Chicago has been ground zero for the national mortgage crisis in many ways, and critics say that a welcome like the one received by the bankers isn’t surprising in an area where 1/3rd of the homes have underwater mortgages.

Take Back Chicago, organized by a coalition of labor unions and community groups and joined by Occupy Chicago, is just the latest show of public anger at the financial system in the Windy City — and in particular at its handling of the housing crisis.

“The government bailed the banks out on our backs, but they haven’t bailed us out,” said Thurlester Ibrahim, a member the Anti-Eviction Campaign, a community group in Chicago. “We’re losing our homes.”

In August 2011, the Chicago area saw a dramatic increase in home foreclosures – notices of mortgage default, which is the first step in foreclosure, were 6,239 in seven Chicago-area counties, according to RealtyTrac.

In a statement to The Wall Street Journal, the Mortgage Bankers Association acknowledged that they share responsibility for the financial crisis that has devastated communities around the country, and that it has cause their industry a “trust deficit.”

Groups on the state and federal level have tried to remedy this mistrust – most recently, Illinois Attorney General Lisa Madigan opened an investigation into ‘mortgage rescue companies’ in Chicagoland alleged to have used attorneys to collect fees to help customers and then not delivering, cheating homeowners out of nearly $375,000.

Madigan also opened an investigation into allegations of mass robo-signing in Illinois – a practice in which companies signed thousands of foreclosure documents without verifying their accuracy.

Yet some demonstrators say that in a state with an official unemployment rate at 9.9 percent, almost 1 percent higher than the national average, these moves are only a Band-Aid.

“We must target additional revenue for investment in public services and critical infrastructure that will create jobs and stimulate private investment in job creation,” said Curtis Smith, President of Lakeview Action Coalition, calling for a more long-term solution. “Serious living wage job creation is the fastest way to fix the economy – America is not broke, but our economy is broken.”

• Banks repossessed a record 102,134 homes in September. That is the highest monthly count ever recorded, and the first time monthly repossessions have surpassed the 100,000 mark.
• Repossessions also hit a quarterly high. Banks took back 288,345 properties between July 1 and September 30, seven percent more than the previous quarter and 22 percent more year-on-year.
• During the third quarter of the year, banks scheduled auctions on 372,445 properties. That is a record high, up five percent from the previous quarter.
• Sales of properties in foreclosure — whether entering foreclosure, or bank-repossessed — accounted for 31 percent of total sales in September.

Banks are repossessing more homes. That is, of course, difficult for families, but ultimately important for the housing market, as banks take the houses back, resell them and clear their books. But the foreclosure fraud crisis is stymieing and slowing that process, in a way that might cause home prices to slide six months or a year from now.

Why? Rather than selling repossessed homes, banks are holding them — and as foreclosures work through the system, that pool of houses will grow. Eventually, though, when the fraud crisis is worked out, banks will start pushing that backlog of houses onto the market. That will flood the housing market with properties, leading to, analysts fear, another nationwide decline in housing prices. (This is, in part, why the White House is resisting a national moratorium on foreclosure: Nobody wants to seize the entire housing market, one-third of which is comprised of foreclosed properties.)

Nobody quite knows how the foreclosure fraud crisis will shake out. But housing analysts and Wall Street are worried that while prices might go up in the short term (with fewer houses on the market), they will drop in the long term.

A foreclosed home in Winchester, Va. (Jay Mallin/ZUMA Press)

Yesterday, Wall Street giant J.P. Morgan Chase announced a $4.4 billion profit in the third quarter. Wall Street analysts should have cheered. Instead, they golf-clapped, while the bank’s chief executive officer, Jamie Dimon, went on the defensive on an earnings call.

[Economy1] The reason: foreclosures, again threatening everything from homeowners’ security to banks’ bottom lines. In early September, an employee of GMAC Mortgage admitted he had signed as many as 10,000 affidavits, required in 23 states to proceed with foreclosure, a month. The affidavits attested that the employee had personal knowledge of homeowners’ financials before the bank foreclosed. Given that he obviously did not, the paperwork might have constituted fraud and the foreclosures were possibly illegal.

