A proposed settlement with the top five mortgage servicers could prolong the foreclosure crisis, drive up mortgage interest rates, slow new home construction and cost $7 billion to $10 billion a year, according to a study from three top economists.
The study, which was commissioned by the financial services industry — including some of the servicers involved in negotiations — unequivocally states that terms sought by the 50 state attorneys general and a host of federal agencies would do more harm than good.
It was written by three economists: Charles Calomiris, a professor of financial institutions at Columbia Business School; Eric Higgins, a professor of finance at Kansas State University; and Joseph Mason, the chair of banking at Louisiana State University and a senior fellow at the Wharton School.
The 25-page study, obtained by ASR sister publication American Banker, is an analysis of the proposed settlement offered by the state AGs in February.
"We find that a settlement along these lines would generate significant unintended negative consequences for housing and financial markets," the study said. "In particular, we find that … the settlement is unlikely to provide broad or lasting benefits … We conclude that the settlement would serve to extend, rather than end, the foreclosure crisis."
Under the 27-page term sheete, servicers would have to make sweeping changes to their processes, including new requirements for mortgage documentation, interaction with borrowers, relationships with active military personnel, loan modifications, principal reductions, bankruptcy proceedings, short sales and technology systems. The servicers have rejected those terms, arguing they are too onerous.
The study echoes their concerns, saying it would be prohibitively expensive to implement and only serve to disrupt the market. According to the study, the terms would increase servicing costs and drive up defaults, increasing foreclosure inventory by $297 billion. It would also raise mortgage rates, by 20 to 45 basis points per year, hurting the economy.
"This proposed settlement is completely unreasonable with the constraints of the marketplace and consumers," Mason said in an interview. "If we want recovery from the mortgage crisis, the clearest path forward is to recognize the losses of banks and the borrowers, and allow the market to reallocate homes from those who cannot afford them to those who can. Preventing the market from doing so will only prolong the mortgage crisis."
When the study is released, it is almost certain to garner criticism from consumer groups and others, who are likely to note that it was funded by industry money. But Mason defended its integrity.
"The banks have no say in the conclusion," he said. "Whenever I do research and the other two authors on this … we never allow any funder to dictate our conclusions. We're academics. If it makes sense to us as economists, we will write it. If it doesn't, we won't. … The base of economics is real financial constraints by real people with budgets."
The study is just the latest attack on the proposed settlement, which was made public by American Banker on March 7. Iowa Attorney General Tom Miller, who is leading the settlement talks on behalf of the AGs, has faced objections from other AGs who argued the settlement went too far by pushing principal reductions. Several Republican lawmakers have also criticized the proposed terms, arguing they are essentially making new laws through enforcement actions.
The banks have offered a counterproposal that would focus on system improvements, but does not include a push for principal reductions.
The crux of the economists' argument is that the AGs' settlement terms would significantly slow the foreclosure process as servicers tried to reduce principal and overhaul systems. That would have a severe impact on the economy, the academics said.
"Our review of existing economic research, as well as our own analysis, leads us to conclude that the settlement, including its delay of foreclosures, would harm the broader economy: stalling construction of new homes; reducing consumer spending and investment; and reducing credit access and economic growth," the study said. "In particular, we believe the settlement cost itself would increase interest rates by 20 to 35 basis points a year, as imposing additional costs on lenders would lead lenders to require higher returns. Furthermore, an increase in strategic defaults as a result of the settlement could increase the foreclosure inventory by $297 billion, and increase interest rates by another 10 basis points."
The economists took issue with a private February report by the Consumer Financial Protection Bureau — first published by The Huffington Post — that claimed the five largest servicers avoided $24 billion in costs between 2007 and 2010 by cutting corners in the servicing industry. The CFPB document said banks should be fined at least that figure.
But the economists said that the AG settlement could cost the economy $7 billion to $10 billion a year due to delayed foreclosures, increased servicing and compliance costs and the hike in interest rates.
"What we found particularly important was the additional cost of delay … if you just start adding those up they get really long, and they increase the foreclosure time by 150%," Mason said. "If you just start thinking every day in foreclosure is a cost to the banks, this raises the cost to the banks."
While the AG terms were focused on fostering more loan modifications, the economists said there was no sign that would help.
"One problem with mandated loan modification is that even significant principal reductions cannot cure the mortgage loan origination issues that are at the heart of the foreclosure crisis," the study said.
Further, the economists wrote that forced principal reductions create incentives for the borrower to default and seek modifications, known as strategic default. They estimate the settlement could increase strategic defaults by 25%.
"For borrowers who can actually repay their modified mortgage, the settlement would allow them to extract concessions from the bank," the report said. "For borrowers that cannot repay the mortgage, the settlement would allow them to delay foreclosure for an extended … period of time."
The proposed settlement would add steps to the foreclosure process such as preventing dual tracking of loan modifications and foreclosure, and allowing borrowers 30 days to challenge a modification denial.
"Adding up the delays, not including those with indeterminate or undefined time periods, the foreclosure process could be delayed up to 280 days, which would increase the existing 17-month foreclosure time line by over 50%," the study said. "Such additional delay would substantially increase the cost of foreclosure to banks and investors."
Overall, the economists said the settlement could adversely affect the very group it was intended to assist.
"Unfortunately the terms of the settlement appear to reflect the absence of regulators with broad understanding of the housing market and its relationship to the national economy," the economists wrote. "Although mandating principal reductions certainly seems 'pro-borrower' on the surface, there is substantial economic research that suggests that the benefits to borrowers would likely be illusory, and the costs to the nascent economic recovery would likely be significant."
The study comes as federal banking regulators are preparing to release their own cease-and-desist orders against the 14 largest servicers. The consent orders are likely to be less far-reaching than the proposed AG settlement terms.