A briefing about the foreclosure fraud crisis: its origin and impacts

Summary: An introduction to the mortgage foreclosure fraud crisis. At this time its size and importance remain unclear, but its evolution and resolution will tell us much about the state of America’s political and judicial systems. Esp see the links to more information at the end.

The story is complex, and well covered elsewhere (see links at the end). This is a brief, with emphasis on the wider implications of the crisis. In a few words, it could have serious effects. Probably more than Wall Street expects, but less than mega-crisis predicted by the crowd.

Background
The problem first emerges
Scope
Beneficial effects?
Ill effects?
Possible solutions?
Forecasts
For more information (updated)

(1) Background

The real estate title system in the US is complex, with safeguards protecting debtor and creditor (for details see this by Barry Ritholz). It’s also local (rules and data are not national). This system worked well for generations, but collapsed during the housing boom.

Loan volume accelerated, overloading key parts of the system. Appraisals were often corrupted, as loan originators routed business to compliant appraisers.
Massive securitization of mortgages ignored these constraints, and erected a pseudosystem on top of it that cheaply processed the high volume of both mortgage origination and securitization (e.g., the Mortgage Electronic Registration System — a faux version of security clearing corporations; see this explanation). Securitization also broke the link between the originator and end owner, with many ill consequences. Among other things, this put great pressures on the servicing firms to lower costs.
During the RE boom years recoveries on foreclosed mortgages were zero or positive, which meant a low rate of foreclosures (homes could be sold by the owner rather than default on the mortgage). So the institutional apparatus for foreclosures atrophied.

The the default bust hit. Massive flow, overwhelming the system — which was never configured for such an event. Remember, experts believed home prices never decline for more than a calendar year. The worst scenario considered by the most experts was flat prices for 3 years.

The servicers (sometimes the bank originating the mortgage, often not) reacted by cutting corners (see this Reuters story). Finding the original loan documents was too expensive, so they used lost document procedures designed for extraordinary circumstances (e.g., fire, flood, or misfiling — see this at Calculated Risk and here at Reuters). Some servicers hired law firms set up as foreclosure mills (e.g., FL), processing incredible numbers of foreclosures. It’s not clear how, but clearly proper procedures were not followed.

As a result there have been many claims that foreclosure notices were never served (an easy way to make serving a high-margin profit center). Employees have admitted under oath in depositions to fraudulently signing thousands of notarized affidavits.

This took place in the 23 states with judicial foreclosures only with the cooperation of Judges. A few Judges protested when shown that their banks and their agents were committing perjury. But the process ran smoothly for the past few years. Now the wheels are coming off. This might be difficult for the financial sector to conceal or mitigate, despite their de facto control over the government’s regulatory machinery.

(2) The problem first emerges

This issue first emerged in 2008, and came into full view in 2009. For example:

“A ‘Little Judge’ Who Rejects Foreclosures, Brooklyn Style“, New York Times, 30 August 2009
“Judges’ Frustration Grows With Mortgage Servicers“, New York Times, 4 September 2009 — The last paragraph shows why banks can flout the law: there are no consequences.

That it has festered for this long, with no corrective action by the government or financial sector, is part of a larger problem: we’ve squandered the time bought (at great cost) with fiscal and monetary stimulus. First aid (bandages and morphine) but no treatment of the problem.

Now it’s become a front-page national issue: The attorneys general of all 50 States will jointly investigate mortgage loan servicers accused of submitting false affidavits, but they stopped short of calling for a national moratorium (see this NYT article).

There are aprox 2.5 million delinquent mortgages (90+ days past due), and 2.3 million in foreclosure.

(3) Size of the problem?

Nobody knows, but guesses range from tiny to massive. Banks are still being caught after their denials (see today’s Financial Times about Wells Fargo). Certainly affected are many securities holding mortgages in the 23 states with mostly judicial foreclosures: CT, FL,HI, IN, IA,KS, KY,LA, ME, NE, NJ, NM, ND, OH, OK, PA, SC, SD, VT, and WI. But it might be far larger, including non-securitized mortgages (e.g., bank held mortgages) and mortgages in single-option states (e.g., the other 27 states, including California).

(4) Beneficial Effects?