The scandal went big, embroiling mortgage-holding banks like J.P. Morgan Chase in a problem of possibly systemic proportions. Stories of banks lacking required title documentation and evicting the wrong families from homes flooded into the press. Financial companies, including J.P. Morgan Chase, halted foreclosures in the states that require judicial review, and then some halted them everywhere. Members of Congress announced hearings. Finally, yesterday, all 50 state attorneys general announced a probe into systemic problems with mortgage documentation.

On the J.P. Morgan Chase earnings call, Dimon promised that there was “almost no chance we made a mistake” with foreclosures. “We think we should continue and get done and make sure we do the right things for the consumers, the investors and the country. So it obviously will increase our cost a little bit and maybe we’ll have to pay penalties eventually to some of the attorneys general but we really think we should just continue.”

But the financial statement itself proved the lie. The bank said it was carefully checking 115,000 mortgage affidavits. It set aside a whopping $1.3 billion for legal costs. And it put an extra $1 billion into a now $3 billion fund for buying back bunk mortgages and mortgage products.

For banks like J.P. Morgan Chase, the issue is not just the legal headaches. It is the financial blowback. The mortgage-documentation scandal, housing experts warn, runs far and deep — involving not just foreclosure papers, but titles and rights and fiduciary contracts. And it has analysts on Wall Street and politicians on the Hill wondering whether the worst-case scenario might involve not just losses, but bank failures or government bailouts.

The pending mortgage problems resemble those that caused the failure of Lehman Brothers, the credit crunch and the ensuing financial crisis in October 2008: Every bank has problematic mortgage holdings on its books, and each bank is interconnected with every other. Before the bubble burst, investment banks bought up faulty mortgages, many of them subprime loans, from lending banks. Investment banks then bundled the mortgages into mortgage-backed securities, for sale to investors. But just as banks are now foreclosing without proper documentation, they were bundling mortgages without proper documentation — abdicating their fiduciary responsibility to investors and muddying the waters as to who actually owns the loans.

That means the investors who own mortgage-backed securities might argue that the products do not meet the contract standards. If those investors choose to sue the originating investment banks en masse, for breach of contract, they would force the banks to buy back the rotten mortgage-backed securities. That would cost in the hundreds of billions — swamping banks’ profits and sweeping away any cash they might be keeping on hand.

At least one mortgage analyst, Josh Rosner, a managing director at Graham Fisher & Co., has said that if investors force banks to take back the $1.3 trillion of mortgage-backed securities in question, it could create a kind of doomsday scenario pitching the markets back into crisis. Indeed, Rosner believes it could feel very much like 2008 again.

“This is poetic justice,” says Janet Tavakoli, of Tavakoli Structured Finance in Chicago. “The mortgages that seem to be most affected are by predatory lenders, or lenders who engaged in fraudulent practices, like appraising a home for twice its value. The careless investment banks were willing to overlook that fraud. But they just bred fraud into their mortgage-backed securities.”

She does not believe every bank will have face write-downs due to mortgage buy-backs. But she does believe the losses might be substantial. “It’s not clear to me that every mortgage has this problem,” she says. “But there’s no transparency on this issue now. And it is clear that we are dealing with massive, systemic fraud.”

One way or another, some on the Hill are bracing for the worst.

“[Banks will] have to buy back one mortgage at a time,” Rep. Brad Miller (D-N.C.) told The Washington Post. “Someone said there might be a second round of bank insolvencies because of this and there might need to be more TARP. There is no chance that Congress would pass more TARP. It’s hard even to see how it ends. But I’ve got to think it creates more uncertainty about the health of the banks.”

Rep. Alan Grayson (D-Fla.) has gone further, proactively asking the Financial Stability Oversight Council — created by the Dodd-Frank financial regulatory reform law — to step in to stop foreclosures and monitor the banks, just in case.

“There are now trillions of dollars of securitizations of these loans in the hands of investors,” Grayson wrote in a letter (PDF) to the Council, which includes Treasury Secretary Timothy Geithner and Federal Deposit Insurance Corp. Chair Sheila Bair. “The trusts holding these loans are in a legal gray area, as the mortgage titles were never officially transferred to the trusts. The result of this is foreclosure fraud on a massive scale, including foreclosures on people without mortgages or who are on time with their payments. The liability here for the major banks is potentially enormous, and can lead to a systemic risk.”

