So now, apropos of the foreclosure mess, which we addressed last week, Sheila Bair, the Chairwoman of the Federal Deposit Insurance Corporation (FDIC), comes forward with a proposal that is so radical it just might work.

First, let’s set the scene, in case this is the first you’ve heard of Foreclosure-Gate.  Banks are trying to foreclose on homeowners that are delinquent in their payments.  But one of those curious things about the law is that whoever forecloses on a property must have standing to do so, that is, he has to prove that he owns the property that he is seizing.  It appears, however, that some banks have been less than candid about their standing.  They should have it; they’re doing the servicing, after all.  But sometimes they can’t prove that they are legally entitled to foreclose, because, in point of fact, the title never registered their claim.  The system that was supposed to take care of this is the Mortgage Electronic Registration System, or MERS.  It, um, failed.  And failed.  And probably is still failing.

That leaves the chain of title in doubt and makes it very hard to foreclose.  The banks circumvented this difficulty in the good old American way – they lied about it.  The coursts were not amused.  And now the attorneys general of all 50 states are ginning up a class-action lawsuit to try to get lenders back for this.

Get them back for what is not clear, because there are maybe six reported cases – nationwide – of a lender foreclosing on someone that really wasn’t behind on his mortgage, and those situations are fairly simply remedied by the parties involved.  The real-estate market in the US is not what one would term “robust” at the moment, and the prospect of a gigantic class-action lawsuit, coupled with the blizzard of punitive follow-on lawsuits (this is America, after all) has the very real prospect of bringing the market to a halt altogether.  If lenders have to retask all their personnel to handle lawsuits, that, coupled with the dramatically increased risk of not being able to foreclose at all on any of their loans (this is what Senate Majority Leader Harry Reid, among others, is calling for), is going to dry up the feeble trickle of mortgage money we now have.

Ms. Bair sees this clearly, and has a solution: modify the mortgages.  Well, we are, say the lenders.  No, you’re not, says Madam Bair, and she’s right.  Banks have not been modifying mortgages at nearly the anticipated rate.  And Ms. Bair has a couple of other data points to provide.  The FDIC owns several banks, and has been working out modifications on its own on behalf of those banks.  In the cases where the modifications have resulted in a 10-40% reduction in the monthly payment, the default rate has been halved, she says.

Think of that!  Reduce the homeowner’s payment, and he doesn’t default on his loan as often.  This is so amazing (in my family, we say amazingcastic, just in case anyone misses the sarcasm) that only the government could possibly have figured it out.

As goo d an idea as this is, there are a couple of problems with this idea of Ms. Bair’s.  The first is more of a hurdle that can be jumped with the right incentives.  That is that the mortgages themselves, as we noted here, are of dubious and often multiple ownership.   Not only do we have to figure out how to identify the owners, we then have to get them all to agree to modify the note, which is the security that the ownership is based on.  Not an easy task, though presumably possible if the incentives are correct.  But that brings us squarely to the second problem, and that is that the incentives are screwed up.

Banks could already have been modifying mortgages by the basketful if there were solid incentive for them to do so.  But that incentive is lacking, in most cases.  The government’s mod plan is cumbersome and weak, with incentives that are far too small to move most lenders to action.  Adding to that, the government – specifically the FDIC – requires a certain asset book from each lender or it will be “stress-tested” out of existence.  The assets on that book consist largely of mortgage notes.  Modify the notes, reducing their value, and the FDIC has the ability to swoop in and declare you bankrupt.  That’s not an incentive to acquiesce to Ms. Bair’s request.  On top of that, the government has all-too-often indicated that it will step in and bail out the banks if they lose money because of foreclosures.  Fannie and Freddie, VA and FHA already own 90% of the US market for mortgages, and that group can always tap the taxpayers if it gets in trouble.  So why modify?

It might be moot anyway. Here’s the quote from the attorneys general in response to Ms. Bair:

Our group of attorneys general and banking regulators is currently looking into the foreclosure problems that have come to light.  In addition to our active inquiries with servicers and lending institutions, we are engaged in extensive dialogue.  We will continue that dialogue with those inside and outside of our multistate group to ensure this process is both thorough and expeditious.  We intend to be fair to consumers, lenders, and investors, and continued input and dialogue will help us attain that objective.

Anytime you say the word “dialogue” three times in one paragraph, you’re spinning.  Let me translate that quote for you, as I speak politics fluently:

We’re elected officials.  Most of us are up for election this year.  We’ll sue the living snot out of you if it will help us keep our jobs.

Despite all this, I wish Ms. Bair well.  I’ve been calling for an across-the-board principal reduction, as a gift from the lenders to the homeowners, as a way of eliminating “strategic foreclosures” (where the homeowner can make the payments but walks away because he doesn’t want to, usually because he is upside-down in the house).  Ms. Bair’s proposal along with something like that would reduce foreclosure rates by as much as 65%, and put a serious floor under the housing market.  It would mean a freeing up of hundreds of billions of dollars of trapped capital in homes that are currently underwater, boosting purchasing power and pouring more billions into consumers pockets (not, this time, government billions, which it has to take from consumers anyway) at a time when that is sorely needed.

Will the proposal founder on the twin rocks of politics and regulatory constriction?  Will you ever have a lender call you and say, “you know, let’s see if we can make this mortgage thing work a little better for both of us”?  Well, we’re coming into the season of miracles.  What better time to see one in housing?

At the very least, if you’re a homeowner that is behind on the mortgage – or even threatening to be so – you ought to call your lender and “dialogue” with them.  It appears that they have new incentive to talk with you.  And we’ll keep you posted here as all this develops.

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