Citi's Flip-Flop on Mortgage Cramdowns: A Really Bad Idea

Jan.13.09 | About: Citigroup Inc. (C)

Whoa. Citigroup (NYSE:C) really has become a wholly owned agency of the federal government. How else to explain the bank’s sudden willingness last week to support the Democrats’ disastrous mortgage-cramdown bill? I understand corporate executives occasionally lose sight of the interests of their shareholders. But in this case, Vikram Pandit hasn’t just forgotten his shareholders’ interests; he’s put Citi in a position to oppose them outright. This is what happens when the federal government becomes your biggest shareholder: people like Dick Durbin and Chuck Schumer get a hand in running things, and they don’t always have profit maximization (or even fiscal prudence) at the top of their minds. Instead, they seem to want to turn Citi into a publicly traded version of ACORN.

If the term “mortgage cramdown” sounds vaguely unattractive, it may be because, from the lender’s perspective, it is—and costly, too. In particular, the Democrats’ bill in Congress would give a bankruptcy judge the right to unilaterally alter the terms of a bankrupt borrower’s mortgage loan. The judge, of course, would be accountable to no one. Yet he could arbitrarily lower the principal balance, for instance. Or cut the loan’s interest rate. Which is to say, the judge would have the right to vaporize a bank’s assets with the stroke of a pen, and without recourse by the lender. Vikram Pandit now somehow seems to believe this is a wonderful idea.

What in the world can he be thinking? A loan, recall, is a contract, willingly entered into between a lender and a borrower. Usually the loan gets paid back on time and in full. But sometimes it doesn’t. And when it doesn’t, the lender takes a loss. That’s the way business works.

But the misbegotten bill Citi now supports would take that balance between borrower and lender and tip it decisively in the borrower’s favor. That would be a disaster. Depending on what gets churned out of the maw of Congress, borrowers will be sorely tempted to file for bankruptcy solely to get a break on their mortgage terms. It’s as if the Democrats are inviting borrowers to legally steal from banks.

In fact, the consumer groups who support the bill—now Citi’s allies—have things completely backwards. “It is painfully clear,” a group of them said last week in a press release endorsing the bill Citi just agreed to support, “that the continuing, and indeed worsening, foreclosure crisis is perhaps the single largest impediment to economic recovery.”

That’s ridiculous. Rising foreclosures aren’t much of an impediment to recovery at all. The worst-case estimate I’ve seen says that 5 million foreclosures will occur over the entire cycle. That may sound like a lot, but remember that they’ll occur in a country made up of over 100 million households. So the overwhelming majority of people simply aren’t directly affected by the foreclosure spike. In the meantime, mortgage lenders need to have recourse to foreclosure if they want to make affordable loans that are also profitable. Yet Citi has now allied itself with groups that seem to have the wacky idea that foreclosures should be stalled at all costs. The bank seems to have forgotten who its friends are—and who its adversaries are, as well.

Remember what got the industry into this mess. During the height of the housing bubble, a lot of idiotic lenders lent money to people who didn’t deserve it. Now that the bubble has burst, the lenders have seen their mistake and are taking their lumps. Why should borrowers (who include not a few speculators and fraud artists, by the way) suddenly get a break? Why is it supposed to be sound banking policy that the government can go back and change the terms of contracts that were freely entered into, after the fact—and always in the borrower’s favor?

The move will cost the banking industry billions, for which the banks will get nothing in return. Oh, and will likely cost you some serious money too. Why? If the bill passes, mortgage lenders will inevitably raise interest rates and tighten terms, to pay for the higher credit costs and uncertainty the bill will undoubtedly cause to occur. Those higher mortgage rates will in turn put added pressure on home prices—which will exacerbate the housing crunch, not help end it. Wonderful.

I’ve been tempted to stick up for Pandit’s leadership at Citi (or at least give him the benefit of the doubt) since the major screwups at the company weren’t of his making. But his cave-in to the Democrats on cramdowns is his own doing. It’s a disgrace. From now on, Vik Pandit hasn’t just inherited the mistakes of others. Now he’s making his own, and the first one is outrageous.