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In Bank of America settlement, who’s feeling the pain?

Regardless of whether the U.S. government’s settlement with Bank of America goes far enough or hits the right targets, the $16.65 billion settlement is significant not simply because of its historic size, but because all Americans — directly or indirectly — were affected by the financial turmoil unleashed by risky lending. And plenty of Americans are still struggling under the weight of bad mortgages.

What was Bank of America’s role in the housing crisis?

Bank of America comes right out with it in their statement Thursday, pointing the finger at residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs).

To understand what those are, and how Bank of America got into legal trouble, requires a review of the housing crisis, and for that we turn to the Making Sen$e vault.

As Making Sen$e has explained before, homebuyers no longer borrow from banks like Jimmy Stewart’s Bailey Building and Loan in “It’s a Wonderful Life.” Instead, a Wall Street firm buys a mortgage, and a bunch of other mortgages, which get pooled together. They then sell off slices of that pool to investors as mortgage-backed securities. So in effect, homebuyers are borrowing from investors.

A collateralized debt obligation groups together — or securitizes — mortgages unequally. As the Baseline Scenario blog describes it, “Some slices are entitled to the first payments that come in each month, and hence are the safest; some slices only get the last payments that come in each month, so when people start defaulting, those are the slides that lose money first.”

There was little fear that the housing market would stop booming; housing was the asset that kept on giving, with Americans buying houses not even to live in, but simply to flip for a higher return. Competition among lenders for borrowers was so competitive, and unregulated, that lenders reduced the percentages required for a down payment. “Some buyers,” as Paul Solman explained in 2008, “were only liable for the loan’s collateral — their home.”

“It was an industry that had sober people thinking crazy thoughts,” Wellesley professor emeritus Karl Case, co-creator of the Case-Shiller housing index, told Making Sen$e Thursday. Case’s poetic reflection on the housing market, just a stanza and a half of which is below, remains one of the best explainers of the crisis.

Fannie and Fred were always ahead,
Then Countrywide got in the fray.
Then Lehman and Merrill and Goldman Sachs
Couldn’t be kept away.
You can guess that MBS
Helped make the trading brisk.
Investors thought that the paper they bought
Was traunched with well-measured risk.

To that, add leverage and default swaps,
And then when house prices fell,
“Smart guys” got hosed as the risks were exposed,
And that was the closing bell.

The risk Bank of America took on as a bank and mortgage lender increased substantially in 2008 when they bought Countrywide, a private mortgage company that had grown by offering sub-prime mortgages to aspirant homebuyers. They got really good at writing paper that made these mortgages look affordable, Case said. Later that year, Bank of America acquired Merrill Lynch, too.

Borrowers, many of whom couldn’t afford their mortgages in the first place, were duped. “It’s kind of like going to your neighborhood grocery store to buy milk advertised as fresh, only to discover that store employees knew the milk you were buying had been left out on the loading dock, unrefrigerated, the entire day before, yet they never told you,” Associate Attorney General Tony West said during Thursday’s press conference.

By the time Bank of America came along, said the National Community Reinvestment Coalition’s John Taylor, it was too late. Regardless of how much they knew about Countrywide’s shoddy lending at the time of purchase, Bank of America inherited a mess of mortgages that went sour fast.

Prosecutors are preparing a separate civil case against Angelo Mozilo, the former chief executive of Countrywide Financial. Mozilo took “extraordinary risk,” said Case, but he doubts that Mozilo intended to collapse the market or thought collapse was likely. “Even people who were underwater,” Case added, “were used to being able to wait for it [the housing market] to recover.”

But it didn’t — and the collapse sent millions of Americans into foreclosure. Meanwhile, Bank of America, Taylor said, is paying the costs of their acquisition of an unregulated predatory lender.

How does the settlement affect shareholders?

So how will the settlement affect consumers, taxpayers, homeowners and the rest of Wall Street?

For everyday consumers — the millions of Americans whose children get lollipops from one of Bank of America’s 5,000 branches or who deposit their paychecks at one of the 16,000 ATMs — the $16.65 settlement means little in a practical sense. The Federal Deposit Insurance Corporation insures depositors’ accounts, so it’s not as if the bank can use their customers’ money to pay off their obligations.

