By Suzanne Kapner
Published: November 1 2010 20:14
Just over two years ago, a collapse in US home prices threatened to bring down the global financial system. As that crisis continues to weigh on the world economy, a new upheaval involving the housing market is again engulfing large banks.
The problem cuts to the core of US property law and raises questions about who has the right to foreclose on delinquent borrowers – throwing a still fragile housing market into further disarray. The crisis also casts doubt on whether these loans were underwritten properly in the first place – the result of shoddy practices that could cost the banks as much as $100bn over the next few years and further damage their credibility in the eyes of investors and regulators.
The attorneys-general of all 50 states as well as the US Department of Housing and Urban Development and the Federal Reserve have launched investigations in recent weeks into how banks claim homes from delinquent borrowers. Ben Bernanke, the Fed chairman, told regulators last month that he was “seeking to determine whether systematic weaknesses are leading to improper foreclosures”.
Politicians seized on the issue ahead of Tuesday’s midterm congressional elections because it has the potential to keep millions of borrowers in their homes. That is a voter-friendly strategy given the record 6.7m properties that are in some stage of foreclosure or delinquency, more than double the historical average. With owner-occupiers accounting for about two out of every three households and America’s jobs market still precarious, many more will be worrying that they too may soon face the same fate.
Housing-related issues are thus expected to play a big role in some closely-contested races, including the re-election bid of Democratic senator Harry Reid of Nevada. The state has experienced the sharpest decline of all in home prices, which Zillow.com, a real estate tracking firm, says have more than halved from their peak.
“Faulty documentation undermines fundamental notions of justice and fair play in any legal proceeding,” wrote John Conyers, the Democratic chairman of the House of Representatives committee on the judiciary, in a recent letter to the trustee overseeing the US bankruptcy system. The Senate banking committee is scheduled to hold hearings on the subject when Congress reconvenes later this month.
During the housing boom, banks rushed to originate home loans and then packaged those loans into securities that were sold to investors the world over. At the peak of the frenzy in 2006, roughly 14 homes changed hands every minute of the day, according to Richard Bove of Rochdale Securities. Some of the loans were sold so many times that important papers, including the promissory note and the lien, which gives the lender the right to claim the property if the borrower fails to pay, were lost or never recorded properly in the first place. That creates a situation, according to Mr Conyers, “where banks move to foreclose without adequate proof of ownership”.
Europe so far seems to have skirted the problem, because it relied less on securitisations to finance homes and because more loans were recorded in the old-fashioned way with documentation stored in bank vaults. But banks in the US are also on the hook for loans that investors including Fannie Mae and Freddie Mac, the government-owned mortgage finance companies, say violated underwriting guidelines. Those investors want their money back. Although banks have vowed to fight these repurchase demands, they are setting aside billions of dollars to cover claims.
To make matters worse, as foreclosures mounted, bank staff cut corners by rubber-stamping thousands of court documents without verifying the accuracy of the information they contained. The resulting legal quagmire undermines their ability to evict delinquent homeowners and put those houses back on the market, an important step towards a housing recovery.
Banks have been playing down the issues, saying most are “technical” glitches that are easily remedied. They add that none of the documentation problems have led to improper foreclosures and argue that delinquent borrowers should not be given a free ride just because some paperwork is imperfect.
It is a battle that is being fought in state courts across the country. Although a full-scale resolution will take years, early indications are that judges will not look favourably on financial institutions that flout due process. Judges have repeatedly ruled that banks must prove they legally own these loans before they can take away the homes.
“What the banks are asking is for the courts to just accept their cases at face value,” says Elizabeth Magner, a US bankruptcy court judge for the eastern district of Louisiana, who has sided with homeowners in multiple cases. “What they’ve forgotten is that they still have to prove that they are in the right.”
Investors, too, seem disinclined to take banks at their word, and have pushed the share prices of large lenders to their lowest levels all year. “There is a real crisis of confidence,” says Charles Elson, a corporate governance expert at the University of Delaware.
The documentation firestorm erupted in late September when GMAC, a large mortgage lender now called Ally, unexpectedly halted foreclosures. That followed court depositions in which employees said they had rubber-stamped thousands of affidavits without verifying information such as how much borrowers owed and how behind they were on payments. JPMorgan Chase and Bank of America also temporarily halted foreclosures while they examined their procedures.
More often than not, these so-called “robo-signers” had only a rudimentary understanding of property laws. According to depositions, one worked as a hair stylist and another as a Walmart salesperson before joining the foreclosure departments of banks.
Some of these robo-signers worked at “foreclosure mills”, law firms that prepared documents for court submission on behalf of the banks at cut-rate prices. At one firm in Florida, named after its founder, David J. Stern, document production was outsourced to the US Pacific island of Guam, according to an employee deposition. As foreclosures heated up, Mr Stern allegedly profited handsomely, buying mansions, sports cars and yachts.
Now his firm, along with three others in Florida, is under investigation by that state’s attorney-general for foreclosure practices that were allegedly unfair and deceptive. Mr Stern’s lawyer, Jeffrey Tew, says the firm is co-operating with the civil investigation and has handed 25,000 documents to the attorney-general. Outsourcing document production to Guam is permissible under rules set by the Florida Bar Association, he adds, saying: “Mr Stern has personally not been accused of anything and there have been no charges filed.”
As questionable as such practices may appear, robo-signers are turning out to be just the tip of a very deep iceberg. During the housing frenzy, banks neglected the most basic aspects of record keeping, including how a mortgage is documented at the time of origination.
