Federal Government and State Attorneys General Push Arbitrary Mortgage Bailout

Back before the election, intellectuals with ties to the Obama administration proposed a trillion-dollar bailout for some (but not all) underwater mortgage borrowers, as a way to increase consumer spending.

Last week, The Washington Post reported that bureaucrats at the newly-created Consumer Financial Protection Bureau (CFPB) want to do something similar on a smaller scale. Their proposal would require banks to write off part of the mortgages of certain (but not all) mortgage borrowers who owe more on their mortgage than their house is worth. Worse, they would require mortgage servicers to write off loan principal on loans owned by other institutions, like pension funds, violating their property rights.

Virtually all of America’s pension funds own mortgage-backed securities. Pension funds that millions of people rely on for their retirements would lose billions of dollars due to reduced mortgage value. These demands are contained in a 27-page proposed settlement sent to the banks by the CFPB, the Justice Department, and state attorneys general who sued the banks over their recent foreclosure documentation lapses. Such demands flout court rulings like Louisville Joint Stock Land Bank v. Radford (1935), which overturned a federal law that wiped out mortgage value.

Meanwhile, the write-offs would reward the most financially irresponsible borrowers, while punishing responsibility. If you were thrifty, and made a big downpayment, you will not be eligible for a write-off, since your mortgage will still be smaller than your house is worth, even if your house declined in value. But if you saved little money, and took out a no-downpayment loan, your loan may be bigger than the value of your house even if the value of your house didn’t fall much. Even a small fall in value would leave you “underwater” on your loan, and thus eligible for a bailout under the proposed settlement, to reduce the size of your mortgage to less than your home value.

(Eligible doesn’t mean you will necessarily get a bailout; the settlement requires banks and mortgage services to satisfy numerical “quotas” of how many mortgages to write down, not to write down the vast majority of such mortgages. The banks actually have perverse incentives under the settlement to give such help to the people who least need it, according to sources cited in a Washington Post story.) Banks say the proposed settlement would discriminate against people who “paid on time and honored their obligations,” that it raises “serious moral hazard issues,” and “could retard the recovery by encouraging borrowers to default.” The settlement will also increase borrowing costs in the future for home buyers, since banks will have to hedge against the risk of future loan write-offs by charging higher interest rates (much as credit card companies raised interest rates and fees after Congress passed a law limiting penalties for irresponsible credit card holders).  So credit will become more expensive for those of us who are responsible in paying our creditors regularly.

Congressional Republicans have complained about this proposal, saying that it imposes policies that “Congress has explicitly rejected,” in order to further the administration’s “political agenda.” Senator Shelby went further, saying that it amounts to a “regulatory shakedown by the new Bureau for Consumer Financial Protection, the FDIC, the Fed, certain attorneys general, and the administration.” (The Bureau of Consumer Financial Protection was set up by the 2010 Dodd-Frank financial overhaul law, which itself violates the constitutional separation of powers and property rights.)

Although initial news stories suggested a Fed and FDIC role in the proposed settlement, subsequent news stories cast doubt on whether they were really responsible for the content of the proposed settlement, which seems to have been primarily the product of state attorneys general and the CFPB.

But if even the Fed was involved, that might reflect Fed officials being out of touch with the reality of today’s housing markets. Although residents of high living-cost areas like San Francisco and Washington, D.C. sometimes pay over half their income in rent or mortgage payments, senior government bureaucrats grew up in a time when housing usually cost no more than a quarter of people’s net income. To some Fed and FDIC officials, perfectly ordinary mortgages seem excessive, leading them to back bailouts for irresponsible borrowers whose payments are lower than what thrifty, responsible people routinely pay without any difficulty. For example, the Fed’s Ben Bernanke, and the FDIC’s Sheila Bair, had backed cutting mortgage payments to 31 percent of household income (minus property taxes) for deadbeat borrowers (even high-income borrowers) from banks taken over by the FDIC, oblivious to the fact that responsible people often manage to pay more than that without difficulty.

None of these mortgage bailout proposals help most borrowers, much less responsible borrowers.

The fall 2010 trillion-dollar mortgage bailout proposal floated by some Obama administration allies would only have written down the mortgage loans of people whose mortgages were held by the government-sponsored mortgage giants Fannie Mae and Freddie Mac.