A Dysfunctional Fix to a Dysfunctional System

The new mortgage servicing regulation proposals are good for regulators, bad for homeowners.


Nearly six months after banks were caught rubber stamping foreclosures and wrongly evicting families from their homes—a scandal since dubbed "robo-gate"—state attorneys general have indicated that an agreement on restitution could be near. But a devil lurking in the details of the settlement agreement with the major mortgage servicers could make a housing recovery much further off than it needs to be.

Earlier this month the state regulators, in association with federal regulators, outlined in pinprick detail how they want the mortgage service industry to be run. From how to handle foreclosure notifications to letting the Consumer Financial Protection Bureau (CFPB) review economic models for determining the value of a home, a 27-page proposed set of standards would have regulators micromanaging the entire servicing industry. Not exactly inspiration for investors to jump back into the housing game.

Even more troubling, reports suggest that regulators may also force banks to modify $20 billion worth of underwater mortgages by writing down the principal balance of the loan and taking the losses themselves.

All this is said to be a punishment for the banks mistakenly foreclosing on a few homes and losing the paperwork on a number of others during robo-gate's last years. However, instead of getting justice for homeowners, this policy would hurt them by halting mortgage lending and expanding the shadow inventory even further, ensuring the housing market takes much longer to recover.

The proposed plan would certainly make it harder to get a loan. Facing an unprecedented $20 billion fine, mortgage servicing fees would certainly jump in the future, to account for the increased risk of federal penalties. This would mean more expensive mortgages for home buyers and those looking to refinance. And, as JPMorgan Chase warned in a research note in late February, some banks may exit the business altogether, reducing future securitization and increasing the cost of mortgage credit for borrowers.

There would also be substantial moral hazard problems associated with lowering mortgage balances, just because housing prices have fallen. There is currently $744 billion in negative equity in the American housing market, according to CoreLogic. Beyond the legal complexities of determining who in this pool would get one of the $20 billion in forced modifications, imagine if just a fraction of those who are falling behind on their mortgages decided to forgo payment in the hopes of getting further government concessions to force banks into modifying loans.

A nightmare on Wall Street, to be sure.

Even Fannie Mae and Freddie Mac, now wards of the Treasury Department, have been slow to embrace principle write-downs for fear that more homeowners would stop paying their mortgages in order to get in on the action.

More legal problems could arise from investors who don't want the mortgages they own modified. But at least regulators have recognized that investors in mortgage-backed securities should not be forced to take a loss, as reports suggest the restitution plan would require the banks to eat the losses stemming from writing down mortgages themselves.

The good news at this point for the banks is that the regulators are not in perfect accord. The CFPB wants a strong principal reduction program while the Comptroller's office prefers to focus on safety and soundness for the 14 largest servicers.

The competing views on how to penalize the banks stem from different ideas of why a fine should be levied in the first place. The administration has, for a long time, wanted to push banks to write down mortgage principal on a wide scale basis, in order to eliminate the high level of negative equity in today's housing stock. And Elizabeth Warren—the not-so-tacit director of the recently created CFPB—has repeatedly argued for reparations from the banks, which she sees as the villains who created the whole mess in the first place. This reflects her ideology more than it does an adequate review of financial history, even from the liberal perspective detailed in The Financial Crisis Inquiry Report.

State attorneys general are also seeking a political win, since they made a huge show out of joining forces to review the foreclosure scandals that emerged in the later half of 2010. A large settlement from the banks would certainly pay dividends in their next elections. These state officials argue that banks have hurt struggling homeowners by not having the appropriate staff and technology to provide timely assistance to borrowers.

And then there are some in the administration who simply want to unclog the pipeline of loans awaiting modification. In order to address this, they tried to enact "mortgage cramdown" legislation in 2009, which failed due to the threat it posed to the rule of law and long-term trust in contracts.

The administration then turned to the Home Affordable Modification Program (HAMP) to modify up to 4 million mortgages by spending $75 billion to give banks cash in exchange for modifying mortgage payments, reducing interest, and keeping homeowners in their homes. The program is now on the chopping block because it has only accepted 500,000 borrowers into the program, paid out only $1 billion in funds and, in several cases, made borrowers worse off than before.

This should provide a warning to policymakers that mortgage modifications really are not the panacea that many believe them to be. Recently released information about HAMP indicates that 75 percent of those who started modifications eventually fell back into delinquency, which was one of the reasons that, by the end of 2010, the shadow inventory has expanded to over a three years supply of homes.

Extending modifications to these individuals simply slows down the foreclosure process, since many homeowners are in homes beyond their means and will likely wind up unable to make even the adjusted payments. Forcing the banks to extend modifications to those who can currently afford their payments, on the other hand, could inspire waves of strategic defaults, clogging the system further.

This is not to say banks are an innocent bunch. The question is whether forcing modifications is the equitable way to provide restitution for those who were wrongly foreclosed on and whether $20 billion is an appropriate penalty for sloppy bookkeeping of mortgage servicing.

The desire of some regulators to punish the banks for their overall role in the financial crisis is understandable, but misplaced. Borrowers who were wrongly foreclosed on should get restitution, but $20 billion is blatant overkill. If the administration follows through with this, it will be much to do with politics and little to do with sound financial policy.

Anthony Randazzo is director of economic research at Reason Foundation. This article originally appeared at Forbes.com.