – someone is feeding ProPublica plausible-sounding inaccurate stories, which the organization continues to publish and proudly stand behind even when proved wrong. These stories tend to portray DeMarco as the man holding back the recovery.
It is this fight, pitting the hope and changers against the handcuffs or law and order crowd, that is the essential dynamic in the housing finance mess. Certain individuals flip between the two – New York Attorney General Eric Schneiderman stalled the mortgage settlement for a year or so, before joining the administration’s side. And the terrain changes constantly, with new legal and political avenues opening and closing all the time. But this is why it’s not an obvious or easily described fight. Many seemingly virtuous groups, like, say, the Center for Responsible Lending, take the side of the big banks, because they believe that it isn’t possible to win against the power of Wall Street, and thus carving out a few rights for homeowners in a rigged market is the best one can do. They want to “help” homeowners, and believe that if the banks get forbearance they will be able to get billions in relief. PICO, a faith-based group, was obsessed with making HAMP work, because its leaders recognized that some homeowners saw reduced payments through that program. Much of the liberal establishment aligns with the hope and change crowd for different reasons, namely a mixture of Wall Street foundation funding, intentional ignorance and groupthink on the core questions at hand, and simple loyalty to the President.
Similarly, many of the handcuff crowd doesn’t seem like they are interested in helping ordinary people. I have spent time with several right-wing investors who are somewhat obsessed with “strategic defaulters”. That said, these investors do want to write down debt on homeowners for self-interest reasons, which is actually a very powerful incentive. They just want bank servicers to comply with the law and they want second liens written down as well, so that their wealth doesn’t get eaten by the big banks. Many of them are idealistic from the capital markets perspective, and point out that there will be no private mortgage market in a few years, that it will simply all be government-supplied credit. They fear, rightly, the day when whether you can get a mortgage will be subject entirely to political whims. Ironically, these people are most closely aligned with foreclosure fraud fighters like Lisa Epstein and Lynn Symoniak and foreclosure defense attorneys like Max Gardner, people who got their start fighting against illegal foreclosures but have become experts on securitization. Helping people is their business, and they are very good at it.
In a future post, I’ll go into what I’ve found around second liens. There isn’t great data, but there’s enough to suggest that the Office of the Comptroller of the Currency should be far more aggressive on write-downs than it has been.