Fixing the Finance Fiasco

With consumer prices climbing and the end of the mortgage meltdown nowhere in sight, it becomes tempting to counsel those trapped in predatory home loans to walk away. After all, the creditors who made the original loans will receive their collateral as repayment. The former homeowners, who have had shelter for as long as they lived in the foreclosed properties can consider their payments rent. It seems just to allow predatory lenders to lose money on foreclosed properties, reaping the crops they have sown. Let those who made the bad decisions bear their consequences, right? Wrong.

The underlying assumption here is that finance companies can sell their stock of houses to whoever can afford to buy them, and that they will take the loss. But these lenders are much too smart to get left holding the bag. That is where you and I come in.

Lenders who foreclose on a property and resell it for a loss have a few tricks for avoiding and sharing the pain. The first trick is to send the dispossessed an IRS form 1099-C, Cancellation of Debt statement, a copy of which goes to the federal government.

The former homeowner is now liable to the IRS for taxes on the reported “income.” For most of us, that amounts to about a third of whatever number is filled in on the form. If the lender loses $30,000, the buyer owes $10,000 to the IRS. As creditors go, the IRS is the worst. Penalties and interest on tax debt increase it very quickly, and are exempt from bankruptcy proceedings.

The lender next turns to one of the federally-chartered corporations or agencies that guarantee virtually all home mortgages, like the Federal Housing Administration (FHA), Fannie Mae, or Freddie Mac, and files the equivalent of an insurance claim. For now, lenders receive a percentage of the money they have “lost” and report the rest on their income statements as a loss. Doing so has enabled them to show investors that net profits were okay before those pesky losses. Eventually, however, Fannie and Freddie are going to be unable to pay out on these loan guarantees, and the pesky losses will grow beyond the industry’s ability to absorb them. Both corporations were already showing net losses as of 2007.

Fannie Mae’s corporate managers further exposed themselves to sub-prime risk when they agreed to help bail out Bear Stearns. But since salaries are a cost of doing business and come out of gross revenues, managers and CEOs will continue to make six-figure incomes while first borrowers, then the rest of us, suffer.

The burning question is “What can we do?” The Federal Reserve seems to think that loosening credit will help. Most folks would not attempt to put out a fire by pouring gasoline on it. If too-easy credit caused the problem, making borrowing even easier is unlikely to solve it.

Requiring lenders to renegotiate loans on reasonable terms is a start. Federal regulation not only of the mortgage industry, but of corporate executive compensation packages could help. Requiring a modicum of financial literacy among borrowers also seems reasonable.

If, in the words of our commander-in-chief, we choose to stay the course, the bottom will fall out in the foreseeable future, and the amount of wealth that will evaporate with it is astronomical. The mutual funds, money market funds and the stock market have absorbed the shock so far. They cannot do so indefinitely, although most Americans seem to think otherwise.

While most ordinary Americans may not own stocks per se, they usually have some kind of retirement savings program, which probably owns stocks, including mortgage funds. When the bubble bursts, those retirement funds are going to be hurt along with the banks, home buyers, mortgage brokers. The hot-shots at the top of the financial food chain, however, are going to be laughing all the way to the bank.

Remember Enron? This time, it won’t be “them;” it will be us.

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