And it seems the banks — if not J.P. Morgan Chase — are also acknowledging that risk. Josh Levin, an analyst with Citigroup Global Markets, described three potential outcomes to investors, citing work by Georgetown law professor Adam Levitin. The first is that courts consider the erroneous foreclosures technicalities, and the losses are minimal. The second is that banks face significant legislation, but ultimately aren’t forced to buy back mortgage-backed securities.

And the third? “In the worst-case scenario,” he said, “the aforementioned issues become a ‘systemic problem’ which causes the mortgage market to grind to a halt.”

Lawmakers say more work is needed to reform Wall Street. (Flickr: Pamhule)

Soon after Rep. Brad Miller (D-N.C.) came to Washington in 2002, a fellow member of the House Financial Services Committee told him to pick an arcane financial issue — any issue — and to make it his pet topic. Miller chose mortgage finance. He knew little about it. Banking lobbyists peppered him with data, but he had difficulty getting much information from independent sources.

[Economy1] “I was even reduced to reading blogs,” he quipped to a crowd of bankers, community organizers, financial reform experts, hedge fund managers and government aides at the Roosevelt Institute’s conference, “Financial Reform: Will It Work? How Will We Know?” on Monday. But Miller educated himself on the topic and became a leader in pushing for stronger regulation of mortgage products. By 2008, as the financial system collapsed, all of his colleagues in Congress had joined him in reading up on everything from liar loans to naked credit-default swaps.

That period of intense interest is over following the passage of financial regulatory reform legislation this summer, Miller and others said on Monday. But that does not mean that reform is done. In fact, because political attention has flowed from Wall Street to immigration, unemployment and myriad other topics, reform is imperiled. The regulatory law gave guidelines for fixing the financial sector, but the rule-writing process has fallen to dozens of agencies and government bureaucrats currently hammering out the details. That means the real work of reform is just beginning and the country is only incrementally closer to a safer financial system.

“It has become quite clear in recent years that the servant’s servant has become the master’s master,” argued Rob Johnson, a former hedge fund manager and current director at the Roosevelt Institute. Banks, he said, which should help companies merge, access credit and grow, instead ended up leeching off of them, piling on fees and unnecessary products. Ultimately, average Americans suffered. “We do not yet have a balance between society, the real economy and the financial sector.”

A few visiting investors noted that the sector has become more concentrated — due to a number of banks failing, and the others picking up their business — and therefore more dangerous. Each one of the systemically risky banks, like Goldman Sachs, has become more systemically important and therefore more likely to receive government backing if financial troubles re-emerge. (It will take years for Washington to put capital requirements and other safeguards in place.) Moreover, the long process of rule-writing allows banks ample time and opportunity to lobby bureaucrats working on legislation.

And that rule-writing is ongoing among dozens of agencies, including the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, the Treasury Department and the Federal Reserve. The government is also in the process of organizing and hiring workers for the new $500 million Consumer Financial Protection Bureau. And the massive legislation is drawing major lobbying interest. This campaign cycle, the American Bankers Association has pledged $13.6 million on lobbying and $2.1 million to campaigns, pushing for looser rules on banks. J.P. Morgan Chase alone has contributed nearly a million to campaigns this year.

So how will those interested in reform know if it is working in the meantime? The question posed to the gathering of 40 or so met with many answers. “[Reform] would be working if the banks were making a lot less money,” Miller argued. “The reality is for it to be successful it has to be a win-lose-win,” with markets and consumers winning, and banks losing. The Wall Street Journal reported yesterday that financial-sector corporate profits are near their all-time highs.

Sen. Jeff Merkley (D-Ore.) was more optimistic. He praised the reform process, citing the creation of the Consumer Financial Protection Bureau, derivatives reform and proprietary trading regulations as big wins. (Elizabeth Warren, the White House and Treasury advisor helping to build the new bureau, attended the conference but did not speak.)

Still, Merkley conceded, “There is more to do.” He noted that ratings agencies — which stamped triple-A ratings on hundreds of billions of dollars of worthless mortgage-backed products in the run-up to the recession — remained unfixed. (“They’re almost useless,” sighed Jerome Fons of Kroll Bond Ratings agency.)

