In the aftermath of the sub-prime lending debacle lawyers and politicians have taken full advantage of the crisis.
A skyrocketing foreclosure rate is good for the legal profession, but the current wave of contentious litigation goes well beyond normal bounds by casting doubt on the rights of mortgage lenders, investors and servicers.
Politicians at the state and federal level have also entered the fray. Paul Krugman declared in his column in The New York Times that all such property rights are "ill-defined" and hence need to be abrogated with new rights created (ex post) by government politicians.
That the subprime lending debacle would generate a legal morass out of proportion to the already huge economic costs of the foreclosure process should not be surprising.
The political interventions that produced the subprime lending bubble also severely distorted the incentives of the aftermath that subsequent political interventions further exacerbated.
It is not just that the quantity of foreclosures is astronomically higher, but that the loss is so severe, with the incidence of most of the loss shifted from borrowers to lenders.
In normal times, foreclosure imposes costs on lenders and loan servicers as well as borrowers. Borrowers bear all loss, including accrued interest and penalties up to the cap at total borrower equity due to the lack of recourse in most states, a protection unique to U.S. borrowers among mortgage systems in advanced economies. When the potential borrower loss equals or exceeds the borrower's equity, borrowers are highly motivated to provide the "deed in lieu" of foreclosure to minimize their costs.
Lenders typically lose money on foreclosures owing to their cost of carry, renovation, management and marketing costs, providing an incentive to forbear when there is a good chance the borrower will recover. Mortgage servicers lose in foreclosure because they must bear all the additional costs with no offsetting revenues.
Hence it is in the mutual interest of borrowers, lenders and servicers to avoid unnecessary foreclosures with strict initial underwriting and meaningful borrower down payments.
A streamlined foreclosure process is similarly in their mutual interest.
As a consequence, mortgage credit is generally cheaper and more readily available in the 27 states with nonjudicial foreclosure where the process is much quicker and costs and outcomes are highly predictable.
Most subprime lending took place at the peak of a house-price bubble, attracting borrowers with low-down-payment or no-down-payment loans. Thus subprime borrowers are for the most part bearing little if any of the cost of foreclosure.
Few subprime borrowers will be worse off than if they had rented once the benefit of living rent free during an extended foreclosure period is factored in.
The political effort to keep defaulted subprime borrowers from being foreclosed upon can only be explained by their sheer numbers and the political complicity in inducing them to borrow in the first place.
The myriad direct political efforts at forbearance have largely failed while severely distorting incentives. Borrowers who would otherwise turn the keys over to the lender may get another year or two of free rent through a foreclosure freeze.
Borrowers who can pay have little incentive to do so when others in similar circumstances pay little or nothing, and paying the mortgage has moved from first to last priority.
In addition to pressuring lenders not to foreclose, politicians have generally supported legal initiatives to slow or stop foreclosures, most recently in response to the so-called robo-signing phenomenon where processors certified they had read documents when in fact they relied on the advice and opinion of others. Krugman cites "the Florida man" who purportedly lost his house, even though it had no mortgage, as evidence of a systemic attempt by lenders to inappropriately confiscate much of the nation's housing stock, and all 50 state attorneys general apparently agree. Robo-signing was stupid, but there is no evidence of a systemic attempt to defraud borrowers.
Shifting the incidence of loss to lenders follows the Dodd-Frank Act in shifting the blame for the subprime lending debacle from politicians and borrowers to lenders. Litigation is now a primary tool.
Previously stable and predictable relationships among lenders, insurers, title companies and servicers are falling victim to this wave of litigation to alter the ex post allocation of losses from the normal pattern.
For example, secondary market investors are interpreting seller representations and warranties more strictly than anticipated. Fannie Mae and Freddie Mac have attempted to "put back" an unprecedented number of defaulted loans on the basis of "fraudulent misrepresentation" to minimize the government cost.
The attempts to create legal ambiguity, however specious they may ultimately be deemed to be, will produce short-term benefits to the purveyors. For example, the right of investors in mortgage-backed securities to foreclose on defaulted borrowers has been a subject of litigation that attempts to forestall foreclosure by casting doubt on their ownership of the notes.
The short-run costs of this wave of litigation pale in comparison to the likely long-run societal costs. The legal profession may generate extra fees measured in the billions of dollars (the cost of the Lehman bankruptcy alone is already $1 billion). Homeowners may get free rent, costing lenders a similar amount.
The single most important pre-requisite to a viable mortgage market is containment of political risk. This requires not only a sufficient legal and regulatory infrastructure, but predictability in the way it will be administered, especially when stressed.
However painful foreclosure was during the Great Depression, the ensuing changes to clarify and strengthen lender rights resulted in predictability in the meaning and application of laws and regulations that have been a tremendous boon to mortgage borrowers ever since.
Lenders can't rationally price political risk and as a consequence generally avoid it.
The political response is most often to insert public institutions such as housing banks (e.g. Fannie and Freddie) to replace private lenders.
The Obama administration has thus far treaded carefully around the robo-signing issue but has not repudiated Krugman's demand, a prerequisite for a return to private mortgage market normalcy.