Who Will Pay for Bad Mortgages?

Chidem Kurdas

The good news is that the US economy continues to grow despite panic rounds caused by the European debt crisis. The not so good news: housing losses continue to drag the economy while regulators, banks, investors and homeowners battle over who will bear the brunt of the real estate bust.

The problem is how to allocate the losses, said Joseph Tracy, executive vice president at the Federal Reserve Bank of New York, speaking at the New York State Society of Certified Public Accountants. Government-sponsored entities Fannie Mae and Freddie Mac want to return bad mortgages to the lenders; the latter not surprisingly resist this; borrowers blame the banks; the banks blame the borrowers.

The most recent salvo in this struggle was news that Standard and Poor’s is being investigated by the Securities and Exchange Commission for its rating of mortgage-backed collateralized debt obligations. Investors in CDO tranches no doubt prefer that somebody else take the fall. That somebody else could be a rating agency but typically is a bank.

All this has huge consequences. Regulators, GSEs and courts may force banks to take on losses. Those potential losses in turn are a drag on bank shares and bank lending. Weaker banks, of course, mean a weaker economy.

Current owners of CDOs – including hedge funds – are not necessarily making a loss. Many bought the securities dirt cheap in the 2008-2009 panic and stand to make a profit. Some of the sellers no longer exist or are still winding down.

This question has been overshadowed by the similar issue of who is going to pay for bad Greek debt—-the answer to that one, it seems, is mostly Germans.

Mr. Tracy did not provide an answer as to who will pay for bad US mortgages, but he suggested that the sooner this is resolved, the better. He sees the long-term picture as one of moderate growth, which means a short-term stimulus will not be effective. The issue is how to shape the environment to encourage long-term growth, he says.

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