[A friend of mine wondered why the foreclosure crisis couldn't be resolved at least in part by the government requiring that the creditor bank being forced to absorb the excess debt. I wrote the following in response, including my own Philippic.]
Consider Grasshopper and Ant. Both buy a $250,000 house in 1995, paying $50,000 down. Both houses ride up to appraised values of $500,000 during the the boom. Ant prudently pays down the mortgage. Grasshopper goes nuts, buying a couple of RV's, a vacation home, all kinds of electronic gadgets, and going to all the Stanford away games. He runs the $200,000 debt up to $350,000.
Comes the deluge, and the value of both homes shrinks back to $250,000. Grasshopper is now underwater. If the government steps in to help him out, Ant shouts to high heaven, and he's right. What the government has done is subsidize Grasshopper's improvident life style. It isn't fair.
Mind you, not everyone under water has acted the part of Grasshopper. Some were tricked into unaffordable loans, some invested reasonably but unluckily, etc. The point is that there is no 'one-size-fits-all' solution.
That's not to say that there aren't remedies. I can think of two, had the Obama administration taken these issues seriously, and I'll thrown in a third for fun.
(1) The first is to limit the creditors to the collateral, not permitting any deficiency judgments after foreclosure. Bear with me here. California has what is called anti-deficiency legislation, with respect to the mortgage on which the original home purchase is based (“purchase-money obligation”). I always thought that this scheme had become standard throughout all the States, but not so. California is a minority State in this respect. It would not have been difficult in concept, and probably not too difficult to implement administratively, to extend this protection to all home mortgage debtors, i.e., the creditor is limited to the collateral and the risk of over-valuation falls on the institution.
Note that such legislation would not help Grasshopper, who over-extended himself with second and third mortgages. His first mortgage, like Ant's, was fair and reasonable. Anti-deficiency measures won't help him. So Ant will not have his nose too far out of joint.
(2) The second thought is to grant any debtor who believes he was tricked into the loan by some sort of fraud, deceit, or unfair business practice, a right to arbitrate the matter. Bear with me again. There are actually two methods of foreclosure, judicial foreclosure (meaning the creditor files suit and seeks return of the collateral as the remedy) and contractual foreclosure, by which the creditor forecloses pursuant to rights granted him in the contract. (Lawyers who practice in the area may have something to say about this – I am out of my fields of expertise and talking general law.) Ninety-nine percent of all foreclosures are the second type – what creditor wants to go through a litigation to recover the security? Any homeowner reading this with his original documentation at hand might want to haul it out and take a look at it. You'll find that the rights to judicial foreclosure have been waived in a series of boilerplate clauses. This was SOP for a few decades.
But the last decade was anything but SOP, and home residential financing, which should be an absolute snoozer both legally and financially, became a go-go affair. Actions have consequences. Time to take another look at those routine adhesion clauses. Allowing debtors to put a foreclosure into a full-fledged litigation is a bit much. But it would have been fairly easy to require bank creditors, as a condition to receiving bail out money, to consent to a modest, simple arbitration, in which a debtor could raise any unfairness he perceived in the loan process or the loan itself. I'd grant the arbitrator sweeping powers to grant any reasonable remedy in equity.
This remedy would be available to Grasshopper, or anyone who thought he or she had been conned into a loan on unfair terms. I do have to say I think the vast majority of debtors who went to arbitration would lose. I don't think there was nearly as much bad practice as claimed. But you would have the remedy when it did occur.
(3) Finally, you have my favorite, requiring investment banks and others engaged in derivative trading to do business as limited partnerships, with all persons above a certain level in management to participate as general partners. That's the old trial lawyer in me. You can have all the sophisticated risk management analysis you want. All I care about is that the firm's own money, and that of the principal players, is right there on the felt beside the clients. I am cynical enough to believe that the whole mess would never have occurred if the financial class that created it had been at risk itself.
This whole issue has been as frustrating as anything I have experienced in my lifetime. I have a family relation who is convinced – stridently – that the cause of the financial collapse was the push to expand home ownership, and the consequent collapse of financing standards. As if – the first occasion in all recorded history of the poor exploiting the rich. Gimme a break. I also have a sometime Internet correspondent who belligerently condemns Gretchen Morgenson's book 'Reckless Endangerment' and perceives the failure of the Congress to enact meaningful reform as the result of Republican intransigence. As if – opposition to the bailout, and insistence on the importance of preserving the moral hazard, was largely Republican. The Republican Main Street constituency, from which the Tea Party was culled, has no more use for Wall Street than it does for Washington.
Both guys are right and wrong. There should have been two hearings in Washington back in 2009, one in a great big conference room about derivative trading abuses, covered by NPR and MSNBC, and another in a smaller room, about the weakening of financing standards, covered by Fox. Dick Fuld, and Goldman, Barney Frank and Fannie Mae – they should all have gone over the coals. There was easily enough octane for substantive reforms in both. Where my Internet friend is dead wrong is that the blame for this failure lies almost solely at the feet of one Barack Obama, his passivity, and the fact that the bottom line is that he is a dyed-in-the-wool Establisment guy.
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