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The Confederate Lawyer
November 20, 2008

A Cure Worse than the Disease
by Charles G. Mills

The mortgage industry in the United States is in a terrible mess, and the steps we have taken to correct it are only going to make that mess bigger.

In a normal economy, banks lend money to people they expect to repay the loans. Banks that are good at this can lend at interest rates below immoral usurious ones and still make a very good profit. The banks that are the best judges of their borrowers make the highest profits.

This is not a normal economy. In 1977, during the Carter administration, legislation was enacted that required banks to lend money back into the communities or neighborhoods out of which they drew their customers. This changed a lot of things. The reputation of mortgage brokers no longer depended on how often they produced reliable borrowers, since the banks were no longer trying to lend only to reliable borrowers. Instead, the banks wanted to keep the government off their backs by lending in the politically designated neighborhoods. Appraisers’ reputations no longer depended on accuracy but on how much business they could generate, since the brokers with whom they dealt now knew that banks would take junk off their hands.

Banks used participations in their mortgages as security to borrow more money, and they relied on projections of default rates based upon their history from the days when they tried only to make good loans. Furthermore, a culture arose of charging interest rates (especially on credit cards) based on having the reliable customer pay for the risk the bank was taking with other borrowers. Some of this interest is higher than the local criminal usury rate.

The result was a mess in which most of the financial system was under-secured on its loans. When this became widely realized, everyone became reluctant to make the kind of loans that had become normal.

In order to get out of this mess, the federal government has bought all of the problems of Fannie Mae and Freddie Mac. This made the people of the United States of America the owners of trillions of dollars of mortgages, many of them in default. The government also bullied the nine largest banks in the country into selling hundreds of billions of dollars of new issue stock to the government. This makes the people stockholders in the owners of every mortgage made by a big bank. Finally, the government will probably buy half a trillion dollars in current market value of defaulted mortgages and hold them directly. In short, the people are going to have a stake in 20 million or so problem mortgages and even more good mortgages.

The government’s final goal will be the same as that of any mortgage lender: to get as much of the loan principal and interest back as possible.

In a normal economy, a bank has experts who determine on a case-by-case basis which mortgages to foreclose and which ones to save by forgiving a monthly payment or two, or at least postponing the delinquent payments. The better these experts are, the more profitable the bank will be.

The government is not very good at doing things on a case-by-case basis. It will hire a new bureaucracy to handle its new portfolio. The bureaucracy will probably be about as compassionate as the Internal Revenue Service and as efficient as the Veterans Administration. There will probably be four types of people in the new bureaucracy.

• There will be some ideologues who believe that it is the right of poor people to own their homes, whether or not they can afford them.
• There will be some people who make an honest effort to return the mortgages to the private sector as quickly as possible.
• The largest group will be people who want to advance their careers by getting as much money as possible for the mortgages for which they are responsible.
• The fourth and most significant group will be those who do the planning, mostly by creating laws and regulations, to get the government out of the mess.

The bureaucratic mentality will prevail. The nine largest banks have government money, and obligations go with it. The people’s investment in the bank loses value if the value of the bank’s collateral goes down. This value goes down if the bank’s mortgage customers do not replace their roofs or cut their grass often enough. Therefore, we will need a set of government standards for the upkeep of houses financed by any of the nine largest banks. Some banks are more compassionate than others with delinquent mortgage borrowers. That will have to end, and a uniform policy on foreclosure will have to be adopted. There will, no doubt, be some in the government who want to stop all foreclosures, but I cannot imagine that they will prevail. It is simply not politically feasible to reward failure to pay one’s mortgage with a free house.

There will be half a trillion dollars or so of mortgages owned directly by the government. We had a similar experience with the Resolution Trust Company that acquired the bad loans of insolvent savings and loan associations and collected or sold them. A lot of these loans were foreclosed directly by the Resolution Trust Company as if it were a bank. Our situation now is worse; the bureaucracy is going to have to administer loans to poor borrowers living in single family homes. This is something the big mortgage companies already do worse than the banks. The Feds will probably show us new depths of incompetence in an industry that has never been free of problems.

The cure we have chosen for our credit crisis is shaping up to be worse than the disease.

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The Confederate Lawyer column is copyright © 2008 by Charles G. Mills and the Fitzgerald Griffin Foundation, www.fgfBooks.com. All rights reserved.

Charles G. Mills is the Judge Advocate or general counsel for the New York State American Legion. He has forty years of experience in many trial and appellate courts and has published several articles about the law.

See his biographical sketch and additional columns here.

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