For shareholders, it’s a different story. In the announcement of the settlement, Bank of America predicts that it will reduce third-quarter 2014 pretax earnings by $5.3 billion, or approximately $0.43 per share after tax. So yes, shareholders are expected to take a hit, and some would argue they deserve that as payback for the spoils that came from overtaking risky loans, not to mention benefitting from government bailout money.

But shareholders don’t have that much control over bank governance, said Stanford Business School’s Anat Admati. In fact, there’s no other industry where shareholders have as little control over governance as in banking, said Simon Johnson, former chief economist of the IMF and co-author of several books on the financial crisis.

You simply can’t buy enough shares to hold that kind of sway over a bank; So yes, the settlement will be a small tax on shareholders, said Johnson, but there’s a big gap between the role played by shareholders and chief executives, whom many critics of the settlement complain are getting away scot-free.

Shareholders don’t seem too upset, though, with shares of the bank’s stock increasing 4 percent Thursday after the settlement announcement. Bank of America CEO Brian Moynihan said in a statement Thursday that the bank believes the settlement, “which resolves significant remaining mortgage-related exposures, is in the best interests of our shareholders, and allows us to continue to focus on the future.”

“It’s a good deal for Bank of America,” said Johnson, who would have liked to have seen criminal prosecutions of high-level people inside the bank and thinks that a settlement helps the bank hide more than it reveals about its wrongdoing. Admati agrees that the settlement is largely symbolic.

And yet Karl Case added, there’s an important balance to be struck between not letting Bank of America run away with unjust profits and not ruining them as a lending institution. “Society has an interest in keeping Bank of America alive,” he said.

That the Department of Justice has repeatedly chosen big financial settlements over criminal prosecutions may be a concerted strategy dating back to what’s now known as the “Holder Doctrine.” As deputy attorney general, Eric Holder issued a 1999 memorandum pointing out the long-term consequences of criminalizing a bank, like the loss of jobs.

Cornell Law School’s Lynn Stout, however, told Hari Sreenivasan on the NewsHour Thursday that the settlements will pack a punch because they “hit the corporate entity where the corporate entity hurts, and that is its wallet.”

Going after executives, she added, wouldn’t get at the heart of the bank’s culpability. “It wasn’t the CEOs and the top executives, many of whom found it quite easy to look the other way and not know what was going on,” she said on the NewsHour. Shareholders, she said, were responsible for the incentives that encouraged bad behavior. “It doesn’t trouble me to think that the shareholders are going to pay some of the settlement.”

Consumer Relief: Help for Americans, but too little pain for the bank?

The settlement is two-pronged: only $9.65 billion is a cash penalty, while the other $7 billion will be in the form of consumer relief, which will go toward homeowners struggling with unrealistic mortgages and demolishing “urban blight.”

But as the New York Times reports, those consumer relief efforts might not hurt the bank as much as the headline settlement figure suggests. For instance, one of the basic ways Bank of America plans to help struggling homeowners is through principal write-downs. This simply means they’ll reduce the principal owed by the borrower on a mortgage. And that’s certainly needed for many struggling borrowers, especially those who can’t afford to refinance, said the National Community Reinvestment Coalition’s Taylor.

However, those write-downs may not necessarily come at a direct cost to the bank. In other words, by reducing the principal owed, the bank isn’t shelling out additional money in this part of the settlement; they’re just not taking in as much. It’s the reduction in principal (in dollars) that counts toward the $7 billion in consumer relief.

Furthermore, as the Times reports, some of the loans that would be written down have already been taken over by investment firms and are out of the hands of Bank of America. Tax deductions could also reduce the amount Bank of America owes six states and a handful of federal agencies, as Better Markets’ Dennis Kelleher explained on the NewsHour Thursday.

But even if some critics don’t think the consumer relief is sufficient, most agree that it’s an important part of the settlement. “I think it’s going to be very helpful,” Taylor told Making Sen$e, when it comes to helping people stay in their homes. Case was more measured. “It’s not going to hurt them,” he said, “but it’s not going to get them out from underwater.”

The bigger significance of the settlement, Taylor said, is the message that “regulation matters.” With better regulators, Countrywide might not have gotten away with such predatory lending, and Bank of America might not have bought the private mortgage company, he said. “The wise thing to do,” Taylor concluded, “is to avoid putting ourselves in these positions” in the first place.

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