The recent $25 billion settlement by 49 attorneys general and the Obama Administration against the five largest mortgage servicers for deficiencies in their foreclosure practices is emblematic of misdirected energy and bad public policy. Like the Dodd-Frank financial reform law, the settlement is living proof that the judgment of politicians can be clouded by fixes that sound good, but miss the target. State and federal governments' need/desire to punish financial services companies is actually constricting lending and impeding the economic recovery.
William Emmons of the St. Louis Federal Reserve Bank attempted to quantify the housing problem in a recent speech. He suggests that loan to value ratios tell the real story of the housing dilemma in this country. Nearly 50 percent of mortgaged homes today have LTV ratios above 75 percent, with the average LTV ratio standing at a staggering 93 percent. The average LTV ratio from 1970 to 2005 was a considerably less risky 75 percent. Using a 75 percent LTV ratio as the standard, today's 93 percent LTV means that housing equity (i.e., the value of the real estate minus the amount of the loan) is deficient by a whopping $3.7 trillion, or 24 percent of the U.S. GDP.
It would require approximately $75,000 additional equity per mortgaged home to return mortgage markets to the more traditional territory of 75 percent LTV ratios. To close this gap, home prices would have to increase approximately 60 percent from where they are today!
The problems in the housing markets are indeed very large and complicated. Paul Willen of the Federal Reserve Bank of Boston challenges the conventional wisdom that principal reductions, which constitute $10 billion of the $25 billion settlement, will solve the housing problem. Principal reductions reduce the probability of foreclosure because borrowers with newly found positive equity can sell their homes. But if principal is reduced enough to prevent foreclosures, it could lead to voluntary sales of properties, which will further depress housing prices, perhaps setting off another round of foreclosures.
The recent $25 billion settlement is disproportionate to the foreclosure violations that occurred. While the violations were serious matters, as Willen suggested, it is not clear that the violations hurt borrowers. In reality, the borrowers subject to foreclosures were seriously delinquent on their loans, and the flawed foreclosure procedures likely kept these homeowners in their homes longer.
The bottom line is that the settlement will at best have a modest impact on the enormous home financing issues the country faces. In all, 750,000 borrowers will receive $2,000 each, and another million homeowners will be eligible for principal reductions. But there are 50 million mortgaged homes in the United States today, and estimates are that as many as 15 million are paying an above-market interest rate of 5 percent or more due to high LTV ratios. That is the crux of the economic problem that we face, and the settlement will not make a dent in it.
Viewed from a macro-economic perspective, a $25 billion fine reduces lending capacity by $250 billion, since banks are able to lend roughly ten dollars for each dollar of capital. If serious violations of law occurred, it would be far better public and economic policy to pursue the individuals who participated in the violations rather than the banks themselves. Pursuing the individuals will be a more effective deterrent against future violations and will allow the institutions to get back to lending more quickly.
Policymakers have a choice – pursue retribution or fix the economy as fast as possible. Noting that the servicers did not receive global releases in return for their $25 billion and therefore still face considerable litigation, it appears that that we may already have the answer to that choice.
We are more than four years into the housing finance crisis. Experience tells us that the economy will not do well unless both housing and the financial industry are doing well.
Policy makers should focus on strengthening the economy by allowing financial services companies to move forward. It is time to stop looking backward and to begin finding ways to encourage banks to return to lending to consumers, homeowners and small businesses. Continuing costly and punitive government litigation against banks is not likely to make banks more receptive to lending money to those who need it most and will not restore robust economic activity.
William M. Isaac, chairman of the Federal Deposit Insurance Corporation during the 1980s, is senior managing director and global head of financial institutions at FTI Consulting, chairman of Fifth Third Bancorporation and author of Senseless Panic: How Washington Failed America. Thomas P. Vartanian, general counsel of the Federal Home Loan Bank Board during the 1980s, is partner and head of the financial institutions practice Dechert, LLC. The views expressed are their own.