Recently, none other than Martin Feldstein, former chief economic advisor to Reagan, made waves with a mortgage modification plan that would include principal write-downs. There is a terrible part to this plan, which has received most of the criticism, but underlying it is an important issue: loan modification as economic instrument. Feldstein’s plan in its details is awful. The plan would write down principal on under-water mortages (mortgages where the loan is larger than the value of the house) to 110% of the home value. The government would absorb half the loss, the bank the other half, and the new mortgage would have one very important feature: it would be full recourse. Mortgages are non-recourse, meaning if the homeowner defaults on the debt, the bank can go after the home, but nothing else. A full recourse loan allows the bank to hound borrowers for the rest of their lives, until principal and interest are paid off. This is a not very altered version of a plan Feldstein proposed in October of 2008, with the full recourse proposal a mainstay. Others have pointed out the obvious dangers of turning millions of homeowners into indentured servants of banks (who committed systematic fraud) – an outcome especially likely, as Dean Baker has noted, when there is high unemployment and economic stagnation. (A point that implicitly applies to student and credit-card debt…)
Unsurprising, Feldstein’s proposal is soft on the banks. But the loan modification idea is nonetheless important, and not just as a stimulus measure. The stimulus effects of loan modification, both principal write downs and restructuring of interest rates/payout schemes, are multiple. The housing market is the ground zero of the balance-sheet side of this recession. Turning non-performing loans into loans that are actually payable by homeowners would not only restore some private balance sheets, but would at least slow down housing price declines, if for no other reason than it would stall foreclosures in an already flooded market. Restoring housing prices, and the increase in revenue streams from performing loans would have a knock-on effect of increasing the value of various mortgage backed securities without requiring sorting out the mess of competing claims. Of course, the implications of this are insanely complicated, and there are issues that, as Naked Capitalism has diligently documented, still need to be resolved regarding massive fraud, improperly securitized mortgages, servicer agreements, and lots of other things we don’t really understand (here, here and here) Of course, the administration has done nothing serious, with HAMP producing pathetic results, especially since it was voluntary and focused on interest rates not principal.
A serious effort would involve strong-arming the banks to take a hit on the principal – a hit they deserve given the systematic dirty dealing, but also because everyone else has taken a hit, and that’s what happens in a debt crunch, where there are way more claims getting called in than can be met. But this is nothing new, and in fact something that happens in all other areas of consumer debt anyhow. Beyond the above considerations, there are some very important long-term reasons why it is best to force the banks to feel pain – principal write-downs and loan restructurings, without making loans full recourse. Forcing banks to feel pain for the mess they facilitated is an essential part of changing risk-management. One aspect of risk management is enacting certain kinds of laws: higher capital requirements, regulation of shadow-banking, reimposing the division between commercial and investment banking. But another key feature is the management of expectations. For example, as has often been noted, bailing out the ‘too big to fail’ creates a moral hazard because if major banks think they will be bailed out for taking systematic risks, then they will engage in much more irresponsible lending than if they thought they would have to pay the costs. The same logic goes for loan modifications and fraud prosecutions. So far, banks have learned that they are unlikely to feel much legal pain even if they manufacture false W-2 statement, engage in robo-signing, and fraudulent securitization. But even more than that, what they have learned is that, when push comes to shove, the shit runs down hill. And at the bottom lies the homeowner. But the homeowner doesn’t have to be there, and if he weren’t, it’s not unreasonable to think home loans would work differently. That is to say, loan modification is a more serious disciplinary instrument than mere legal action because it affects all loan activity, not just the illegal stuff. It is precisely the indiscriminate nature of a loan modification program that makes it effective. If every single bank thinks it might be forced to write-down perfectly legal loans if they fail to perform, then they will be more likely to take a step back from the brink the next time around. Of course, financial crises are a regular part of capitalism. A stiffer hand with banks alone will do little to change that. But there is still a general point worth noting. The banking system is (like corporations) a product of law. It is supposed to be shaped to allow for the pooling of unused savings to be lent out to where that money can be used productively – ie, in the public interest. It does not work that way now, and there are many instruments, large and small, for reasserting public control over a system in which the costs are socialized, but the profits not. A general, public program of loan modification could be seen as one step in that direction – not just for the gains in fairness, and the immediate help it would give to struggling homeowners, but for the broader assertion of public control over the banking system.