Others pointed to problems with the derivatives clearinghouses, which might now be the new “too big to fail” institutions. (If banks post insufficient capital to cover their derivatives trades, and another credit crunch hits Wall Street, with investors pulling cash out, the government might be forced to bail them out to calm the markets.) Some criticized the new Treasury Department Office of Financial Research, tasked with understanding Wall Street’s new innovations. Dozens of such niche issues arose.

“There are the tools there to do this,” Mike Konczal, a Roosevelt fellow, said. “Now it’s an issue of political will. [The financial regulatory law] doesn’t presuppose that [reform] will happen. But it does have the tools to do it.”

He concluded: “Those tools sit there, and there’s going to be a lot of pressure not to use them.”

The unexpectedly deep plunge in home sales this summer is likely to force the Obama administration to choose between future homeowners and current ones, a predicament officials had been eager to avoid.

Over the last 18 months, the administration has rolled out just about every program it could think of to prop up the ailing housing market, using tax credits, mortgage modification programs, low interest rates, government-backed loans and other assistance intended to keep values up and delinquent borrowers out of foreclosure. The goal was to stabilize the market until a resurgent economy created new households that demanded places to live.

As the economy again sputters and potential buyers flee — July housing sales sank 26 percent from July 2009 — there is a growing sense of exhaustion with government intervention. Some economists and analysts are now urging a dose of shock therapy that would greatly shift the benefits to future homeowners: Let the housing market crash.

When prices are lower, these experts argue, buyers will pour in, creating the elusive stability the government has spent billions upon billions trying to achieve. “Housing needs to go back to reasonable levels,” said Anthony B. Sanders, a professor of real estate finance at George Mason University. “If we keep trying to stimulate the market, that’s the definition of insanity.”

[...]

“The administration made a bet that a rising economy would solve the housing problem and now they are out of chips,” said Howard Glaser, a former Clinton administration housing official with close ties to policy makers in the administration. “They are deeply worried and don’t really know what to do.”

This is all a little weird. First, the plunge in home sales was not really “unexpectedly deep.” Economists, including economists in the administration, knew perfectly well that the tax credits would pull sales from the summer into the spring. Second, some are “now” urging a dose of shock therapy? Barry Ritholtz, for one at least, notes, “I have been arguing for the government to step away from propping up the housing market for several years now.” Finally, even if the White House is out of ready chips, housing is probably on the precipice of small, localized price declines. And if housing does go south nationally again, the Obama administration could undertake measures like principal write-downs.

For the average worker who has lost her job since May 31, the cost of COBRA has tripled. (Flickr, Steve Rhodes)

In the first week of July, Andie Davis’ husband, who worked in manufacturing, lost his job, as hundreds of thousands of Michiganders have since the onset of the recession. Soon after, he started collecting unemployment insurance benefits that might last the family of four as long as 99 weeks. Davis hopes that the benefits will keep the family afloat — the mortgage paid, school lunches made, the electricity on — without forcing her to tap into the family’s savings.

[Economy1] But to keep the family financially stable while both she and her husband look for work, she has decided to forgo health insurance. The Davis family looked at how much COBRA would cost them, thinking the government would help pay for it. Had her husband lost his job just six weeks earlier, Washington would have footed about two-thirds of the premium bill. But since Davis’ husband lost his job after May 31, the young couple is on their own.

The change has gone little-noticed, both by the press and by the laid-off persons impacted by it. But a popular stimulus provision, the federal subsidy of COBRA benefits, expired for newly unemployed workers as of the first day of June. That means, for the average worker who has lost her job since May 31, the cost of COBRA has tripled.

COBRA — a provision created in the Consolidated Omnibus Budget Reconciliation Act of 1985 — gives workers the option of buying into their old health-care plan when they lose their job. Before the recession, COBRA let workers who lost their job through no fault of their own pay the entire health-care premium plus a two-percent administrative fee to keep coverage, about $8,800 per year for the average enrollee. (Generally, COBRA lasted 18 months.)  As part of the American Recovery and Reinvestment Act, or the 2009 stimulus, Congress subsidized this coverage, given the massive number and economic hardship of laid-off workers. The subsidy paid for 65 percent of health-care premiums for up to 15 months, meaning an average enrollee paid less than $3,000 a year.