A long moratorium on foreclosures would boost consumer spending of families no longer paying their mortgages –a variant of the broken-window effect, just like a hurricane or earthquake. The national average for time from default to foreclosure was 302 days in 2005 — 302 mortgage and rent-free days — in 2005. It’s now 478 days (573 in Florida, 792 in NY). A big inducement to default for people having negative equity houses, especially if paying 40% or more of their disposable income to the bank.

If substantial number of mortgages are voided, then we have more of the deleveraging by default that has so pleased some economists.

(5) Ill effects?

It’s potentially a large hit to both the housing (paralyzing resales) and the finance sector (lost capital), both large and already weak section of the economy. Plus there is potential for substantial lost income and principle for households, institutions (e.g, insurance companies), and pension funds owning mortgages. Perhaps more serious would be lost public confidence in our financial system — rightly so, as this shows a level of criminality and incompetence on banks and government that’s astonishing to all but the most cynical. Will banks commit fraud and perjury but suffer no consequences?

The social effects might go beyond lost confidence. The bank bailouts were the initial spark that ignited the Tea Party Movement. The silent majority is not always silent, and once aroused seldom rational or proportionate in its responses.

(6) Possible solutions?

The problem is solvable. But solutions have become far more difficult to implement now that its caught fire. It’s politicized. There are two dimensions to the problem.

First, what happens to existing mortgages in default, for which there are clear and tested procedures? The banks will have to prove titles. That’s doable, taking only time and money.

What’s the remedy for the millions of fraudulent foreclosures already done? These are fodder for class actions lawsuits seeking punitive damages. Or little might be done, esp with past foreclosures, due to the banks political strength. Washington is largely a wholly owned subsidiary of the Financial sector. Note this bill that blasted thru Congress in a few weeks that might have preempted much of the litigation (the Interstate Recognition of Notarizations Act; see this Huffington Post article for details). A Reuters story about the bill erupted days or even hours before Obama could sign it; the next day he announced a pocket veto of the bill.

(7) Forecasts

The wires buzz with wild guesses about the evolution of this crisis. Wall Street has almost ignored the issue until recently, and the few firms who have written about it forecast few effects. Many others writing about it forecast mega-results. Collapse of public confidence, bankruptcy of banks and government-sponsored enterprises (e.g., FNMA), and so forth. Probably both are wrong:

The odds of a permanent moratorium or a substantial fraction of mortgages being cancelled: zero.
Odds of mortgage default rates rising due to loss of public confidence in the financial system: high.
Odds of large political effects from this: medium.
Odds of some banks suffering substantial losses from increased processing and litigation costs, mortgage write-downs, and under-reserving: medium
Odds of a significant (perhaps 20%) fraction of mortgage paper suffering a large drop in prices: low.
Odds of massive litigation leading to large losses in mortgage paper and bank equity: low.

All of the above increase in event of another leg down in the economy. People will get desperate. Home prices will drop, perhaps 10% or more. Corelogic says 11 million (23%) of home mortgages had negative equity at the end of 2Q, and 2.4 million more had <5% equity. Negative equity is the largest driver of defaults.

Why might the crisis have so little impact? The factors keeping the effects small are the same as those keeping this crisis simmered for 2 years. Judges are bank-friendly. District Attorneys and legislatures are even more so. Today in America money talks so loud that it drowns out our voices.

(8) For more information

(8a) Other reports about this campaign of lawlessness – and actions to stop it

For the best coverage of this problem see the archives of FireDogLake.
Also see the articles by Yves Smith at Naked Capitalism, esp this summary
This problem has been known since 2007! See the history at Calculated Risk (a bank-friendly version)
“Challenges to Foreclosure Docs Reach a Fever Pitch“, American Banker, 18 June 2010
“Fannie and Freddie’s Foreclosure Barons“, Andy Kroll, Mother Jones, 4 August 2010 — Be seated when you read this!
Attorney General Bill McCollum has launched 3 investigations into allegations of unfair and deceptive actions by Florida law firms handling foreclosure cases, press release dated 10 August 2010
“At Elizabeth Warren’s debut, a spotlight on incomprehensible mortgage disclosures“, Slate, 21 September 2010
“JP Morgan Based Home Foreclosures on Faulty Court Documents, Lawyers Claim“, Bloomberg, 26 September 2010
Recommended: “Congress Taking Cautious Approach with Foreclosure Mess“, American Banker, 14 October 2010 — Note how the Republicans are, as always, totally committed to defending business interests. This supports my guess that the political effects will be larger than the economic, and that the banks’ political power will keep results to a manageable level.