With the latest chapters of the foreclosure mess, we have a conundrum: Being fair to some players could end up causing more pain for society as a whole. How then, should we proceed?
Nearly any public policy choice can be evaluated from a number of viewpoints: What is fair? What is legal? What is economically efficient? What will produce the best overall outcome for society as a whole?
Ideally, one policy option is the best under all possible criteria. But in real life that is seldom the case. And right now, some financial institutions are caught in a two-sided crunch. Much is at stake.
One side of the crunch is the huge number of foreclosures on individual residences. In the decade leading to 2007, mortgage lenders built a tremendous capacity to generate new mortgages. They did not make commensurate increases in their capacity to work out restructurings with borrowers in default or to properly process all the paperwork involved in foreclosures.
When the housing bubble collapsed, many lenders, including the largest, were not able to handle a wave of defaults. Many did not agree to restructurings, even when it would have been in their own best financial interest, because their back-office processing capacity could handle only a fraction of the pending cases.
They similarly made woefully inadequate administrative preparations for handling foreclosures in accordance with longstanding law. This led to employees “robosigning” thousands of documents attesting to accuracy, careful processing and review of cases. In some cases lenders or specialized foreclosure consultants backdated or even forged documents. Confronted with such facts, bankruptcy judges are increasingly unwilling to approve foreclosures in states which require court approval. A coalition of state attorneys general from all 50 states is investigating possible illegal practices and perjury. Foreclosures on tens of billions of dollars worth of housing hang in the balance.
The other side of the crunch involves companies that packaged mortgages into a variety of “mortgage-backed securities” ranging from simple pass-through pools of loans to bizarrely complex “structured investment vehicles” that were corporations in themselves, often based in off-shore tax havens.
Again, the companies in question created tremendous capacity to crank out large volumes of new securities. But many cut corners in doing due diligence, or carelessly misrepresented material facts about the securities they peddled. They also relied on new and legally-untested documents and institutions, including an umbrella organization, the Mortgage Electronic Registration Systems (better known as MERS), to hold legal title to millions of mortgages while their legal ownership supposedly changed hands, even though no such changes were registered in the counties or states where the mortgaged properties were located.
In this case, the same omission affects both issues. If a mortgage packager failed to fully comply with existing law about “continuous chain of title” when assembling some mortgage security, can anyone foreclose if the household borrower defaults? And don’t the buyers of the security have some right of compensation?
This is, to put it bluntly, the biggest legal-financial mess our country has ever faced. The amounts of money at stake are enormous. If the courts decide that large numbers of foreclosures are not valid, many lenders, large and small, will go broke. If the courts similarly decide that many mortgage-backed securities sold had serious legal defects and can thus be “put back” to their originators, some of the largest financial institutions in the country will go broke.
In some cases, major commercial and investment banks are in peril of insolvency from both sides of the debacle. It is not an exaggeration that all of this could bring us back to the abyss we faced in September 2008, when Lehman Brothers failed.
Unprecedented uncertainty from many sources is pulling down on the global economy right now like a pack on a soldier in the waves of Omaha Beach. The economic uncertainty rooted in the legal uncertainty on both sides of the “originate-and-distribute” mortgage industry is only making things worse.
From the point of view of economic efficiency, a fast and definitive legal resolution that ends uncertainty and does not cause wholesale bankruptcies among financial firms is the best option.
But such a resolution may not be fair to borrowers, some of whom faced outright fraud as well as incompetence on the part of lenders. Nor may a quick, imposed resolution be fair to many lenders if it meant that defaulting borrowers could keep their properties scot-free.
Similarly, the carelessness in generating new securities may mean that many buyers, including European banks and state pension plans, will have the legal right to force issuers to buy back myriad legally-deficient ones. That, however, might trigger economic disaster if it led to a cascade of bankruptcies involving some of the world’s largest commercial and investment banks.
The old Latin injunction “let justice be done though the heavens fall” has a nice ring to it, but falling heavens in the form of a financial sector collapse can cause enormous human suffering. And a quick but arbitrary resolution that preserves financial institutions may inflict great injustices on many borrowers and lenders. Legal resolution of both faces of the mortgage debacle will come eventually. Many will be hurt on one side or the other, regardless of what form the resolution takes.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.