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Wednesday, July 30, 2008 | City Attorney Mike Aguirre has filed a lawsuit against Bank of America and its new subsidiary Countrywide. The central complaint of the suit appears to be that Countrywide engaged in fraudulent practices by putting people into high-risk mortgages and that Countrywide, as Aguirre put it in a press statement, “originated loans with little or no regard for the borrowers’ financial ability to afford the loans or to sustain homeownership.” The suit is intended to prevent Countrywide (now Bank of America) from initiating foreclosure on any homeowner who has a high-risk mortgage and who actually occupies the home.

The lawsuit may be well-intentioned, but it’s unlikely to help San Diego and there’s a fairly good chance that it will make things worse.

It’s also yet another bailout attempt.

It’s true that many borrowers were defrauded by members of the mortgage industry. The mortgage industry participants involved should be thoroughly smacked around by the long arm of the law.

But the suit seems much more sweeping than that. It attempts to stop Bank of America from foreclosing on any owner occupier — fraud victim or not — with a high risk loan. (“High risk” here is my shorthand for low-down payment, “teaser-rate” loans that trade low initial payments for higher payments down the road). And Aguirre stated that he “would like to see San Diego become a foreclosure sanctuary.” The suit seems less intended to protect fraud victims than to stop San Diego foreclosures outright.

There’s a big difference between those two goals.

It’s true that many borrowers were defrauded. But a lot more borrowers weren’t defrauded. Most of the borrowers who have defaulted or will default on their mortgages are in that situation because they willingly took on high risk loans in order to buy homes that they couldn’t really afford with the intent of profiting from home-price appreciation.

This type of behavior was absolutely rampant during the boom. To cite just one representative statistic, an incredible 67 percent of San Diego mortgages issued throughout most of 2006 had teaser rates.

Rather than being pressured or defrauded into taking on high-risk loans, most boom-time borrowers eagerly snapped them up. Perhaps Countrywide had, as Aguirre put it, “little or no regard for the borrowers’ financial ability to afford the loans or to sustain homeownership.” But neither did the borrowers themselves.

Whether these borrowers acknowledged it or not, they were taking a big gamble on the housing market. When that gamble didn’t pay off, they bailed out.

A sizable subset of this group, incidentally, lied about their incomes so that they could purchase more expensive homes than the lenders would have allowed.

Do all these people really get to be in the sanctuary too?

According to the lawsuit and Aguirre’s statements, the answer is yes. People who took unwise risks and even those who themselves defrauded Countrywide are now being protected, at someone else’s expense, from the consequences of their own actions. Chalk up another bailout attempt.

Whether you consider it a bailout or not, it’s not clear how this suit will help those who deserve it.

Let’s review some background.

It’s important to understand that foreclosures are not causing the housing downturn. The downturn is the result of the massive speculative bubble by which home prices rose far beyond the levels that could be supported by local incomes. Now the bubble has burst and prices are falling back toward reality.

Foreclosures are an effect of this process, not its cause. Most people who default on their mortgages do so because they are “upside-down” meaning that the home loan amounts, which are based on bubble-era pricing, are greater than the values of the homes themselves. Borrowers in this situation often have little incentive to keep paying a loan that’s worth more than the home itself when they could rent an equivalent home for less than they are paying on their loans. So, they stop paying the mortgage.

In this type of situation, preventing a lender from foreclosing doesn’t actually help the borrower, who’d still be better off dumping his or her oversized mortgage.

The only way to actually help the borrower in such a case is to reduce the loan balance so that the borrower is no longer upside down. But that ushers in a whole new set of problems. True, it would help some people at first. But then everyone else, seeing that they could get their loan balances reduced if they stopped paying their mortgages, would want in, too.

The potential chain reaction of mass defaults could cause the entire mortgage market to seize up. This would almost certainly render the housing situation worse, not better.

If Aguirre wants to put a halt to foreclosures without changing loan balances, he won’t help many people. And if he hopes to force reductions in loan principals, he could cripple the mortgage market and substantially worsen San Diego’s housing crash.

The lawsuit carries another potential consequence. No matter who wins this round, lenders may start to feel that they will no longer be allowed to foreclose on homes in San Diego. As a result, they may be reluctant to issue future home loans here without protecting themselves through higher rates. The lawsuit could potentially make it substantially more difficult or expensive for a borrower to get a mortgage in San Diego.

Such futility and unintended consequences are to be expected when politicians try to fight the symptoms rather than the disease.

Here at voiceofsandiego.org we’ve been warning for years that the boom-era frenzy of risky mortgage lending — still well underway when we started writing about it — would have dire consequences. If the lenders were to be taken on, that was the time to do it.

But the risks were studiously ignored back when the good times appeared to be rolling. Now the damage is done. The money’s already been borrowed and home prices have been driven into the stratosphere. All that can be done now is to allow the damage to heal.

Home prices have to come back down to levels that are supported by incomes. The bad loans must be purged from the system. That’s the only fix at this point. This process will not be pleasant, but it will be vital to restoring the long-term health of San Diego’s housing and mortgage markets.

Like all the other bailout attempts we’ve seen, Aguirre’s lawsuit seems intended to short-circuit this crucial return to normalcy. And like other bailouts, it is likely to do more harm than good.

Rich Toscano hosts the “Nerd’s Eye View on voiceofsandiego.org. He is a financial advisor with Pacific Capital Associates*; he also writes about San Diego real estate at Piggington’s Econo-Almanac. Contact him at rtoscano@pcasd.com.

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