Understanding the Foreclosure Mess


By Mitch Gurney

October 20, 2010

Often a crisis like this goes viral and understandably this one certainly has and following the current events becomes challenging. As I stated in my first posting all parties to a mortgage agreement should be held accountable and face the consequences of their actions if they break the terms of that agreement. Homeowners who have defaulted on their payments and have been foreclosed on should lose their home. The actual holder of the note does have legal standings to foreclose if documentation is in good order and should.  A resolution will be found to fix whenever the ‘chain of title has been broken’ and ambiguity exist as to who the actual holder of the note might be. And a resolution will found for those cases where foreclosure has occurred and fraudulent paperwork was used in place of potentially missing documents. I am certain there may be some folks who will attempt to take advantage of this situation in an attempt to keep their homes but if they are in default this situation should not entitle them to a house scot-free. There have been reports of some homeowners who were not in default that have been wrongfully foreclosed on and in such cases they should get their homes back. I am confident these matters will be fixed especially if authorities want to restore health and integrity to the real estate market.

To bring clarity to my post, The Foreclosure Crisis, No Big Deal Right? Think Again! while following this story at Mish’s Global Economic Trend Analysis I’ve learned that the origin of the quotes used by John Mauldin in his article that I featured are from Gonzola Lira as per his claim in Statement on the Kotok Plagiarism. Mish specifically commented on two statements made in those quotes:


  • To repeat: if the chain of title of the note is broken, then the borrower no longer owes any money on the loan.
  • People still haven’t figured out what all this means. But I’ll tell you: if enough mortgage-paying homeowners realize that they may be able to get out of their mortgage loans and keep their houses, scott-free?

Mish points out:

‘…that is complete nonsense. It will mean delays and legal expenses to figure out who has the right to foreclose, but it sure as hell does not mean borrowers own their house free and clear.

This certainly [is] NOT a license to stop paying the bills and keep houses scott-free. Anyone who tries is going to lose their house!

Mish also points out based on additional input he has received:

The core problem is that the legal issues of note ownership and agency in the foreclosure situation were never settled when trusts were created. Robosigning, MERS, and “show me the note” are all symptoms of that, not causes.

…getting homes for free” is a silly reaction, however, the banks should not be let off the hook for failing to do their legal homework.

If you are learning about this crisis for the first time, understanding what is actually broken here is very important. If you haven’t done so already those interested in gaining a better understanding of this situation I encourage reviewing a five part series of links I provided at the end of my previous post that do an excellent job in explaining this crisis on a basic 101 level by giving a brief explanation including charts. Here are some highlights:

Part I: The Chains and the Stakes

A mortgage consists of two parts. The first is the note, or the IOU, which is the borrower’s promise to pay. The second is the mortgage, which is the security, or the lien, or the actual interest.

Joe’s lending takes the mortgage note to a sponsor to turn these mortgages into a bond. The sponsor was often an investment bank like Bear Sterns. Now that investment bank puts an intermediary in between itself and the trust. This intermediary is usually called a depositor, and sometimes there are several of them in the chain.

What’s the worry here? Well many of these mortgage originators were fly-by-night shops, shady enterprises that collapsed the moment they hit trouble. And many of them cut corners and one of the corners they may have cut would have been to send the note to the trust. Specifically, there is worry that many mortgage originators never sent the notes to the depositors. Originators wanted volume to get fees and may not have done all the paperwork correctly. There are a lot of things that have to end up in the trust when I take out a mortgage, things like the note, title insurance, supporting documents. But the note is the most important.

Why is this important? Well the trustees usually sign several certificates saying that they have verified all the documentation in these trusts. More

Part II: What is a Note, and Why is it so Important?

The note is the IOU, it’s the borrower’s promise to pay. The mortgage, or the lien, is just the enforcement right to take the property if the note goes unpaid. The note is crucial.

Why does this matter? Three reasons… the first is that the note is the evidence of the debt. If it isn’t properly in the trust then there isn’t clear evidence of the debt existing.

And it can’t be a matter of “let’s go find it now!” REMIC law, which governs the securitization, is really specific here. The securitization can’t get new assets after 90 days without a tax penalty, and it can’t get defaulted assets at all without a major tax penalty. Most of these notes are way past 90 days and will be in a defaulted state.

This is because these parts of the mortgage-backed security were supposed to be passive entities. They are supposed to take in money through mortgage payments on one end and pay it out to bondholders on the other end, hence their exemption from lots of taxes; the tradeoff is that they can’t be de facto managers of assets, and that’s what going to find the notes would require. More

Part III: Why are Services so Bad at Their Jobs?

