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Shakedown or Bailout? The Mortgage Servicing Settlement

posted by Adam Levitin

How's this for contrasting interpretations:  the AGs' proposed mortgage servicing settlement is being termed both a "shakedown" (WSJ editorial page) and a "bailout." (Jesse Eisinger at ProPublica--ok, he uses the word "gift", but still).  

Wow.  That's some divergence in characterization of an incomplete term sheet.

I think both of these interpretations miss the mark, as neither really gets what a settlement is.  A settlement is a voluntary contract and represents compromises by both sides in order to avoid uncertain litigation outcome.  The WSJ's interpretation is just nuts--the cheerleaders for freedom of contract are complaining about the price of a contract offer.  Addressing Eisinger's bailout charge is more complex.  Details below the break.    

(1) Shakedown?  

Once again, a settlement is a contract—isn’t the WSJ the biggest proponent of freedom of contract? The AGs made the banks an offer—the settlement is the price for buying peace. The banks can take it or leave it. It is a voluntary decision. It isn’t an offer they can’t refuse—we know that as they have refused. (Recognize that if you disagree, you're implicitly arguing that a large portion of convicted felons in this country shouldn't be incarcerated as their plea bargains--settlements--were offers they couldn't refuse.)

So what possibly makes this settlement a “shakedown”? Does the WSJ think it is too high a price? Isn’t that the banks’ decision, not the WSJ editorial page's? I was unaware the the Journal was routinely in the business of opining on the fairness of deal prices. And what possible basis would the WSJ have for deciding whether the price is too high? It’s not as if they know the first thing about what’s going on on the ground with foreclosures. The only way an uninformed observer could reach this conclusion is the operating assumption is that the Captains of Finance can do no wrong. And if you buy that malarkey after the financial crisis, well, I can offer you a great deal on some subprime MBS…

 (2) Bailout?

The AGs' proposed settlement offer would require proportionate reductions in second liens to first liens; it would not require a second lien to be wiped out if the first lien were impaired, which is what would happen in foreclosure. But as Felix Salmon correctly notes, this is a voluntary negotiation happening against the background of foreclosure law. It doesn't need to track foreclosure law, and if the loan defaults and goes into foreclosure, the second lien will get wiped out, if there isn't enough to pay off the first lien in full. I think Mike Konczal is right to respond to Felix that even if the settlement doesn't have to track foreclosure law, it might be good policy to do so. 

Let me step back, though, and give some framing to the second lien issue and why it is such a sore point for banks, bank regulators, and homeowners. This is really an issue about the tension between bank regulatory policy and social policy. My concern is that there isn't a neutral decision-maker balancing out these concerns.  

During the financial crisis, our major banks were both illiquid and insolvent (or at least short of the required regulatory capital). These problems were intimately tied together. Insolvency begets illiquidity. No one will trade with a counterparty they fear is impaired.

Today the banks are liquid, but still insolvent. That’s only because of massive federal intervention. The federal government became the liquidity provider of last resort by functionally guaranteeing the major banks’ debts. That restored the market confidence necessary to restore liquidity. As long as that implied federal backing continues (and no one believes that Dodd-Frank resolution authority will ever be used when the shit hits the fan), the system can move forward. The regulatory thinking is that with some time, the banks will earn their way back to solvency, and maybe, just maybe then the implied federal backing can diminished…until the next crisis.

Here’s the problem: Federal bank regulators are trying to deal with insolvency on the cheap. They know that politically there will be hell to pay if they actually have to stick more money into the banks to recapitalize them. That option is simply not on the table. So the strategy is to delay loss recognition (extend and pretend) and under that rubric is also “no extraordinary losses”. Think of this as a variation of using inflation to wipe out non-indexed debts.  Or, to use a medical analogy, the regulators are hoping that the patient will be restored to good health without any treatment.

