Obama's Foreclosure Inaction Risks Katrina Redux

The foreclosure crisis that seems on the brink of spinning out of control may be the decisive nudge that pushes the U.S. into a double-dip recession. Banks that have only just begun to recover from the worst financial crisis since the Great Depression are about to find themselves in straitjackets.

As was the case during the aftermath to Hurricane Katrina, Washington seems not up to the task. Instead of facing the problem head-on, President Barack Obama has mostly deferred to state attorneys general. This is a terrible time for Obama to finally discover the virtue of federal restraint.

Delayed foreclosures and litigation regarding how they are carried out might cost U.S. lenders $10 billion, according to one new estimate. Questions could be raised about any foreclosed property, and the only thing between banks and a humungous legal fiasco is the possibility that trial lawyers and state attorneys general will show restraint. Ask tobacco companies how that might work out. Attorneys general are opening widespread investigations, and trial lawyers might tie banks in knots, holding out for fat class-action settlements.

While lines are forming to take a pound of flesh from the banks, their real-estate activities are all but frozen. It will be difficult for lenders to make decisions about future loans with their capital positions so fundamentally in question.

Next Spitzer

The probability that some ambitious, populist attorney general--does the name Eliot Spitzer ring a bell?--goes overboard seems high if the detective work is left to the states. A neutral and authoritative statement of the facts by federal regulators would go a long way toward limiting the legal feeding frenzy. If entire swaths of the foreclosure landscape are deemed high jinks-free, then banks can breathe a sigh of relief and start lending again.

Which means that Washington needs to step in and do what it can to preempt the coming legal morass.

As was the case with Katrina--a different kind of disaster, under a different president--there's a lot of confusion about what role the state and local governments need to play in this mess. To date, Obama has been content to let the states lead. This will allow the same type of extortion game to play out that sucked billions from the tobacco companies.

Obama's position is particularly puzzling in light of the fact that there's a sparkling new federal entity that could take charge of the runaway train.

Attention Please

The Financial Stability Oversight Council, created by the Dodd-Frank financial overhaul law, is charged with maintaining financial stability and monitoring systemic risk. If the council takes its assignment seriously, it should turn its attention to the foreclosure crisis, take authority for resolving it, and do so as swiftly as possible.

A nice place to start would be to identify the percentage of foreclosures that were made in error. If that is very low, and the facts are made public, the litigation wave may be stopped in its tracks.

Anyone who has ever been to a real-estate closing can grasp what is going on. A housing transaction requires that a borrower provide countless signatures on almost every page of a massive stack of paper. Reviewing each page is virtually impossible for typical homebuyers, but that doesn't stop them from signing and attesting that they understand all the terms.

Imagine you are being deposed by an adversarial attorney, who asks: "Are you sure you read every word in the document you signed?" If you're like me, you would have a hard time answering honestly in the affirmative.

Temptation to Skim

During foreclosures, bank officials face a similar temptation to skim, especially when banks are being swamped by thousands of problem cases. It seems clear that many of them yielded to that temptation and then gave false assurances that documents were reviewed carefully.

This doesn't necessarily mean that the foreclosures were in error. But doubts about foreclosure processing mean that virtually every foreclosure that has occurred can now be challenged as invalid. This is true for recent foreclosures that purportedly have been processed by "robos." And it also may apply to foreclosures that occurred in the past. Can banks really be sure that they were more careful three years ago?

The stakes are high. The latest average estimate for U.S. gross domestic product in the third quarter is only 1.9 percent. With growth so slow, it would take only a nudge to push the economy back into recession.

If Washington continues to give the foreclosure crisis the Katrina treatment, the credit contraction that follows will likely be that nudge.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.

Photo Credit: Bigstock/Andy Dean Photography

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