On Friday, Bank of America announced that it had suspended all foreclosures in the US; many large banks are doing the same. The stated reason for the halt was the need to clean up the foreclosure paperwork process, but in reality BofA is caving to threats from Washington and the trial lawyers. Surprisingly, some of the media reported the profound damage to the housing market that a foreclosure moratorium will cause. Still, the media generally missed the perverse market signals sent by government interference in the mortgage market.

The more left leaning Old Time Media breathlessly reported that some BofA officers had signed thousands of foreclosure notices in a single month, with the implication that without a thorough individual review of each loan contract, BofA could not fairly assert its foreclosure rights. As even the dimmest homeowner knows, the promissory note boils down to this: ‘make every payment on time or you will lose your home to foreclosure.’ Nobody alleges that BofA foreclosed on even a single home performing mortgage. The media, trial lawyers, and Washington pols are simply grasping at straws over the paperwork issue, as everyone who received a foreclosure notice is behind on his payments. How to dispose of the foreclosed property may remain an issue, but the homeowners are absolutely in default. In fact, the actual signature of a foreclosure notice is the final step in a thorough system of billing homeowners and giving them proper notice of non-payment. Since most mortgages are standardized boilerplate documents, reviewing each of them individually is a pointless effort.

The argument that foreclosures should be stopped due to potential paperwork errors is a canard of the socialist left, as the likes of Sen. Harry Reid have argued for a foreclosure moratorium as a matter of social policy. They view foreclosure as a plot by banks to ruin the middle class, but in fact foreclosures are a painful, but essential step toward restoring the US economy. Without foreclosures, the residential real estate market will never find equilibrium, where homes sell quickly and buyers can confidently invest. A tracking survey by Credit Suisse consistently reports a top cause of the slow real estate market is buyer uncertainty as to the direction of prices. Blocking foreclosures leaves a glut of inventory hanging over the market, slowing sales and leaving buyers uncertain about the true value of their new investments. As usual, Washington’s intervention makes matters worse.

In addition to threats by lawyers and politicians, many banks have a further incentive to halt foreclosures – their short term survival. Generally, banks carry their non-performing loans at an estimated value higher than the real market. Non-performing loans often represent overbuilt areas or poorly maintained properties whose real values are lower than similar performing loans. That, combined with traditional overconfidence, leads to a balance sheet of fiction. For many banks, foreclosing on all non-performing mortgages would lead to insolvency and FDIC seizure. These banks are better off slogging along, and paying their officers’ salaries, as long as possible. Unfortunately, this is exactly the pattern of willful ignorance that caused Japan’s lost decade of economic malaise. Without the foreclosure of hopelessly non-performing mortgages and their properties’ sale at the market price, many banks will be unable to write new loans for years. The foreclosure moratorium locks capital into failed investments and denies it to the healthy ventures that could grow the economy and create jobs. The FDIC should step up the sale of bank owned properties, allow even a thousand weak banks to fail, and attract new capital to reform these assets into solvent banks that are able to make new loans.

A foreclosure moratorium also sends perverse signals to homeowners. Without the credible threat of foreclosure, a homeowner whose mortgage is upside down would be foolish to continue payments. Instead of paying his mortgage, this homeowner would more rationally pay down his student loan or credit card; he would rationally take a nice vacation or put money in his IRA before paying an upside down mortgage. If the normal foreclosure process takes a year without a moratorium, a homeowner could live rent and tax free for years under a Reid sponsored foreclosure moratorium.

Rather than egg on lawyers and threaten banks, Reid should encourage the pace of foreclosures. While heartbreaking to many homeowners who genuinely tried to pay their loans, the foreclosure process nonetheless is the only way to restore the banking system to health, encourage new homeownership, and provide predictability to homebuilders who employ tens of millions in the US.