To fix the economy, let bad banks die
Since the housing market peaked in 2006, the nation has suffered through nearly half a decade of financial and economic hell. It’s past time for the politicians to do what they should have done in the first place. That is, protect the nation’s priceless assets: the rule of law and free markets. Instead, the pols are protecting the worthless assets of zombie banks that do not know how to be banks.
Two years ago, many of the nation’s largest banks should have failed — because their business model failed. That business model was willful incompetence. Back then, banks, including Countrywide Financial, now part of Bank of America, showcased this incompetence in helping homeowners borrow money they could never repay.
Today, thanks to Washington’s bailouts, the bad banks are still alive. So is their disastrous business model. The banks now showcase their incompetency in their inability to foreclose on defaulted homeowners in an orderly, timely and non-fraudulent fashion.
In the past two weeks, Bank of America, JPMorgan Chase and some competitors temporarily halted most foreclosures. The banks stopped foreclosing as employees came forward to say that they had defrauded courts — that is, falsely attested that they knew the facts of thousands of foreclosure cases when they did not. Often, the banks cannot locate the documents that confirm a lender’s right to foreclose. Even as banks resume foreclosures, as Bank of America did this week, they have a motive to proceed slowly because they do not want to book the losses that come with property sales.
But the banks’ dawdling imperils economic recovery, in ways prosaic and profound.
The prosaic: Borrowers stay stuck in homes they can’t afford, meaning they can’t get on with their lives. Prospective home buyers still can’t afford property, and those who can remain wary because until lenders clear their backlog of foreclosures, house prices won’t fall to realistic levels. At the same time, small businesses cannot create jobs because banks and investors stuck with old, bad loans don’t want to make new ones.
The profound: Botched foreclosures erode the property rights on which the nation’s prosperity rests. When a person buys a home, he must know that he enjoys the legal right to keep and sell that property. Property rights break down if, three years from now, a former owner can say that she did not get her day in court and therefore a sale should be invalidated.
Thankfully, regulators, including the Federal Reserve, have the power to act. Banks, after all, must operate safely and soundly. By definition, a financial institution cannot be safe and sound if its executives have no idea who owns what and who owes what. Nor can a bank operate safely and soundly if it cannot properly value its or its customers’ assets, something it cannot do if it has not mastered the work of asserting legal rights to those assets.
Here’s what Washington should do: Regulators should require banks to promptly fulfill their safety and soundness duties. Banks would do so, obviously, by foreclosing on defaulted homeowners in a timely, consistent and honest fashion, even if it means that the firms must shell out big money to hire enough qualified people.
Alternatively, the banks could choose —in the same timely fashion— to reduce the amount of money that borrowers owe so that borrowers could afford to stay.
One way or the other, it’s time to get it over with.
Here’s what Washington will do, though: nothing. Regulators know that if they force banks to foreclose quickly, legally and consistently, the firms would have to take significant, perhaps crippling, losses on the loans on their books. Fannie Mae and Freddie Mac, which hold and insure many loans, would have to take fresh losses too.
Further, investors who purchased mortgage securities could sue, alleging, among other things, that underwriters misrepresented third parties’ capacity to ensure that someone would oversee mortgage paperwork on a day-to-day basis.
In other words, big banks could fail. And that’s the problem. Despite having signed into law the Dodd-Frank financial reform bill three months ago, the White House still has not created a predictable way in which large financial firms can go under, with investors taking warranted losses. Instead, the new law directs regulators to make up the job as they go along. Regulators are terrified of testing their discretion and of precipitating a 2008-style panic.
Smart bankers feel this fear. They know that regulators will not cause markets to question a large bank’s viability, even if it means enabling the slow strangulation of economic recovery. This knowledge explains the banks’ casual attitude toward their public trust. Banks remain permanent wards of the state, immune from full market and legal discipline.
As for the politicians, their policy is ignorance. President Obama doesn’t want to have to ask for his own TARP. Congressional Republicans want no reminder of Bush-era bailouts. They maintain the fiction that the financial crisis is in the past.
Someday, reality will intrude, and it won’t discriminate over whether a Democrat or a Republican is in the White House. In the meantime, Washington’s policy of ignoring irretrievably broken banks could inflict another half-decade of “housing” crisis on the rest of us.
Nicole Gelinas, the author of “After the Fall: Saving Capitalism From Wall Street — and Washington,” is a contributing editor to the Manhattan Institute’s City Journal. E-mail: nicole@city-journal.org
