Sunday, October 17, 2010

Itsy Bitsy Spider... the impact of the US Foreclosure Crisis explained

If you follow this blog you know I tend to write about four things.

Real Estate, the Economy, the Banking System and Gold/Silver.

The four are inter-connected.

Lately I have spent a lot of time on the looming Foreclosure Crisis in the United States. I cannot stress enough how major and significant this story is.

A website I like to follow, Pragmatic Capitalism, recently sumarized the significance of this story. I hope you will indulge me with this condensed summary of the issue.

By the end I am confident you will have a crystal clear understanding of it's significance.


We are currently sitting on the precipice of a dangerous cliff. The confluence of a looming bank credit crisis in the US and a sovereign debt banking crisis in Europe could lead to another full-blown world banking crisis.

The potential is there.

Right now the housing recovery in the United States is stalled. Lending is tighter, as is reasonable. Banks actually expect you to have the ability to pay back the mortgage you take out (solid FICO scores) and want reasonable down payments. Only 47% of applicants have the FICO score to get the best mortgage rates.

Enter the Foreclosure Mess. What is actually happening here?

Homeowners can only be foreclosed and evicted from their homes by the person or institution who actually has the loan paper. Only the note-holder has legal standing to ask a court to foreclose and evict. This is important. It is not the mortgage that is important here. The note, which is the actual IOU that people sign, promising to pay back the mortgage loan is what is crucial.

Before mortgage-backed securities (MBS), most mortgage loans were issued by the local savings & loan. So the note usually didn’t go anywhere: it stayed in the offices of the S&L down the street.

But once mortgage loan securitization became a part of the industry, things got sloppy... they got sloppy by the very nature of mortgage-backed securities.

The whole purpose of MBSs was for different investors to have their different risk appetites satiated with different bonds. Some bond customers wanted super-safe bonds with low returns, some others wanted riskier bonds with correspondingly higher rates of return.

Therefore, as everyone now knows, the loans were ‘bundled’ into REMICs (Real-Estate Mortgage Investment Conduits, a special vehicle designed to hold the loans for tax purposes), and then “sliced & diced”... split up and put into tranches, according to their likelihood of default, their interest rates, and other characteristics.

This slicing and dicing created ‘senior tranches,’ where the loans would likely be paid in full, if the past history of mortgage loan statistics was to be believed. And it also created ‘junior tranches,’ where the loans might well default, again according to past history and statistics. (A whole range of tranches was created, of course, but for the purposes of this discussion we can ignore all those countless other variations.)

These various tranches were sold to different investors, according to their risk appetite. That’s why some of the MBS bonds were rated as safe as Treasury bonds, and others were rated by the ratings agencies as risky as junk bonds.

But here’s the key issue: When an MBS was first created, all the mortgages were pristine ...none had defaulted yet, because they were all brand-new loans. Statistically, some would default and some others would be paid back in full... but which ones specifically would default? No one knew, of course.

So in fact, it wasn’t that the riskier loans were in junior tranches and the safer ones were in senior tranches: rather, all the loans were in the REMIC, and if and when a mortgage in a given bundle of mortgages defaulted, the junior tranche holders would take the losses first, and the senior tranche holder last.

But who were the owners of the junior-tranche bond and the senior-tranche bonds?

Two different people.

Therefore, the mortgage note was not actually signed over to the bond holder. In fact, it couldn’t be signed over. Because, again, since no one knew which mortgage would default first, it was impossible to assign a specific mortgage to a specific bond.

So how do you make sure the safe mortgage loan stayed with the safe MBS tranche, and the risky and/or defaulting mortgage went to the riskier tranche?

This is where the famed MERS, the Mortgage Electronic Registration System, comes into play.

MERS was the repository of these digitized mortgage notes that the banks originated from the actual mortgage loans signed by homebuyers. The purpose of MERS was to help in the securitization process. Basically, MERS directed defaulting mortgages to the appropriate tranches of mortgage bonds. MERS was essentially where the digitized mortgage notes were sliced and diced and rearranged so as to create the mortgage-backed securities. Think of MERS as Dr. Frankenstein’s operating table, where the beast got put together.