For the Davises, under COBRA, coverage might have been a manageable $400 a month. When Davis looked into enrolling her husband and herself, she found it would cost more than $1,100 a month — leaving the family just a few hundred dollars for the mortgage, utilities, gas and food. She sought information on other private plans, but considered all of them too expensive. For now, the Davises are purchasing barebones coverage that will help pay hospital bills in case they are in an accident.

She rationalizes: “Me and the husband, we’re young enough that we can go without visits to the dentist and the [gynecologist] for a year,” and she argues, “I just do not see how it would be worth paying that much money for coverage, when we’re looking at a lot of other problems.” She argues that if the choice is between routine care and paying the electric bill, she will choose the latter. In the meantime, she is praying that her husband’s asthma does not flare up in the fall and hoping that they find jobs soon.

The Davises are one of hundreds of thousands of families doing the same. According to a study of 200 very large employers by Hewitt Associates, the COBRA provision doubled the proportion of laid-off workers enrolling in the program. In the fall of 2008, before the subsidy, about 19 percent of laid-off employees enrolled in COBRA. During the first six months of the subsidy, 38 percent of laid-off workers chose to. Now, with the subsidy’s end, enrollment rates are plummeting.

“Enrollment rates will likely decline over time as workers can’t, or aren’t willing to, afford the high premiums associated with COBRA coverage,” Hewitt’s Karen Frost said in a statement. “It’s possible these laid off workers are simply seeking coverage with a new employer or through their spouse’s employer. Unfortunately, it’s also likely that some are just foregoing health insurance altogether.” The National Employment Law Project estimates that 144,000 individuals and families per month have lost out on the subsidy.

It wasn’t supposed to be this way, but the extension of the COBRA subsidy became caught up in the tax extenders bill — also known as the jobs bill or H.R. 4213 — a large package of popular stimulus provisions that eventually died at the hands of a Republican filibuster. Senate Democrats managed to move unemployment insurance benefits, but few other portions of the popular bill made it through a Senate allergic to deficit spending.

The COBRA subsidy is highly popular: Hart Research found that 70 percent of Americans support extending it.  And many on the Hill fought to keep it in the tax extenders bill or to push it through other provisions. “Millions of Americans have been hard hit by the recession and lost their jobs through no fault of their own,” Sen. Robert Casey (D-Pa.) argued. “If Congress turns its back on them, they will have an even more difficult time making ends meet. With no premium assistance, COBRA health care benefits would consume 75 percent of the monthly unemployment payment for a Pennsylvania family.”

He offered an amendment to keep the subsidy within the jobs packages, and along with Sen. Sherrod Brown (D-Ohio) has offered it as a standalone bill. The Extend COBRA Premium Assistance Program Act of 2010 provides a six-month subsidy for workers laid off between May 31 and Nov. 30. The provision is entirely deficit-neutral, eliminating a tax break on annuity trusts as a pay-for. (The bill is one of many that would extend COBRA. On the House side, Rep. Susan Davis (D-Calif.), for instance, introduced a bill doing so until relevant portions of Obama’s health care bill come into effect in 2014.)

Casey and Brown’s bill is popular — cosigned by Democratic Senators John Kerry (Mass.), Carl Levin (Mich.),  Sheldon Whitehouse (R.I.), Debbie Stabenow (Mich.), Patrick Leahy (Vt.), Christopher Dodd (Ct.), Al Franken (Minn.), Roland Burris (Il.) and Daniel Akaka (Hi.) and supported by a slew of others. But it is caught in committee, and its likelihood of passage any time soon is small.

That means that the popular provision is likely dead, and for families like the Davises, health care coverage will remain an unaffordable luxury.

David Abromowitz, senior fellow at the Center for American Progress, said the main problem with the funding is that lenders will benefit without requiring any concessions or matching of the federal aid. “My concern is what are we asking from lenders who are going to get the benefits source to pay those loans for 24 months,” he said. Under the program, lenders don’t have to make principle reductions on loans or major modifications, he said. Lenders should also be required to make concessions and possibly even match funding. “Banks also should be required to share in the burden being faced by homeowners,” he said.