The second lien issue threatens to derail the extend, pretend, and hope for growth strategy. If banks had to take significant write-downs on their second lien portfolios, it would be hard to escape the fact that our 4 largest banks are broke. (The same story applies to principal reductions on first liens too.) Absent extraordinary regulatory forbearance (billions of dollars of regulatory “goodwill” suddenly appearing on the balance sheets isn’t so crazy given that it is the value of the regulators’ goodwill toward our largest banks), these banks would be required to raise tens of billions of capital, pronto. That would mean dilution of existing shareholders and ixnay on the dividends for a while. And if the banks can’t raise that capital on the market, then they’d be back in TARP. Except that this time, there isn’t TARP authorization and there’s a messy statutory requirement of an orderly liquidation.

This shows what Dodd-Frank really accomplished: it doesn’t guarantee the liquidation of insolvent big banks. Instead, it guarantees that no big bank will ever be deemed insolvent.  The Dodd-Frank orderly resolution authority just incentivizes extend and pretend by limiting bank regulators’ other options (even if they weren’t politically limited).

So what we have here is an exactly a bailout.  It's regulatory forbearance in order to avoid having to actually recapitalize the banks. There's a benefit to the banks from doing this, but it's a little different than a bailout. The banks benefit, but no federal dollars are being spent and the cost of the endeavor is being borne by a large, but limited group of homeowners, rather than by the tax base as a whole (so Rick Santelli can rest easy with his money.) I get why Jesse Eisinger wants to call this a bailout, but I'd like a more precise terminology. Let me take a stab at establishing a taxonomy for bailing, and propose calling this a "bail-around".

The CFPB and the Policy Coordination Problem

Irrespective of its name, let’s be frank about the policy trade-off involved with second lien extend-and-pretend. The price for keeping up the pretense of bank solvency is lots of families losing their homes. For bank regulators, that’s simply someone else’s problem. (But whose? The CFPB that doesn’t yet exist? The AGs? HAMP?)

What we’re seeing now are the social externalities of bank regulation. We can’t really expect bank regulators to act differently. We've told them to make sure the banks are safe and sound, but we've also said that their only remedy for an unsafe and unsound bank is the death penalty, which forces them to do regulatory accounting contortions and look the other way.

But we should expect there to be policy coordination within the administration that will balance out the bank regulatory issues with social policy issues. This sort of coordination should be occuring in the White House. Unfortunately, I don't think that is happening. My sense is that the decisions on this are really left at Treasury, which is to say they are left to bank regulators.To my mind this is a severe dysfunction in policy coordination.

Indeed, there really isn't another voice to be heard on the issue in the administration except for the still non-existent CFPB. Perhaps that is why Congressional Republicans and the WSJ editorial page are so outraged that Elizabeth Warren, who is heading up the CFPB transition team, even gets to be in the room. Heaven fofend that someone might point out that there are other policy factors to consider!

The AGs provide another voice, but there are limits on what they can do. The AGs don't get a seat at the table when the White House hammers out federal policy. It's also not so easy for them to move the ball alone. They can't press a magic litigation button and get a judgment. Litigation has risks and takes years and time is of the essence when dealing with foreclosures. They also face possible preemption arguments from the banks and OCC if they try and move against national banks. The Consumer Financial Protection Act (Dodd-Frank) gives the AGs the authority to enforce CFPB rulemakings, but until there are CFPB rulemakings, it is not clear whether they can enforce existing federal statutes and rules, and until July 21, at the earliest, all federal enforcement authority still lies where it did before the finacial crisis--with the bank regulators.  

Frankly, I think this case is now the prime exhibit for why we need an independent CFPB---we need a financial regulator that is tasked with a job other than safety-and-soundness because otherwise all decisions will be made on a safety-and-soundness basis, even if there are disasterous social consequences.

What's astounds me is that I would have thought that this problem was behind us. I recall making this same argument before Dodd-Frank, but it seems that it won't go away until there's a Director for the CFPB and there's finally a cop on the beat. The administration spent a lot of political capital ensuring that there would be CFPB legislation. But that legislation isn't meaningful unless there is a Director for the CFPB; a lot of provisions of the statute require action by the Director. I hope the adminsitration will ensure that there's a Director in place at the CFPB by July 21. Otherwise they spent a lot of political capital for tickets to regulatory Groundhogs Day. 

