The Foreclosure Crisis: Eroding Trust -- and Ending the Recovery?

Mortgage foreclosure crisisThough just about everyone has heard about the scandal over "robo-signing" of foreclosure documents, the issues are so complex that what's at stake isn't always clear. After reading dozens of news accounts, editorials and the most widely followed financial blogs, I've assembled a basic account of the scandal -- and outlined five of its potential implications.

1. That homeowners who failed to pay their mortgages will lose their homes through the foreclosure process is not the primary issue. What's at stake is due process of law.

2. The issue isn't just about a minor "technical procedure," as the banks and mortgage-servicing industry are claiming. Boiled down to its essence, the problem is simple: If an individual citizen did what the banking/mortgage-service industry has done, that is, forge signatures and ignore procedures designed to protect property rights, then the documents would be rejected and the individual would be accused of fraud or embezzlement.

Yet, when banks and mortgage servicers break these same laws, it gets brushed aside as a trivial "oops, we forgot to dot the i" technicality. This flouting of the law by politically powerful banks undermines one of the key tenets of the American way, which is that we're all equal before the law.

The systemic flouting of the law that has been uncovered points to a disturbing conclusion: Two systems of law are operating in our nation, one for "the little guy" and one for banks and mortgage servicers.

Accounts of abuse, ignoring procedural law and gross incompetence are now legion. For instance, one Florida homeowner who didn't even have a mortgage was foreclosed by Bank of America (BAC). Only after a local newspaper began investigating the case did the bank move to sort out what could be viewed as an illegal "taking" of real property.

In another case, Deutsche Bank National Trust filed to foreclose even though it had sold the mortgage to Goldman Sachs, meaning it had no legal right to foreclose. One judge found that roughly half (46 out of 104) of the foreclosure motions filed in his court were so full of errors that he refused to approve them.

Many commentators have already dismantled the bank/mortgage servicers' claims that the legal issues are all just trivial technicalities. It's hardly trivial that documents filed in court are the foundation of our legal system. A signed affidavit is legally equivalent to providing live testimony in court. If an affidavit is untrue, that's the same as lying in court, which is a crime called perjury.

Yet the current system is filled with "robo-signers" who electronically signed up to 10,000 foreclosure filing a month, making a legal claim of their accuracy. Furthermore, though attorneys are prohibited from making a material misrepresentation to the court, it's clear that such misrepresentations of fact (such as who actually owns the mortgage) are widespread in foreclosure proceedings.

3. The system of
slicing up mortgages into pieces and then bundling the pieces into securities is structurally flawed.

In essence, the widespread "packaging" of hundreds of mortgages into mortgage-backed securities (MBS) marketed by Wall Street investment banks has bypassed the property rights laws that underpin ownership and transfer of home loans and deeds.

In the pre-MBS days, a bank would originate a home mortgage and then hold the loan as an asset, collecting the interest and principal payments from the homeowner. But Wall Street banks divided the payments that go toward interest and loan principal into "tranches," or slices, which were assembled by risk and rate of return into pools of mortgages that were then sold as a single security.

With the mortgages divided into pieces that were then bundled into securities that were bought and sold numerous times, the ownership of the underlying mortgage and home often became muddled. This is how two different companies can end up filing foreclosure documents on the same house.

Add in the large number of securitized home equity loans that piggyback on first mortgages and derivative securities such as collateralized debt obligations (CDOs), and you get a nightmarish mishmash of "senior tranches" and multiple claims on the same property.

Stripped of complexity, the issue is straightforward: Every time these securities changed hands, the various claims on the underlying house should have been transferred as well. In many cases, they weren't. In some cases, foreclosures have been allowed even when the original mortgage has been lost.

If you don't need the original document to take someone's home, then exactly what rule of law is at work in America?

4. The nation's system for recording mortgages is woefully inadequate to the task of tracking home loans that have been sliced and diced into tranches and traded freely as securities.

