Mortgage Mess: Shredding the Dream; Major Fight over Enormous Losses Yet to Come

The foreclosure crisis isn't just about lost documents. It's about trust—and a clash over who gets stuck with $1.1 trillion in losses say BusinessWeek writers Peter Coy, Paul M. Barrett and Chad Terhune in a comprehensive 7 page article called Mortgage Mess: Shredding the Dream.

The article kicks off with a high-profile case of Joseph Lents who has been in default for 8 years and is still living in his home because no one can come up with the note. Such cases are extremely rare, yet highly publicized as if they widely occur.

The article continues with a discussion about MERS including this interesting comment:

"The Florida Bankers Assn. told the state Supreme Court last year that in many cases the physical document was deliberately eliminated to avoid confusion immediately upon its conversion to an electronic file."

Then there is the issue of LPS, America's biggest mortgage-and-foreclosure outsourcing firm.

"LPS supplies much of the digital plumbing for the convoluted home-finance system. At the start of 2010 it said its computer programs were handling 28 million loans with a total principal balance of more than $4.7 trillion—or more than half the nation's outstanding mortgage balances."

Because of robo-signings and other questionable practices the U.S. Attorney's Office in Tampa and the state of Florida are investigating whether LPS and affiliated companies have fabricated documents and faked signatures.

LPS employees "seem to be creating and manufacturing 'bogus assignments' of mortgage in order that foreclosures may go through more quickly and efficiently," the Florida Attorney General's Office says in an online description of its civil investigation.

To keep the paperwork moving, LPS uses a variety of incentives. Top-performing workers receive monthLY "Drive for Pride" awards that sometimes include $500 in company stock and a spot in an underground parking garage. LPS also devised a coding system to grade outside foreclosure attorneys based on their speed in completing tasks. Fast-acting attorneys receive green ratings; slower lawyers are labeled yellow or red and may receive fewer assignments. "Bill will move quickly and expect you to be there to pull your weight," says Jerry Mallot, executive vice-president of the Jacksonville Regional Chamber of Commerce. "I wouldn't call the environment at his company kind and genteel."

In yet another case involving HSBC ...

Judge Sigmund, who has since retired, scolded one of HSBC's outside lawyers for being too "enmeshed in the assembly line" of managing foreclosures and ordered her to take extra ethics training. The judge instructed HSBC to remind all of its lawyers in writing not to defer excessively to computerized data systems. LPS, the judge added, did not deserve punishment because the outsourcer had merely provided tools that others misused.

McCollum, the Florida AG, suspects that in other cases LPS is more than an innocent facilitator. In April, he says, "a homeowner contacted us," alleging that LPS paperwork had been "forged in some way.

Fraud investigations are now underway.

Quoting unnamed sources, The Washington Post reported on Oct. 19 that the Obama Administration's Financial Fraud Enforcement Task Force is investigating whether financial firms committed federal crimes in filing fraudulent court documents to seize people's homes.

I hope these fraud cases result in high profile convictions but more than likely a few low-profile scapegoats are tossed to the wolves in an attempt to placate the public.

High States Fight

None of the above is what the real fight is about. The fight is all about who takes the hit for another $1-$2 trillion in losses that are coming.

Even if the documentation problems turn out to be manageable—as Bank of America (BAC) and others insist they will be—the economy will still suffer long-term consequences from the loose underwriting that caused the subprime housing bubble. According to an Oct. 15 report by J.P. Morgan (JPM) Securities, some $2 trillion of the $6 trillion in U.S. mortgages and home-equity loans that were securitized during the height of the bubble, from 2005 through 2007, are likely to go into default. The report says the housing bust will ultimately cause losses of $1.1 trillion on those bonds.

Laurie Goodman, a mortgage analyst at Amherst Securities Group, said in an Oct. 1 report that if government doesn't step up its intervention, over 11 million borrowers are in danger of losing their homes. That's one in five people with a mortgage. "Politically," she wrote, "this cannot happen. The government will attempt successive modification plans until something works."

Wall Street's unspoken strategy has been to kick mortgage losses down the road until an economic recovery reinflates the housing market. The faulty-foreclosure crisis has forced the issue back into the present tense, triggering a fight over who will bear the brunt of those losses. The combatants—all of whom are trying to minimize their share of the damage—include homeowners, lenders and mortgage brokers, loan servicers and the underwriters of mortgage-backed securities, the buyers of those securities, title insurers, rating firms, and the federally controlled mortgage buyers Fannie Mae (FNM) and Freddie Mac (FRD). J.P. Morgan predicts that bondholders will absorb most of the estimated $1.1 trillion loss—but may succeed in foisting about $55 billion on banks. If the bank losses turn out to be steeper than J.P. Morgan and most other analysts expect, taxpayers may be asked to inject more capital into the financial institutions. Fannie Mae and Freddie Mac, already wards of the state, might require more capital as well.

Meanwhile, a high-stakes fight is breaking out between the banks that made loans and the investors who bought them. A shot was fired on Oct. 18 when a group of major investors claimed that Bank of America's Countrywide Home Loan Servicing had failed to live up to its contracts on some of more than $47 billion worth of Countrywide-issued mortgage bonds. The group said Countrywide Servicing has 60 days to correct the alleged violations, such as failure to sell back ineligible loans to the lenders. According to people familiar with the matter, the group includes Pimco, BlackRock (BLK), and the Federal Reserve Bank of New York.