Despite his reservations with the funding, he emphasized that with millions facing foreclosure, the fragile economy and a slowing economic recovery, “anything that slows or stops foreclosures is good.” “It’s targeted well toward people facing a temporary situation when they can’t pay their mortgage because of unemployment,” he said.

Dean Baker of the Center for Economic and Policy Research also says that he imagines many of the borrowers will end up losing their homes anyway.

I’m a little sunnier on this program — mostly because it is a replica of a highly successful Pennsylvania state program. I wrote in July:

[T]he Emergency Homeowners’ Relief Fund [is] a $1 billion fund to help unemployed workers stay in their homes. [...] Legislators modeled the program after Pennsylvania’s successful Homeowners’ Emergency Mortgage Assistance Program, or HEMAP. Since its creation in 1984, HEMAP has helped 41,500 homeowners with $433 million in loans. About half of HEMAP loan-takers have repaid in full to date. And 90 percent of HEMAP participants have avoided foreclosure.

“Millions of American homeowners, through no fault of their own, have lost their jobs in the current economic downturn and have faced the loss of their piece of the American dream,” [Rep. Chaka] Fattah said in a statement. “[HEMAP] — which the Emergency Homeowners’ Relief Fund is patterned after — is a proven success in Pennsylvania and it will work nationally. It will keep families in their homes, providing emergency relief from foreclosure for those with a proven history of working and paying their mortgage.” He added: “[F]inancial reform isn’t just about saving banks and markets from failure. It has a message for distressed and unemployed homeowners: We won’t allow you to fail either.”

And Pennsylvania has actually expanded HEMAP to keep up with the recession, now allowing loans for up to three years. Housing advocates and many state politicians argue the main problems with HEMAP have been underfunding and too-high rates of loan denial. They also argue that forcing banks to write down mortgages would help to cure the illness rather than treating the symptoms.

Flickr: respres

On Wednesday, Fannie Mae, the government-sponsored enterprise that buys up mortgage contracts from loan originators to keep the housing market liquid, announced new penalties for homeowners who strategically default. “Defaulting borrowers who walk away and had the capacity to pay or did not complete a workout alternative in good faith will be ineligible for a new Fannie Mae-backed mortgage loan for a period of seven years from the date of foreclosure,” the company announced, adding that the policy goes into effect July 1. “Fannie Mae will also take legal action to recoup the outstanding mortgage debt from borrowers who strategically default on their loans in jurisdictions that allow for deficiency judgments.” The new provisions mean that if you strategically default, you likely cannot get a conforming mortgage for seven years. And if you strategically default in some areas, Fannie Mae will come after you in court.

[Economy1] But the Fannie Mae rule — one of several new provisions aimed at penalizing strategic defaulters — raises the possibility that the government and loan servicers might imminently begin targeting an economically vulnerable population, one characterized by housing insecurity and joblessness. It brings up the immediate concern — for both defaulting homeowners and the agencies trying to keep them paying — of how to distinguish “strategic” defaulters from those defaulting because they have no choice. And the data shows that those considering default are by most metrics in financial straits, whether solvent or not.

Consider, for instance, the situation of Charlene Mueller-Holden of Newark, Del. Mueller-Holden is a wife and the mother of two young boys, ages three and six. She lost her $60,000-a-year job as an instructional designer in January 2008. Two and a half years later she has not found a job, despite persistent searching.

“My family is slowly starting to lose the things that everyone takes for granted — a roof over our head and food on the table,” she says. “I was living the American dream. I did everything that everyone tells you to do. I had a great 401k, life insurance and five months’ [worth of] bills sitting in the bank in case of an emergency,” she notes.

The family lives in a modest three-bedroom. After Mueller-Holden exhausted her $1,200-a-month unemployment benefits and the family traded in for a cheaper car, exhausted its savings and tapped its retirement accounts, it has still had trouble keeping up on the mortgage. Her husband brings home around $1,800 a month — the family’s only source of income now. The $1,046.73 monthly mortgage payment started eating up 60 percent of the family’s income. Given food, gas and utilities — plus the cost of keeping the kids clothed and unexpected car repairs — the Mueller-Holdens became hard-up. They refinanced their mortgage under the Home Affordable Modification Plan, seeking to bring the payment down to a sustainable level. Their new payment? $1008.77 — 56 percent of their monthly income. And the balance on the mortgage increased.

