Wednesday, January 4, 2017

When you're stealing houses, what's right?

This is my third post in response to David Dayen's Chain of title. If you have any interest in the foreclosure crisis of the previous decade, I recommend it highly.

My first post provided a primer on the process of mortgage securitization, setting up the aspects of the process which led to the "need" for banks to fabricate documentation in order to foreclose on homes that they didn't necessarily own.

The next post provided a representative catalog of varieties of fraud perpetrated by the financial sector in the course of the foreclosure crisis.

This post is about one way of thinking about the rights and wrongs of the situation.

According to the Wall Street Journal, "More than 9.3 million homeowners went through a foreclosure, surrendered their home to a lender or sold their home via a distress sale between 2006 and 2014."

To be clear at the outset, I'm not claiming that all those foreclosures were wrong.
People got into trouble for a variety of reasons. At one end of the spectrum, people knowingly took a bad risk, borrowing too much money to buy a house when they knew they'd be hosed if house prices didn't keep going up - and at some point, they had to stop going up.

A little less culpable are people who hadn't worked through the long-term consequences of their borrowing. They saw the low monthly payments that applied during the first two or three years, and didn't really think about what it would mean for them when their payments reset upward. Now, that's not a great defense (going into the largest financial transaction of your life without thinking carefully through the consequences, but:
  1. We do a pretty poor job of financial education in this country, and
  2. The banks were pretty eager to lend and not so eager to point out what things would be like in three years.
Next on the scale toward sainthood are people who made a purchasing decision that maybe wasn't ideal, but wasn't obviously crazy, and then life happened: someone lost their job, a family member incurred unexpectedly large medical expenses, a couple goes through a costly divorce, etc. You had a mortgage that you could pay when life stayed smooth, but some serious turbulence made your payments untenable. With enough financial turbulence, even a very prudent home-purchasing decision could turn out to have been a mistake.

You might think of this group as the "sympathetic" group: it's true they are behind on their mortgages, but they've tried hard to be economically responsible people, and life is just beating them up. In a perfect world, lenders would be good about working with these borrowers to avoid default and foreclosure. If you go to the bank and explain your situation, maybe your loan can be restructured, maybe there's someway of buying time if it looks like you'll be in better shape a year from now.

The final group are the truly innocent: they made all their payments in full, on time, and some part of the mortgage industry shafted them. See the previous post for examples of how to do this (not that I'm encouraging you to try); in brief, lenders could delay crediting your payment; they could charge you for inspections or insurance you didn't know about, then deduct the cost of that from your payment, putting you in arrears, racking up late fees, which they also wouldn't tell you about, so while you thinking you're paying on time and in full, they're recording you as being ever further in arrears.

Dayen makes a very strong case that a significant portion of those lost homes involved some variety of fraud in some part of the financial industry. There were millions of forged documents, "recovered" files that were robo-signed by someone called a "vice president" of some bank but actually paid $10 an hour for putting their name (or someone else's name to paper), attesting that the material in the file was true and accurate, when they'd only spent a minute perusing it, if that.

In the case of the "truly innocent," the right outcome is clear: you made all your payments on time and were the victim of a scam; now a bank is forging documents to be able to foreclose on a house to which they have no conceivable right.

In the case of the "sympathetic" borrowers - they made a reasonable decision, but hit bad luck - you could make a case that they deserve to be foreclosed on. After all, it is true that they aren't making their monthly payments.

But it's not true that foreclosing on them is necessarily the best policy for society. Foreclosure is obviously damaging for the family involved. It's also damaging to the neighborhood, particularly if the house can't quickly be sold to a new owner-occupant.

Banks should have been working with struggling borrowers to find ways, as through loan modifications, to keep them in their houses. Instead, as Dayen documents, they often used the modification process to string people along. Rather than foreclose on you in March, tell you that if you can make partial payments, we'll try to work out a "mod," then in September go ahead and foreclose on them. You were going to foreclose anyway, but this way you got six more months of payments out of them.

But don't forget the forged documents. If the Smith family really isn't paying their mortgage (because of a job loss, perhaps), the bank has the right to foreclose, but presumably they need accurate, valid, authentic documentation to show that they are the entity entitled to take the house.

And the central point of Chain of title is that in millions of cases, banks didn't have that.

OK, so we have a borrower who indeed is not paying her mortgage. And we have a bank that indeed does not have proper documentation to foreclose. What should happen?

One thing that happened, particularly visibly starting in 2009, was that people who weren't paying their mortgages were portrayed as deadbeats. Sure, the banks' documentation might not have been perfect, but the foreclosure was legitimate in principle, because the borrower wasn't paying.

And let's say we insist that the banks have accurate, valid, authentic documentation, or we don't let them foreclose. Do you mean to say we're going to let someone get a free house?

That raises the dreaded specter of "moral hazard." This colorful term is about what happens when we insulate people from the bad consequences of risky behavior. When you take a risk, you know it might work out well for you, or it might work out poorly. If both types of consequences land on you, then you are likely to weigh your risks carefully and stay away from unwise risks. If we let you have the benefit when your risk turns out OK, but protect you from the bad consequences if things go poorly, then you have less incentive to be careful about the risks you take, and so you take unwise ones. You're protected, but society bears the cost of those bad decisions. That's "moral hazard."

People who bought houses took a risk. Now things have gone south for them - the risk didn't turn out well - so they need to deal with the negative consequences. Otherwise, we're creating moral hazard.

That all sounds nice and serious and like you're not just trying to screw over borrowers, but are actually concerned about the whole economy.

Except that moral hazard applies to banks as well.

Banks take a risk every time they make a loan - any borrower might, in principle default. So they should only make good loans. The securitization model of mortgage-backed securities (MBS) described in my first post on Dayen's book allowed them to make loans to borrowers with worse and worse odds of repaying. Securitization made those loans possible, but it didn't stop them from being crappy loans with a relatively high risk of default. It was the banks' job to know that, and they took a risk by pretending it wasn't true.

And the securitization itself involved an end-run around 300 years of English and American property law. They couldn't have run the MBS machine as hard as they did if they'd had to follow the rules about how loans are transferred and how those transfers are recorded. So they took a risk and ignored the rules and lost track of the paperwork.

If you let a bank foreclose even when it doesn't have proper paperwork, you're creating a moral hazard problem - arguably a bigger one than when you let someone stay in their house because the bank doesn't have the proper paperwork.

As Dayen points out, there's a more directly practical reason not to allow such foreclosures. In a criminal case, when the prosecutor presents evidence that was improperly obtained, that evidence is supposed to be thrown out. The defendant may actually be guilty, and the evidence in question may actually prove that. But if we want the police to follow proper procedures in gathering evidence, we still insist that improperly gathered evidence be dismissed. Otherwise, we're giving the police an incentive to ignore the rules.

The same goes for foreclosures. The borrower may legitimately deserve to be foreclosed on. But if we let you do it without the proper paperwork, we're giving you an incentive to continue ignoring the rules of property transactions in the future.

But that's not what we did. We let banks keep taking people's houses, using shit documents, not caring about the incentives that created for future behavior by banks.

The banks said, "Moral hazard for me but not for thee."

And the political system - including the Obama administration - apparently decided that was fine.

Next up: my final installment, on why I think this was a huge political miscalculation.

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