Comments

It's obvious that borrowers are on their own. It's been obvious for a long time. Politicians and regulators want a way to "solve" this problem without having to put their name on it? Figure out a way to make Marcy Kaptur's HR 5510 work.

Renovate the judicial system. Bring the courthouses into the 21st century. Imagine what you're local courthouse could do with $2-3 million for renovations. Carve out X dollars for legal aid programs in each of the 50 states. Make the programs recoverable grant programs so they recoup funds to continue operation.

Look back over the last few years and see where all of the revelations originated. Brian Bly, Crystal Moore, Jeffrey Stephan, Laura Hescott, Scott Anderson... All uncovered, discovered, depositioned by private litigation.

I just heard from a borrower this morning. Their meeting with local counsel went well. Prospective counsel knows FC defense well. They have a solid case. A winnable case. Made all of their trial mod payments on time. Received their approval letter for a permanent mod. Then they received another letter saying "Ooops, our computer systems crashed and we lost all of your data. You're going to need to resubmit it." And, miraculously, they suddenly don't qualify for a loan mod. And that's not even taking into consideration the fraudulent chain of title, securitization, force placed insurance or accounting issues.

They're heading for an auction date next week. And they may very well lose the house b/c the one thing they can't do is put the retainer fee together for the attorney in time. And they do realize that, like it or not, lawyers need to be fed on occasion too. I'll even go out on a limb and say that the good ones helping borrowers and creating good case law deserve it... ;)

Access to the court system and solid case law are the only things that are really going to SOLVE this "crisis". Crappy chains of title are going to be around for the next 20 years at least. A single piece of legislation created to sweep everything under the rug TODAY is going to solve that problem? Not a snowball's chance.

Like it or not, the CFPB has been politically wounded. Maybe mortally so. Only time will tell on that. Besides, no other "agency" that I know of ever takes action on behalf of individual consumers. It's almost a mantra. Somehow, I don't see the CFPB reaching down to individually help George and Martha at 123 Main St. Yourtown USA with legal counsel.

Congress doesn't need to "fix the problem." All it needs to do, if it really wants to do ANYthing, is give the people of the United States the tools necessary to fix their own individual problem. By fixing the small problem the big problem gets solved.

Forgive the analogy but this is an elephant. It's going to take one bite at a time... If Congress would simply supply the sporks everyone else would get to work.

this is not a negotiated settlement between private parties but a settlement between the states and private parties in lieu of prosecution.
By treating the second liens as essentially pari passu with the first liens the AGs are once again bailing out the banks, who hold most of the second liens. And they are doing so at the expense of the investors. So once again the laws are subverted in the bankers interests and the criminal financial class gets to pass the costs of their crimes onto others.

Mike, you nailed it right on the head and it is also the reason that the Banks are freaking out. What you describe is the EXACT outcome they do not want. There are so many cases that are ongoing right now that have them nervous and they can't fathom an onslaught of more cases, which is what I foresee happening.

Many lawyers and certainly many Pro Se litigants have been paving the way by getting rulings from the courts, mostly against them, but at the same time advancing the ball and recently there are decisions that are forming the case law and defining the issues ever so more tightly.

I heard one person liken what is going on to what happened years ago with the tobacco suits. Finally what determined law was winning legal actions brought by individuals and classes.

It's going to be an uphill battle, and I empathize with the folks you referred to (there are millions more like them), but it has to keep advancing if we're ever going to get to the end of it individually, and as a country and society.

Let's put a number on the second-lien problem.
Among the Big Four Banks(BofA, Citi, JPM and Wells), we are looking at more than $400 billion. If we are charitable and estimate a recovery rate of 50 cents on the dollar, that is $200 billion in losses, and those losses disproportionately hit BofA and Wells Fargo--to the point of insolvency. That is why there is no "mark-to-market" for these assets; otherwise, we flash back to October 2008.

Negotiated private settlements are coming! Do not expect the system will produce a just settlement by itself. We must all fight individually to compel a just outcome for ourselves. Educate and arm yourself and please step into the ring. The Banks may have unlimited resources but Americans have an unlimited will to fight for justice!

http://diligencegroupllc.net/

American Homeowner

-AH

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