“This year my husband’s overtime has been cut out and his hourly salary has been cut and now we are just grateful he has a job,” Mueller-Holden says. “We are beyond struggling. Each month I have to go through our bills to see which one might be able to wait, because we have to buy bread and peanut butter so the kids have something to eat. No more vegetables, no more fresh fruit. No new or used clothes for them this year.”

According to Mueller-Holden, it is not a question of whether the family will default on the mortgage if she does not find work, and fast. It is a question of when and how. The family’s credit score is already seriously tarnished. “I used to have an 820,” Mueller-Holden, says, referring to her FICO score. Imminent default and the six- or twelve-month period before actual foreclosure would provide some relief. No other federal program or bank refinancing initiative will. Indeed, the government itself is on the verge of penalizing strategic defaulters. The FHA Reform Act passed by the House but not yet taken up by the Senate excludes strategic defaulters from receiving Federal Housing Administration-backed loans — a provision included with bipartisan backing, including from most Republicans and Rep. Barney Frank (D-Mass.), the head of the House Financial Services Committee.

The question confronting Mueller-Holdens and the millions of other homeowners facing default is this: How will Fannie Mae and other entities going after defaulters decide what “strategic” default really is? Will they qualify? Will the government or their bank come after them, even when they are on the verge of poverty?

Certainly, over the course of the recession, strategic default has emerged as a phenomenon, with a few particularly famous cases of families pulling the plug on the mortgage and heading to Disney World. The most cited study of strategic default, from credit firm Experian and consulting firm Oliver Wyman, found that as many as 588,000 families strategically defaulted nationwide in 2008 — mostly prime and subprime borrowers in the “sand states” worst hit by declines in home values. Experian and Oliver Wyman deemed people defaulters strategic if they went from having “perfect payment histories” to stopping paying the mortgage entirely, intentionally and suddenly. (All in all, more than three million homeowners received foreclosure filings from banks that year, and banks repossessed 850,000 houses.) But a more recent study by the Federal Reserve showed that four in five strategic defaulters walked away only when deeply underwater, and generally after an “income shock,” such as job loss.

Fannie Mae did not respond to repeated requests for clarification about how hard-up homeowners will need to be before they can default without the new penalties. Thus far, none of the housing experts reached by TWI knew the definition either. The FHA Reform Act that might institute federal penalties for some defaulters instructs the Department of Housing and Urban Development to figure it out. But Mike Konczal of the Roosevelt Institute points to the strictures used by one subprime lender in the 1990s: post-mortgage income of less than $400 a month per family member.

By that standard, Fannie Mae would let homeowners like the Mueller-Holdens off of the hook. They live on just $790 a month after taxes and mortgage payments, but before utilities and all other expenses. (Additionally, they attempted to ameliorate their situation through a HAMP refinancing that ultimately proved useless, as Fannie requests hard-hit borrowers do.) But they exemplify the 5.5 million Americans currently in the foreclosure pipeline. A majority have suffered an “income shock,” like job loss. For many, their mortgage is eating up more than half of their post-tax income.

And now, they have Fannie to worry about.

It is not entirely clear how this will work, because Fannie does not originate mortgages. What will happen, I presume, is that Fannie will somehow blacklist the borrower, making it less likely that a loan-originating bank will give her a mortgage. In this case, I imagine, that borrower will not have access to a conforming loan, meaning she either will not get a mortgage or will get a more expensive and risky exotic product. Additionally, Fannie says that in jurisdictions where it can, it will go after strategic defaulters to get back the money it lost on the mortgage.

Here is the full release, and I’ll update as I figure out just what this means for defaulted borrowers:

Fannie Mae announced today policy changes designed to encourage borrowers to work with their servicers and pursue alternatives to foreclosure. Defaulting borrowers who walk-away and had the capacity to pay or did not complete a workout alternative in good faith will be ineligible for a new Fannie Mae-backed mortgage loan for a period of seven years from the date of foreclosure. Borrowers who have extenuating circumstances may be eligible for new loan in a shorter timeframe.

