The U.S. Needs a Meaningful Mortgage Settlement: Simon Johnson

Discussions around this weekend’s International Monetary Fund annual meetings in Washington made it clear that the standard macroeconomic toolkit has little more to offer the U.S. It’s time to try something else.

Monetary policy has reached its limits, and further fiscal stimulus isn’t in the cards. Three years into the financial crisis, the U.S. economy is still held back by weak consumer confidence. Meanwhile, the global financial system continues to face instability, most notably because of the persistent sovereign-debt crisis in Europe.

With roughly a quarter of all U.S. households with mortgages owing more on their loans than their homes are worth, it’s no surprise that consumption, which accounts for 70 percent of gross domestic product, is restrained.

The consequent lack of demand discourages business investment, which means job creation remains weak. People are afraid of losing their homes and that fear keeps spending down and thus prevents them -- and their neighbors -- from getting jobs.

What can be done to break this vicious circle? One suggestion from some officials this weekend -- and of course many banks -- is to accept a relatively small amount of money to settle the various robo-signing and other mortgage document cases that state attorneys general are pursuing. The claim is that this would put the banks back on their feet and spur lending. This is a complete illusion.

TARP Props

The biggest banks were propped up during the crisis by the Treasury Department using Troubled Asset Relief Program funds and by the Federal Reserve with huge loans in various forms. Some institutions, including Citigroup and Bank of America, were put back on their feet several times.

But this approach has proved insufficient to spur an economic recovery. Left to their devices, banks will always fail to restructure loans on a scale sufficient to make a macroeconomic difference. Negative equity or near negative equity weighs on consumers and depresses confidence, but no single private firm will ever take into account those broader consequences.

To date, the government’s efforts on mortgages have been lame -- and much less than was done to save the biggest and worst managed banks. There’s also zero chance that this Congress would authorize the use of any public money to support mortgage relief. At the same time, it’s only fair and reasonable that there should be redress for homeowners who were tricked into mortgages they couldn’t afford, evicted without due process or otherwise mistreated by banks.

Principal Reductions

Appropriate redress would presumably include loan modifications and the possibility of principal reductions for those who borrowed from particular banks during specified periods, or who took out various kinds of dangerous loans (for example, the infamous exploding adjustable mortgages, in which low teaser interest rates were used to fool people into ignoring how much rates would quickly rise.)

Bank misconduct allegedly was on a grand scale throughout the origination, securitization and loan-servicing processes, particularly for loans taken out from 2005 through 2008. It is conceivable that an appropriate settlement would include enough restructuring of payments to make a difference at the level of significantly reducing household debt burdens.

Unknown Amounts

Unfortunately, we don’t know the exact amounts that could be involved because the Justice Department has sat on its hands for three years and no attorney general has been able to complete a full investigation. Some AGs, such as Eric Schneiderman of New York, argue that we need such an investigation as the basis for a comprehensive settlement. Surprisingly, many other AGs and some federal agencies seem increasingly inclined to accept the $15 billion to $20 billion that the banks have put on the table, and declare the matter closed.

We got into our current financial morass because state and federal officials bent over backward to allow banks to do what they wanted. During the most intense crisis period, official strategy under President George W. Bush, and again during the Obama administration, was to support big banks -- and to keep them on their feet with minimal personnel, governance or business model changes. Now some AGs and the Obama administration want to call it quits and let the banks go back to business as usual.

The policy over the past 30 years of giving the big banks pretty much what their executives want has proved to be an unmitigated disaster. It’s time to change that in a fair and reasonable manner. Let every disputed mortgage case be examined separately, using the full process of the law. If that prospect is too daunting for the banks accused of serious misconduct, then they should reach a settlement that’s big enough to make a difference.

(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a professor at the Massachusetts Institute of Technology and a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)

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