However, legally... and this is the important part... MERS didn’t hold any mortgage notes: the true owner of the mortgage notes should have been the REMICs.

But the REMICs didn’t own the notes either, because of a fluke of the ratings agencies: the REMICs had to be “bankruptcy remote,” in order to get the precious ratings needed to peddle mortgage backed securities to institutional investors.

So somewhere between the REMICs and MERS, the chain of title was broken.

Now, what does ‘broken chain of title’ mean?

Simple: when a homebuyer signs a mortgage, the key document is the note. As I said before, it’s the actual IOU. In order for the mortgage note to be sold or transferred to someone else (and therefore turned into a mortgage-backed security), this document has to be physically endorsed to the next person. All of these signatures on the note are called the ‘chain of title.’

You can endorse the note as many times as you please... but you have to have a clear chain of title right on the actual note: I sold the note to Moe, who sold it to Larry, who sold it to Curly, and all our notarized signatures are actually, physically, on the note, one after the other.

If for whatever reason any of these signatures is skipped, then the chain of title is said to be broken. Therefore, legally, the mortgage note is no longer valid. That is, the person who took out the mortgage loan to pay for the house no longer owes the loan, because he no longer knows whom to pay.

To repeat: if the chain of title of the note is broken, then the borrower no longer owes any money on the loan.

Read that last sentence again.

The broken chain of title might not have been an issue if there hadn’t been an unusual number of foreclosures. Before the housing bubble collapse, the people who defaulted on their mortgages wouldn’t have bothered to check to see that the paperwork was in order.

But as everyone knows, following the housing collapse of 2007-2010 (and counting), there has been a boatload of foreclosures... and foreclosures on a lot of people who weren’t sloppy bums who skipped out on their mortgage payments, but smart and cautious people who got squeezed by circumstances.

These people started contesting their foreclosures and evictions, and so started looking into the chain-of-title issue, and that’s when the paperwork became important. So the chain of title became crucial and the botched paperwork became a nontrivial issue.

Now, the banks had hired ‘foreclosure mills’... law firms that specialized in foreclosures... in order to handle the massive volume of foreclosures and evictions that occurred because of the housing crisis. The foreclosure mills, as one would expect, were the first to spot the broken chain of titles.

Well, what do you know, it turns out that these foreclosure mills started to fake and falsify documentation so as to fraudulently repair the chain-of-title issue, thereby ‘proving’ that the banks had judicial standing to foreclose on delinquent mortgages. These foreclosure mills even began to forge the loan note itself.

Again, let's repeat that.

The foreclosure mills deliberately, and categorically, faked and falsified documents in order to expedite these foreclosures and evictions. Bloggers have even uncovered a price list for this ‘service’ from a company called DocX, a price list for forged documents.

Talk about your one-stop shopping!

So a massive fraud was carried out, with the inevitable innocent bystanders getting caught up in the fraud. There has been the guy who got foreclosed and evicted from his home in Florida, even though he didn’t actually have a mortgage, and in fact owned his house free and clear. And there was the family that was foreclosed and evicted, even though they had a perfect mortgage payment record.

Now, the reason this all came to light is not because too many people were getting screwed by the banks or the government or someone with some power saw what was going on and decided to put a stop to it... that would have been nice, but it isn't what happened.

No, alarm bells started going off when the title insurance companies started to refuse to insure the titles.

In every sale, a title insurance company insures that the title is free and clear... that the prospective buyer is in fact buying a properly vetted house, with its title issues all in order. Title insurance companies stopped providing their service because, of course, they didn’t want to expose themselves to the risk that the chain of title had been broken, and that the bank had illegally foreclosed on the previous owner.

That’s when things started getting interesting: that’s when the attorneys general of various states started snooping around and making noises.

The fact that Ally Financial (formerly GMAC), JP Morgan Chase, and now Bank of America have suspended foreclosures signals that this is a serious problem...obviously.