“We’re taking these steps to highlight the importance of working with your servicer,” said Terence Edwards, executive vice president for credit portfolio management. “Walking away from a mortgage is bad for borrowers and bad for communities and our approach is meant to deter the disturbing trend toward strategic defaulting. On the flip side, borrowers facing hardship who make a good faith effort to resolve their situation with their servicer will preserve the option to be considered for a future Fannie Mae loan in a shorter period of time.”

Fannie Mae will also take legal action to recoup the outstanding mortgage debt from borrowers who strategically default on their loans in jurisdictions that allow for deficiency judgments. In an announcement next month, the company will be instructing its servicers to monitor delinquent loans facing foreclosure and put forth recommendations for cases that warrant the pursuit of deficiency judgments.

Troubled borrowers who work with their servicers, and provide information to help the servicer assess their situation, can be considered for foreclosure alternatives, such as a loan modification, a short sale, or a deed-in-lieu of foreclosure. A borrower with extenuating circumstances who works out one of these options with their servicer could be eligible for a new mortgage loan in three years and in as little as two years depending on the circumstances. These policy changes were announced in April, in Fannie Mae’s Selling Guide Announcement SEL-2010-05.

Mike Konczal at the Roosevelt Institute has some good thoughts on this. My question remains: How does Fannie know who is a “strategic” defaulter, and who is a plain-old defaulter? Most “strategic” defaulters, I have found, would be plain-old defaulters within a matter of weeks or months — particularly given that 80 percent of subprime borrowers who default do so only because of income loss.

In his prepared testimony, Paulson cites governmental homeownership policy as the underlying reason for the housing bubble and ensuing credit crunch:

Underlying the crisis was the housing bubble, and it is clear that several policy decisions shaped the home mortgage market. Excesses in that market eventually led to a significant decline in home prices and a surge of loan defaults which caused tremendous losses in the financial system, triggered a contraction of credit, and put many Americans — quite literally — out on the street. These excesses were driven in large part by housing policy. From 1994 to 2006, home ownership soared from an already spectacular 64 percent of U.S. households to a staggering 69 percent due to the combined weight of a number of government policies and programs. Fannie Mae and Freddie Mac, the government sponsored enterprises (GSEs) comprised a central part of U.S. housing policy. The GSEs operated under an inherently flawed model of private profit backed by public support, which encouraged risky revenue seeking and ultimately led to significant taxpayer losses.

The United States has always encouraged home ownership, and rightly so. Home ownership builds wealth, stabilizes neighborhoods, creates jobs, and promotes economic growth. But it must be pursued responsibly. The right person must be matched to the right house (and consequently the right home loan), and in the years before the crisis we lost that discipline. The overstimulation of the housing market caused by government policy was exacerbated by other problems in that market.

Geithner, in his prepared remarks, instead focuses on regulation:

Nearly eight decades ago, after a series of banking crises led to the Great Depression, the United States put in place broad protections over the financial system. These reforms — deposit insurance, prudential rules to limit risk-taking by banks, and improved transparency and investor protection in our securities markets — alongside the Federal Reserve’s role as lender of last resort, laid the foundation for a more stable banking industry for several decades.

Over time, however, the financial system outgrew those protections. A large parallel financial system emerged outside of the framework of protections established for traditional banks. A great diversity of financial institutions emerged to provide banking services to individuals and companies, and they were allowed to operate without being subject to the same constraints applied to traditional banks. The shift in mortgage lending away from banks, the growth of the relative importance of non bank financial institutions, the increase in the size of investment banks, and the emergence of a range of specialized financing vehicles are all manifestations of this phenomenon.

Of the two, I think Paulson’s are the more interesting comments. Realistically, I fear there is only so much that the government can do in regulatory terms to stop Wall Street from blowing bubbles in the pursuit of profit — in that Washington can do nothing to shut down Wall Street’s trillion-dollar motive to seek outsize returns. But the Hill can turn off the tap of money and credit at the source of those outsize returns. Rising homeownership combined with and stoked by cheap credit not only put millions of people in homes, but created millions of new funding and securitization streams for Wall Street. If getting rid of Fannie and Freddie removes the government subsidy to that pipeline, in a way, housing market reform could be a bigger deal for the banks than the Dodd bill.