…the first rule of mortgage lending is that you don’t foreclose.  And the second rule of mortgage lending is that you don’t foreclose.  I’ll let Lewis Ranieri, who created the mortgage-backed security in the 1980s, tell you: “The cardinal principle in the mortgage crisis is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fiduciary. The bank, or someone like a bank owned them, and they always exercised their best judgment and their interest. The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary.”

In the past you had Jimmy Stewart banks. The mortgages were kept on the books of the bank. You had someone who you could go to and renegotiate your mortgage. With mortgage-backed securities, the handling of payments and working-out of troubles moved to servicers. Servicers in a mortgage-backed security have two businesses. The first is transaction processing. Their other business is to handle default situations.  In addition to the fixed fee they get for servicing each individual mortgage they get paid from default fees like late charges. They get to retain most, if not all, of these fees. So right away they have an incentive to not find ways to negotiate to get a mortgage to a good state. They also have a strong incentive to keep a steady stream of fees and charges going to their books rather than to investors.  So anything that puts servicers in charge of negotiating mortgages, say the Obama’s administration’s HAMP program is designed to fail… More

Part IV: How Could this Explode into a Systemic Crisis?

Right now the foreclosure system has shut down as a result of banks’ own voluntary actions. There is currently a debate on whether or not the current foreclosure fraud crisis could explode into a systemic risk problem that perils the larger financial sector and economy, and if so what that would look like.

No matter what happens, the uncertainty about notes and what is currently going on with the foreclosure crisis is terrible for the economy. Getting to the heart of this problem so that negotiations can be worked out is important for getting the economy going again. There is little reason to trust what comes out of the servicers and the banks in whatever they conclude at the end of the month, and the market will know that. Only the government can…clear the air here as to what the legal situation is with the notes and the securitizations. [A couple of]…unlikely but dangerous scenarios should this blow up… [could be]…[the] Title Insurance Market Breaks Down; If that happened there would be no mortgage sales (except for those involving cash) in the country. The system would simply stop. Everyone with an interest, from realtors to Wall Street to construction to huge sections of the economy, would face a major crisis through this short-term pinch…[currently]…the title insurance market, which is largely concentrated and also holding very little capital for a nationwide crisis scenario, is investigating the current problems. They are holding off on certain types of foreclosed properties; if they decide to hold off all together you could see a scenario where Congress is pushed to act immediately.

The second would be a wave of lawsuits. As we discussed in Part Two, many of the servicing agreements allowed for the trustees to force the depositors and sponsors to purchase mortgages without notes. That would be 100 cents on the dollar for mortgages worth pennies. If the trustees don’t take action, the investors could sue them. And the tranche warfare on this issue is intense, as foreclosures versus a few more payments radically change the balance between junior and senior tranche holders (See Tracy Alloway on tranche warfare here)… More

Part V: The Necessity of Government action and ways out of the Crisis

Here’s a guess:  In one month, the large banks will conclude that there are no problems with its foreclosure processes.  The massive fraud that was committed on the courts was the result of a few bad apples, but those are now gone and its back to business as normal.

At this point, either as a citizen or as a financial market participant, would there be any reason to believe them? Is there any reason to believe that the servicer and foreclosure mill fraud is over? That [the] securitizations actually have the proper legal documentation necessary?   That borrowers and lenders are actually getting a chance to come to mutually beneficial situations? Is there any reason to believe they aren’t lying?

…Servicers aren’t currently regulated. They have a patchwork of state regulators and the OCC may regulate their parent company if it is a bank or thrift, but there’s no current government agent to provide any accountability here.   So without action, there’s going to be no one to confirm or deny that anything has actually changed in the housing market…More

With the above information in mind I return to additional coverage of more recent developments provided by Mish in which he spotlights where the greater risk could exist and it’s anyone’s guess what the Fed and lending institutions might do with this particular aspect of the crisis:

PIMCO, Blackrock, NY Fed Seek to Force BofA to Repurchase $47 Billion in Soured Mortgages:

At long last, the real issue regarding soured mortgages has stepped up to the plate. Please consider:

Pimco, NY Fed Said to Seek BofA Mortgage Repurchases:

Pacific Investment Management Co., BlackRock Inc. and the Federal Reserve Bank of New York are seeking to force Bank of America Corp. to repurchase soured mortgages packaged into $47 billion of bonds by its Countrywide Financial Corp. unit, people familiar with the matter said.
A group of bondholders wrote a letter to Bank of America and Bank of New York Mellon Corp., the debt’s trustee, citing alleged failures by Countrywide to service loans properly, their lawyer said yesterday in a statement that didn’t name the firms. The New York Fed acquired mortgage debt through its 2008 rescues of Bear Stearns Cos. and American International Group Inc. More

Mish explains:

One way we know this is the real deal is by who is participating. The New York Fed’s participation says this is going to happen.
Right now the number is at $47 billion. How large does it get?
Bear in mind that is $47 billion in mortgages, not $47 billion in potential losses. However the amount is bound to grow by leaps and bounds.
It is curious as to why this took so long.