Banks that size, with that much exposure to foreclosed properties, don’t suspend foreclosures just because they’re good corporate citizens who want to do the right thing, and who have all their paperwork in strict order... they’re halting their foreclosures for a reason.

The move by the United States Congress last week, to sneak by the Interstate Recognition of Notarizations Act, was all about the banking lobby.

They wanted to shove down that law, so that their foreclosure mills’ forged and fraudulent documents would not be scrutinized by out-of-state judges. The spineless cowards in the Senate carried out their master’s will by a voice vote... so that there would be no registry of who had voted for it, and therefore no accountability.

And President Obama’s pocket veto of the measure? He had to veto it... if he’d signed it, there would have been political hell to pay, plus it would have been challenged almost immediately, and likely overturned as unconstitutional in short order.

As soon as the White House announced the pocket vet, the very next day the Bank of America halted all foreclosures, nationwide.

Why do you think that happened? Because the banks are in trouble... again. Over the same thing as last time... the damned mortgage-backed securities!

The reason the banks are in the tank again is, if they’ve been foreclosing on people they didn’t have the legal right to foreclose on, then those people have the right to get their houses back. And the people who bought those foreclosed houses from the bank might not actually own the houses they paid for.

And it won’t matter if a particular case... or even most cases... were on the up and up: It won’t matter if most of the foreclosures and evictions were truly due to the homeowner failing to pay his mortgage. The fraud committed by the foreclosure mills casts enough doubt that, now, all foreclosures come into question. Not only that, all mortgages come into question.

The full import of what this means is only starting to seep into the collective consciousness.

And as it does, it won't be long before enough mortgage-paying homeowners realize that they may be able to get out of their mortgage loans and keep their houses, scott-free. Once they realize this, that’s basically a license to halt payments right now, thank you. That’s basically a license to tell the banks to take a hike.

What are the banks going to do... try to foreclose and then evict them? You can already hear the cries of "show me the paper, Mr. Banker."

This is a major, major crisis.

The Lehman bankruptcy could be a spring rain compared to this hurricane. It has the potential to bring the system down.

Who will want to buy a mortgage that is in a securitized package with no clear title? Who will get title insurance? Some judge somewhere is going to make a ruling that is going to petrify every title company, and the whole thing grinds to a halt.

Let’s be very clear. If the banks in the US cannot securitize mortgages, there is no American mortgage market. To go back to where lenders warehouse the notes will take a decade for the infrstructure to be built. In the meantime, housing prices are devastated. Whatever wealth effect remains from housing gets worse, and the economy rolls over.

Meanwhile all those subprime and Alt-A mortgages written in the middle of the last decade? They were packaged and sold in securities. They have had huge losses.

But those securities had representations and warranties about what was in them. And guess what, the investment banks may have stretched credibility about those warranties.

There is the real probability that the investment banks that sold them are going to have to buy them back. We are talking the potential for multiple hundreds of billions of dollars in losses that will have to be eaten by the large investment banks.

And all this coming as European banks are going to have to sort out their own sovereign debt problems.

Shades of 2008? It’s all inter-connected. And if you are have stocks in anything related to the financials in any way, you may want to take steps to protect yourself.

Oh what a tangled web has been weaved.



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  1. I understand what you have said but, I don't think you're being very realistic when you say "if the chain of title of the note is broken, then the borrower no longer owes any money on the loan." People still borrowed this money and they still owe it..........I really don't think people are going to getting their houses for free.........lets get real here!!!!!

  2. There are a number of legal viewpoints playing out on this issue.

    Gonzalo Lira has written about a couple and their fight with Wells Fargo Bank. You might find it interesting. You can read it here.

  3. Actually, this is exactly what it means. Until the bank can re-establish a clear chain of titles LEGITIMATELY (through the proper channels like local county's record's office and pay all the dues and fees that they did not and then get slapped for messing with defaulted properties while avoiding taxes through REMIC). That process can take more time than the bank can stay solvent. So let the games begin.

    So yah, for all practical intents and purposes (in the context of a time frame it will take to sort this mess out), these houses are free.