Back in the good old days, mortgages were recorded with local officials, usually at a cost of $35 each, and every time a loan changed hands the file was updated, creating a tangible paper trail. To avoid paying that fee, banks came up with their own system, a digital registry known as the Mortgage Electronic Registration System. Mers is listed as the creditor on 64m loans, supposedly giving it the right to foreclose on any of those properties if borrowers stop paying.
But according to recent rulings by the supreme courts of Kansas, Arkansas and Maine, Mers is no more than a placeholder and cannot bring foreclosure actions on behalf of the banks. Moreover, it is not even clear whether Mers has the right to sell these mortgages back to the banks, because it may never have technically owned them in the first place. “Mers is a legal fiction created so that the banks could avoid paying fees to the local government,” says Christopher Peterson, a professor at Utah university who has studied the issue. “Financial institutions can change their commercial practices, but they can’t change the law – and that is creating some significant problems for them.”
Mers says it is fighting these rulings and points out that the Kansas state legislature recently overturned the decision by the state’s highest court.
Another legal anomaly, however, involves how these loans were packaged and sold to investors. The loans are supposed to be transferred to the securitising trusts at the time of sale. But the banks, in their haste to sell as many of these securities as possible, cut another corner: they assigned the loans in blank form and planned to fill in the paperwork later. It is unclear whether such practices will hold up in court, raising questions about whether these trusts ever actually owned the loans. That could put their tax-exempt status in jeopardy, potentially saddling investors with a further huge bill.
Will these problems have a real impact on how homes are repossessed, at great cost to everyone involved in the housing market, or are they merely bookkeeping errors, as the banks suggest? After all, no one is making the case that these borrowers are up to date on their payments.
According to Laurie Goodman at Amherst Securities, 25 per cent of the borrowers in California involved in foreclosure proceedings have continued to live in their homes for two years after stopping mortgage payments. In Florida, the proportion approaches 50 per cent.
Mr Elson, the corporate governance expert, says delinquent borrowers should not be let off the hook just because the banks were sloppy in their record keeping. “It’s not right that certain people can default on their mortgage and continue living in their homes, while the rest of us have to pay,” he says. But John Vogel, a professor at Dartmouth’s Tuck School of Business, says that banks need to take responsibility for making bad loans in the first place. “The banks are taking the position that it’s all the borrowers’ fault, when that is clearly not the case,” Mr Vogel says.
Some courts are losing their patience with banks that do not play by the rules. A bankruptcy judge for the southern district of New York is recommending sanctions against JPMorgan for filing documents in a foreclosure case “that appear to be either patently false or misleading”.
In a court filing, JPMorgan says it does not believe sanctions are appropriate but admits that the history of the loan in question “may not have been fully detailed”.
Analysts have begun to tally the carnage. Even worst-case scenarios are not expected to put the banks out of business but “will be a drag on earnings for years to come”, says Paul Miller of FBR, an investment bank. Whatever the outcome at the polling stations on Tuesday, foreclosure problems will exact a hefty price on an already battered mortgage system.
Fannie and Freddie
As repossessions rise and sales fall, the costs of home ownership mount
With its neatly mowed lawn and freshly painted white woodwork, the four-bedroom, red-brick house at 1023 Creek Bend Road looks just like all the other homes on this suburban street in Carrolton, Texas.
But since July – when the house, a 30-minute drive north of Dallas, entered foreclosure – the cost of keeping it spruced up has been borne by Freddie Mac, the government-owned mortgage finance company.
As of June, the latest month for which data are available, Freddie Mac and its larger sibling, Fannie Mae, owned more than 191,000 such properties, nearly double the number of a year earlier. Since both are acquiring foreclosed properties faster than they can resell them, they have warned that the number of repossessed homes on their books will continue to increase.
Fannie and Freddie, known as government-sponsored entities, were created to provide banks with additional financing not to act as landlords. Banks make home loans and then sell some of them to the two GSEs, thereby freeing up their own capital to make further loans.
The system worked fine until billions of dollars of subprime mortgages were pumped through the system during the housing bubble that peaked in 2006. Today, with borrowers defaulting in record numbers, the GSEs – taken over by the government in 2008 following losses arising from the property market crash, and in receipt so far of $148bn from taxpayers – are claiming tens of thousands of foreclosed properties as collateral on these bad debts.
The number of homes on their books is expected to rise even faster as foreclosure moratoriums imposed by major lenders temporarily halt sales, following disclosures that certain procedures for reclaiming homes from delinquent borrowers were not followed. Paul Miller, an analyst at investment banking firm FBR, estimates that such delays could cost $1,000 for each additional month that a home remains in limbo.
Freddie Mac has already spent $500m this year on cleaning bills, taxes and insurance premiums on its “real estate owned” properties. At 1023 Creek Bend Road, repairs and pool maintenance so far total $27,000.
All this upkeep has failed to convince buyers; there have been no offers since the house was put on the market in August for $289,900. Local estate agents say they are seeing more foreclosed homes like this coming on to the market, suggesting that even the well-to-do are having trouble meeting their mortgage payments.
Foreclosure forecast
What will the foreclosure crisis cost the banks? Analysts’ estimates vary widely but relatively conservative numbers from Royal Bank of Scotland put the price tag at:
● $4.3bn to settle fines imposed by the attorneys-general
● $25bn to repurchase faulty loans from private investors
● $13bn to repurchase faulty loans from government-owned mortgage finance companies Fannie Mae and Freddie Mac
Copyright The Financial Times Limited 2010.
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