To enable a smooth trading system of these MBS, the banking/mortgage industry set up a privately owned loan-tracking service known as the Mortgage Electronic Registration System (MERS) in 1997. The registry acts a sort of legal proxy of ownership, thereby eliminating the need to record changes in property ownership in the traditional manner, i.e. in local land records.

MERS records loan assignments electronically. It doesn't own the mortgages it registeres, but it's listed in public records as a nominee for the actual owner of the loan or as the original mortgage holder.

Assigning ownership of mortgages to this registry saved the industry a bundle. MERS was estimated to have saved the mortgage industry an $1 billion in its first decade of existence. Some 60 million loans are registered to MERS.

5. Outright foreclosure fraud is now systemic. This includes forged signatures, falsified mortgage numbers, false claims of ownership, false claims that the paperwork has been properly reviewed and document fabrication.

Indeed, for a price, you can have any missing document you might need to file a foreclosure motion "recreated" or "created" out of thin air.

Now that this systemic reliance on falsified documents, forged signatures and myriad "shortcuts" (such as not having the original mortgage) has been revealed, several lenders have halted foreclosures and evictions. Some have stopped proceedings in the 23 states that require a judge's approval, while others such as Bank of America have halted foreclosures in all 50 states.

In response to a public outcry about these widespread abuses, the attorneys general of 40 states are pooling resources to investigate the mortgage and foreclosure industries. One state AG has already filed suit against a leading mortgage servicer, alleging fraud in foreclosures processed by the firm. Ohio Attorney General Richard Cordray said the fraud was the "tip of an iceberg of industrywide abuse of the foreclosure process" and is asking for civil penalties of up to $25,000 for each violation of consumer laws.

Freezing the U.S. Real Estate Market

This systemic breakdown of the procedural laws intended to protect property rights may well have far-reaching consequences beyond lawsuits by public agencies and by individuals who have been harmed or defrauded.

Flawed foreclosure documents mean sales of foreclosed home are in limbo: How can any future owner obtain title insurance when the ownership of the mortgage and thus the integrity of the foreclosure itself is in question?

If millions of foreclosed homes cannot be sold with unambiguously clear titles, then that will effectively freeze a significant portion of the American real estate market. After all, about a third of all home sales involve residences in default or foreclosure.

Fannie Mae has been pulling foreclosed homes off the market, scotching signed deals and removing properties from inventory of unsold homes. Homeowners already in the foreclosure process are now wondering if the foreclosure-fraud debacle can delay or even cancel their impending eviction.

Indeed, the widespread fraud and blatant flouting of the law by politically powerful lenders is eroding many Americans' belief in the fairness of the financial and legal systems. As a result, some are asking why they should continue following the rules when lenders and mortgage servicers evade and abuse the law with impunity.

How Does the U.S. Solve Its Real Estate Crisis?

Stories about middle-class homeowners ensnared in what's either fraud or misrepresentation, depending on one's interpretation, now include a troubling subtext: Some of these once rock-solid citizens are refusing to comply with the demands of lenders.

Some high-visibility commentators are characterizing the foreclosure and MBS debacle as "the biggest fraud in the history of the capital markets." Hyperbole, or simply the truth few dare to state?

While that can be debated, what cannot be debated is the massive loss of trust in the foundations of property rights and rule of law that has occurred. Also not debatable is the impact this loss of trust is having on the housing market, large sections of which are effectively locked.

If distressed mortgages cannot be foreclosed and impaired debts can't be liquidated via auctions or sales on the open market, then how does the U.S. unburden itself of the overhang of housing supply and uncollectible mortgages? It cannot do so with this cloud hanging over the housing and mortgage markets. That will have serious consequences for banks that aren't collecting mortgage payments, for servicers facing massive lawsuits and, eventually, for the value of housing in a market stuffed with a "shadow inventory" of distressed or defaulted homes that can't be sold.

Could the foreclosure mess end up stalling the economic recovery? Perhaps the answer can be found by rephrasing the question: How can an economy be healthy if its mortgage, banking and housing markets are in a state of profound financial and legal disruption?

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