Is the foreclosure crisis overblown?

Here are Andrew Ross Sorkin and Joe Nocera of the New York Times having a video debate about the foreclosure crisis.  Nocera thinks this is a key economic issue. Sorkin thinks the issue is overblown.

My take: For political reasons, the Obama Administration would like to deep six this issue because it could harm the technical recovery from becoming a real recovery by 2012, when the President is up for re-election. The only way this issue gets traction is via Republicans, the states or the courts.

But, as for the merits of the debate, clearly there was an epidemic of fraud perpetrated during the housing bubble. Many so-called homeowners – who are really renters with a mortgage because they have no equity  – were complicit in this fraud at loan origination. Do we use the government’s resources to uncover these fraudsters and prosecute them? Probably not, as there are thousands of these cases for governments with limited resources to track down.

Instead, the government’s resources should be directed at uncovering fraud within banks. From a purely practical perspective, this makes sense because there are a much more limited number of targets. But from a societal perspective it does as well. Banking is a cartel established by government. The government extends banking licenses. Government regulates banking activities. And government sanctions those that engage in unsafe and unsound practices. This is not a free market, folks. It’s not like I could set up a bank tomorrow and start making loans. My operation would be shut down immediately and I would be thrown in jail.

What do we as society get out of this arrangement? Supposedly, it stops criminals and fraudsters from setting up shop and ripping people off and creating Ponzi schemes for their personal profit, leaving their customers and institutions bankrupt.  As a result, government has required those fortunate few who get banking licenses to adhere to a strict set of rules.  That’s what a bank’s fiduciary duty is all about: trust, faith, confidence – all of that.

A fiduciary duty is a legal or ethical relationship of confidence or trust regarding the management of money or property between two or more parties, most commonly a fiduciary and a principal. One party, for example a corporate trust company or the trust department of a bank, holds a fiduciary relation or acts in a fiduciary capacity to another, such as one whose funds are entrusted to it for investment. In a fiduciary relation one person, in a position of vulnerability, justifiably reposes confidence, good faith, reliance and trust in another whose aid, advice or protection is sought in some matter. In such a relation good conscience requires one to act at all times for the sole benefit and interests of another, with loyalty to those interests…

A fiduciary duty is the highest standard of care at either equity or law. A fiduciary (abbreviation fid) is expected to be extremely loyal to the person to whom he owes the duty (the "principal"): he must not put his personal interests before the duty, and must not profit from his position as a fiduciary, unless the principal consents. The word itself comes originally from the Latin fides, meaning faith, and fiducia, trust.

–Wikipedia

The failure to uphold fiduciary duties of even a few larger institutions will put the entire banking system in doubt. What we witnessed in 2008 and early 2009 was a loss of trust, faith, confidence. It was a classic solvency crisis masquerading as a liquidity crisis – with doubt about which specific institutions had engaged in reckless behaviour putting a cloud over every bank in the entire system and causing liquidity to dry up economy-wide. When banks engage in unsafe and unsound business practices, they put the entire economy at risk in a way that you see in no other sector of the economy. This is why regulators in the US are supposed to take prompt corrective action in closing insolvent institutions and those institutions with unsafe and unsound business practices.

Regulators failed in doing this – and are continuing to fail, at least as far as the largest institutions are concerned. Again, all available evidence suggests practices were often not just ‘sloppy’ but fraudulent from mortgage origination to packaging of mortgage-backed securities to foreclosure. The entire process is riddled with fraud from liar’s loans to securitizations worthy of putbacks to fabricated documents to robo-signers. How government deals with this has nothing to do with the homeowner, frankly. First and foremost, it is about protecting the integrity of our financial system. To the degree homeowners feel they have been defrauded, courts should grant them every right to appeal foreclosure.

What should be done regarding the banks is  a staffing up of fraud departments in regulatory agencies. This has to be followed by an in-depth investigation into all of these fraud issues. Institutions engaging in unsafe and unsound practices will have to be taken into receivership and fraudsters will be have to be prosecuted. That is certainly what we saw after the S&L crisis.

But, you know and I know this is never going to happen now unless it is forced upon us by the courts or another crisis.