For policymakers, the dilemma is this: Enormous losses will cause problems wherever they end up. They could further harm Fannie and Freddie, which insure the vast majority of the nation's mortgages and have already received nearly $150 billion in taxpayer support. Or, if Fannie and Freddie succeed in pushing the burden back to the banks, the losses could cripple some of the major institutions that have just emerged from a government bailout. Bank of America faces $12.9 billion in buyback requests, and mortgage insurers have asked for the documents on an additional $9.8 billion on which they may consider seeking repurchases, according to regulatory filings. (Bank of America has put aside $4.4 billion for buybacks, and CEO Brian T. Moynihan says the costs will be manageable.) "The Treasury is very aware that they can't push too hard on this because if you do push too hard it might put the companies in negative capital again," says Paul J. Miller, an analyst at FRB Capital Markets. "There's a lot of regulatory forbearance going on."

A Point About Fraud

I have received several emails on the subject of fraud. Let me repeat something I have said many times because some seem to have missed it:

I am well aware of the fraud issues and I hope those who committed fraud end up in prison.

Regardless, fraud is not really what is driving this mortgage mess to the forefront.

The Real Battle

Yves Smith at Naked Capitalism downplayed the takeback issue in More on Why the PIMCO, BlackRock, Freddie, NY Fed Letter to Countrywide on Putbacks Is Way Overhyped.

I see it differently. We have already seen banks forced to do things at "Bazooka Point", and the fact that the NY Fed is involved in one suit against BofA tells me that something will happen.

More than likely a determination of who can afford to take what losses will be factored into any settlement. If so, some big, but not necessarily lethal bank losses are coming. The fight now is how to allocate those losses.

This is not an insignificant fight and I expect a "negotiated at bazooka point" solution that no one will be particularly happy with.

A Look at Proposed Solutions

The article dives into solutions, most of which simply do not work.

Harry Reid Solution

One option, opposed by the Obama Administration and most Republicans in Congress but favored by Senate Majority Leader Harry Reid and others, is a national moratorium on foreclosures. It would last until regulators assure themselves that lenders have straightened out their foreclosure procedures.

This option kicks the can down the road, does nothing to alleviate the foreclosure mess, and adds to bank losses. In short it is hopelessly flawed, so flawed that even Obama will not go for it.

Goodman Solution

Goodman, the Amherst Securities analyst, says banks need to reduce the principal that people owe on their homes so they have an incentive not to walk away. "Ignoring the fact that the borrower can and will default when it is his/her most economical solution is an expensive case of denial," Goodman writes. If the home whose mortgage was reduced happens to regain value, 50 percent of the appreciation would be taxed, she says. Meanwhile, to discourage people from sitting tight in homes while foreclosure proceedings drag on, she would have the government tax the benefit of living in the home rent-free.

Reducing principal has one significant flaw. I discussed that flaw in Why Do Lenders Foreclose Rather Than Make Principal Modifications?

The Seen and Unseen

Lawler answered the question with two questions, but there is another factor at play that is far more important. I am surprised he did not mention it.

Here's the real deal: If lenders gave loan modifications to everyone who was seriously underwater, it would openly invite everyone who was underwater to stop paying their mortgages.

Thus, while it may appear to make economic sense to work out a principal reduction (the easily seen effect suggests the lender would lose less by working out an arrangement than opting for foreclosure then having to unload it at fire sale prices), it is highly likely to be a losing strategy in the long run because it creates a moral hazard of opening inviting everyone who is underwater to stop paying their mortgages.

It is important for lenders to maintain as many consequences as they can (foreclosure is a serious consequence), or they will encourage everyone who is underwater to stop paying their mortgages. Principal reductions would be a mistake from this point of view.

It is always important to consider the seen and the unseen effects of an action.

It's also important to note that principal writedowns would be an immediate hit to earnings. As for the idea to allow homeowners to participate in some of the appreciation, I have to ask why wouldn't they just walk and participate in all of it?

I do not see many takers of such an option.

As for taxing the benefit of living in the home rent-free, I am in favor of taxing the missed mortgage payment as ordinary income after some reasonable length of time. That might even assist the next option.

Citibank Solution

CitiMortgage is testing an innovative alternative based on the legal procedure known as "deed in lieu of foreclosure." The owner turns the deed over to the bank without a fight if the bank promises not to foreclose, lets the family stay in the house after the agreement for six months, and gives relocation assistance.

I like that solution. It helps those foreclosed on for a period of time and ensures the homeowner will not trash the place when they leave.

The caveat here is for the homeowner to make sure they get a full release of all liabilities or someone may come after them down the road for deficiencies. Please see
Before Walking Away Consult An Attorney for problems pertaining to deficiencies.

Harvard Economist Edward Glaeser Solution

Other ideas: In a New York Times blog post on Oct. 19, Harvard University economist Edward Glaeser suggested federal assistance to overwhelmed state and local courts, as well as $2,000 vouchers for legal assistance to low-income families that can't afford to fight foreclosures.

Good grief. Delays add expenses. Giving taxpayer money to help people add further losses to the banking system is simply inane.

Pervasive Sense of Injustice

The article concludes ...

Speed is essential. The longer it drags on, the more the foreclosure crisis corrodes Americans' faith in their financial and legal systems. A pervasive sense of injustice is bad for the economy and democracy as well. Take Joe Lents. The Boca Raton homeowner hasn't made a mortgage payment since 2002, but he perceives himself as a victim. "I want to expose these guys for what they're doing," Lents says. "It's personal now."

By the way, the article points out "Joseph Lents was accused of securities law violations by the Securities and Exchange Commission. Facing a little over $100,000 in fines and fees, and with his assets frozen by the SEC, Lents stopped making payments on his $1.5 million mortgage."

Note that all of this happened because of securities law violations, before robo-fraud, before the big securitizations mess, etc.

These isolated cases get lots of media attention, but the odds are overwhelming that anyone who tries that now will lose their house.

There have been millions of foreclosures, how many cases like this are there?

Joseph Lents is no hero. He is a model for everything that is wrong with the system, on both sides of the equation. He is also a perfect example as to why we need to clear the foreclosure backlog.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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