That these mortgage pools were misrepresented is widely understood.
The banks even knew they were doing it. In case you missed it, please consider:

Smoking Gun: New Evidence of How Wall Street Shafted Pension Funds by Misrepresenting Mortgages; Rep Miller Calls for Full Audit of Fannie Mae:

Josh Rosner, who heads the research firm Graham Fisher, presents new proof that banks knew they were selling bad loans. The following video is as discussion between Rosner and Elliot Spitzer about the smoking gun and what to do about it. It’s well worth a listen…

view video.

Commenting on the Dylan Ratigan Show, Mish also notes:

Democratic congressman Brad Miller calls for an audit of all the loans at Fannie and Freddie to see if they were conforming to the standards necessary to get government backing:

Partial Transcriptview video

MILLER: There are $trillion of mortgage backed securities out there that are very much in doubt. The pension funds have been pushing for some time now to get information about whether the securitizer, the big banks that bought the mortgages and put them in pools, and sold the mortgage backed securities, whether the securitizer should have to buy back the mortgages for not meeting the contractual requirements.
If those banks have to buy back that stuff it’s a big liability.

RATIGAN: Let’s not kid ourselves, it’s lights out…

Mish comments:

Whether or not the buybacks are coming …constitute “Lights Out” or not depends on three factors:

  • Actual volume of forced buybacks
  • Losses on those buybacks
  • How quickly banks have to realize those losses

This can easily drag on for years. However, if it doesn’t and if the losses are significant enough, any banks that have to repurchase mortgages are going to be in serious trouble.

Bank of America has announced they plan to resume the foreclosure push in 23 states:

Bank of America announced on Monday that it would resume home foreclosures in nearly two dozen states, despite the running controversy over how banks handled tens of thousands of cases of homeowners facing eviction.

In commenting on the BofA announcement, Mish observed:

While I find it [hard] to believe that BofA could have validated all of those foreclosures, the fact remains that 99.99% of those being foreclosed on, deserve to be foreclosed on (by someone), if they are in default.
Again, I do not want to make light of “robo-signing” and I am not, because some people ought to face criminal charges over this. Yet, from the perspective of the person being foreclosed on, all this process means (at most) is some potential delays. Given that some foreclosures suspensions are off already, the delays may even be less than I thought.

In contrast, that PIMCO, Blackrock, NY Fed Seek to Force BofA to Repurchase Soured Mortgages is a very big deal for bank earnings, and possibly even for the banking system itself.

The housing market without this foreclosure crisis is in sad shape and while the crisis may not cause the real estate market to collapse this situation certainly doesn’t help it any.

Martin D. Weiss of Money & Markets reported this morning:

The Mortgage Bankers Association (MBA) has just announced that new mortgage applications have slumped again despite some of the lowest interest rates in history — a drop in demand that bodes ill for the entire housing market.

Moreover, the slumping market can only be aggravated by the foreclosure fraud crisis that has burst onto the scene in recent days.

Some people thought Bank of America’s decision this week — to restart its foreclosure machine in 23 states — ended that crisis. But it didn’t.

Right now, as I write these words, the White House is meeting with regulators and administration officials to review federal investigations into the foreclosure fraud crisis.

Also right now, 50 state attorneys general are plowing ahead with their investigations of the nation’s largest mortgage lenders, including Bank of America, JP Morgan and many others.

Judges in Florida and other high-foreclosure states say they’re expecting a flood of legal challenges from defaulting homeowners who see this crisis as a golden opportunity to keep their homes

Will these legal issues ALONE cause the collapse of the mortgage market? Mike Larson tells me the answer is “No, but it’s going to cost the banking industry billions MORE dollars and drag the crisis out even LONGER.”

And make no mistake: The mortgage and foreclosure crisis is already big enough even WITHOUT this additional confusion.  How big?

The most critical measure of the crisis is the percentage of homeowners that are late in making their mortgage payments — the mortgage delinquency rate … and it’s astounding how much it has changed…More

Late this afternoon it was reported in the press that NY to hold lawyers accountable on foreclosures:

The chief judge of New York’s courts implemented a new rule Wednesday requiring every lawyer handling a foreclosure to sign a form verifying that all paperwork in the case is accurate.

The move comes amid an uproar over accusations that mortgage lenders nationwide cut corners on paperwork and legal procedure as they moved to seize millions of homes. It follows a slew of other state efforts to challenge the foreclosure debacle.

Attorneys general in all 50 states and the District of Columbia are jointly investigating whether mortgage companies have violated state laws. In Maryland, an emergency measure approved this week by the state’s highest court outlines how state judges can review foreclosures and stop them if documents are invalid.

Mitch Gurney

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