Swagel, BrookingsMy last post discusses one aspect of Phillip Swagel’s insider description of the thinking at the Bush/Paulson Treasury on the financial crisis, its inability to see, let alone grasp the implications of, the massive fraud in mortgage origination.

Swagel, who served as Assistant Secretary for Economic Policy from December 2006 to the end of the Bush administration, provides insight into Treasury’s rationale for rejecting Bankruptcy Cramdown as a partial solution to the problem. Commenter danps calls it “patently dishonest”, and I agree. Here are Swagel’s own words:

To avoid more foreclosures required someone to write a check—either the government or lenders. The attraction of the so-called bankruptcy cram down proposal, under which bankruptcy courts could retroactively change mortgage contracts by reducing the loan principal, was that it appeared to be “free”— it was to the government—but this is because the cram down is a forced transfer from lenders to homeowners. Treasury opposed the cram down proposal out of a concern that abrogating contracts in this way would have undesirable consequences for the future availability of credit, especially to low-income borrowers. Some current borrowers would benefit from having their mortgage balance reduced, but future ones would find it more difficult to obtain a loan.

Even as a metaphor, this is intellectually dishonest. No one has to write a check. The lender already wrote the check, and the reality is that the money is gone. Avoiding a foreclosure requires lenders to accept that loss, to recognize their failure as lenders or investors, to admit that they are not masters of the universe, just stupid banksters. Why should they admit to their abject failure, or worse, admit to their participation in the whole fraudulent scheme of over-selling mortgages to people who could never afford them? They can blame the victim, and get the Congress to give them money for nothing.

Cram down is not a forced transfer from lenders to homeowners. The stupid/crooked lender already gave the money away. Cram down is the way the loss is shared among all creditors. The secured creditor gets the value of its collateral. The difference, the loss, is an unsecured claim. In a Chapter 13 case, the Debtors pay the mortgage, and maybe a car loan, and the rest of their disposable income is paid to the pool of unsecured creditors pro rata. This is so sensible, we do the same thing in Chapter 11 reorganizations.

The Sacred Contract argument makes a brief appearance, this time in the form of concern trolling about low-income borrowers, the possibility that they will be cut off from credit going forward. Corporations use Chapter 11 to modify their contracts, and it doesn’t seem to affect the ability of other corporations to borrow. Rich people like Donald Trump use personal Chapter 11 cases to restructure their mortgages on their second and third homes. That doesn’t stop banks from lending to rich people. Competent lending is about making sure that the income of the borrower is enough to pay the debt. It works for low-income people as well as for middle and high income people. It isn’t rocket science, just basic banking. But, of course, that is so old-fashioned, hardly suited to paying banksters giant piles of money.

The most horrifying thing about Swagel’s argument is that it ignores the source of the problem. It wasn’t the borrowers who caused the problem. It was the lenders, who made fraudulent loans to people who couldn’t repay. Fraud increased the demand for pricier houses. If borrowers were limited to amounts they could repay, they would have been buying cheaper houses. Starting in 2002, rising prices were the result of artificial, fraudulent demand. Those weren’t real prices, and they aren’t coming back. And Paulson knew it: he thought the problem was that too many people were in the wrong house, not the wrong mortgage.

There is a moral hazard problem here: banks are getting bailed out of their fraud and breach of their duties to shareholders and taxpayers. The solution is to teach banksters and their investors that they have to eat the losses they caused by fraud. Anything else is an abdication of responsibility. Why do the people who perpetrated this fraud get money from taxpayers? Why aren’t they prosecuted, or at least fired and sued? And why can’t Americans get relief from the overwhelming fraud in bankruptcy?

The Bush/Paulson Treasury shows its true colors. It is a tool of banks. I’m not seeing anything better from the Obama/Geithner/Summers Treasury.