Wow, someone in DC has connected the dots: that the banks’ failure to adhere to contractual and legal requirements in the residential mortgage backed securities market are so extensive and widespread as to constitute systemic risk. Alan Grayson, Congressman from Ground Zero of the foreclosure mess, is calling on the Financial Stability Oversight Council to investigate the escalating foreclosure fraud crisis.
Although the data points we have seen so far could be considered anecdotal, we have evidence that strongly suggests that major RMBS originators, the investment bank packagers, and the bank trustees failed to convey the notes (the borrower IOU, which is critical to having the legal standing to foreclose in 45 states) to the RMBS trusts starting in 2005, perhaps even earlier. And comments from industry insiders suggest this problem is pervasive.
That puts a cloud over the entire US RMBS market, the biggest asset class in the world. This paper was sold as secured; the ability to offset the cost of borrower defaults by seizing and selling his house is critical to the value of the instruments. And if no assets were conveyed to a particular trust by closing, an even uglier possibility exists: under New York law, which was elected by RMBS as governing law for the trust, it would be considered to be “unfunded”, which means it does not exist.
Now the rather sick irony is that this monster screw-up probably affects Fannie and Freddie paper only indirectly; presumably, it will a given that this will be treated as if the government guarantee covers this little mess. The Obama Administration is the last bunch of folks that will look into the fine print to see if Fannie and Freddie ought to eat this liability. I’ll admit I have not looked into the Fannie/Freddie procedures on this one, but I’d have trouble believing their rules would include having the government guarantee extend to operational screw ups that prevent losses on guaranteed mortgages being relieved by foreclosures. I’d have to believe they have putback procedures which will not be applied because the consequences would be too devastating to Team Obama’s best friend, the banking industry. So Frannie and Freddie not pushing the losses related to foreclosures back to the banks would be yet another back door bailout.
Felix Salmon is also on the case and makes some sound observations as to the larger implications:
….the mother of all legal messes has already emerged from the foreclosure crisis, and threatens not only a large chunk of the financial system but also venerable civic institutions, like the courts, which have thus far emerged from the crisis largely unscathed….Yves here. It appears there are four ways this crisis might play out:
Argentina’s sovereign default has been called “the slowest trainwreck in history”, but this one might turn out to be slower, bigger, and much less fair. Millions of people have already lost their houses to lenders who didn’t have the proper paperwork, and it’s unlikely they will ever get any redress. For people who haven’t yet been foreclosed upon, however, it could now be a very long time before they lose their house.
The big-picture consequences here are by their nature unpredictable, as no one has a clue how this might all play out. But I can think of a few themes:
1. Bond investors, who have seen the value of their mortgage-backed debt rise impressively over the past 18 months, could find themselves unable to find any kind of bid at all. The paper will still be cashflowing, but those cashflows will be surrounded by enormous uncertainty, and no one’s going to want to buy them except at extremely deep discounts until the mess is cleared up.
2. Mortgage servicers will go from being assets to being liabilities, and banks which own mortgage servicers could find themselves on the hook for substantial losses.
3. The time from default to foreclosure will become indefinite, and as a result there will be a significant uptick in strategic defaults, especially in states with judicial foreclosures.
4. The “shadow inventory” of houses which aren’t on the market but will eventually be sold once the bank gets around to foreclosing will grow substantially from its already-enormous level.
1. Congress intervenes to try to wave a magic statutory wand to make many of these problems go away, invoking its authority over national/interstate banks. To the extent industry incumbents admit there is a problem (Tom Adams reports there was amazing denial at an American Securitization Forum conference earlier this week), they immediately say, “Congress will pass a law.” But any Federal statutory remedy will run roughshod over well settled state real estate law and New York trust law. This is big state/Federal rights matter, potentially one of those rare Constitutional battles that the average citizen will care about.
2. The Federal government comes up with a mass refi program of sorts. Even though in theory that might also run afoul of various state law issues, the reason the states are fighting is they see the devastation foreclosures are creating in their cities and towns. It would probably take some to-ing and fro-ing, but state legislatures would be far more inclined to play ball with this solution than the one outlined in point 1. But this is so contrary to how Team Obama operates that I see no will to go down that path, and the odds that the incoming Congress will be even more anti-spending is another not-trivial impediment.
3. Mass deep principal mods. As we indicated, there are programs which are ready to go and only need some tweaking to help servicers make deep mods. With mortgage loss severities at 70% or worse, a 40% principal mod for borrowers, say, is a win for everyone but the servicer. And before readers howl that this is unfair, life isn’t fair. Moreover, lenders restructure loans all the time; it’s normal creditor behavior to rework a loan if the outcome looks to be more profitable than liquidating.
The critical bit is assessing borrower viability. There is no point trying to save borrowers who are so broke they can’t afford payments even with a reduction in principal to, say, the current market value of the house. The and the NACA program provides a platform for handling what has been the sticking point, collecting evidence of borrower income and preparing a budget so a bank can see how much discretionary cash flow he has.
While the banking industry will insist this would be a simply horrid outcome, what would turn the tide is private or attorney general suits in a particular state leading to a mass resolution. That would turn the tide regarding perceived viability.
But mass mods would also leave the servicers with big losses on all the advances of principal and interest they have made to investors, and will force banks to end their phony accounting on second mortgages. It’s entirely plausible this puts some banks back in the TARP, which from my perspective is a good outcome. It would be hard after all the banks’ false claims that all was well and outrageous 2009 bonuses not to seem some pain imposed, at a minimum, the firing of top management for cause (meaning no severance) and the replacement of boards.
4. Continued gridlock. I expect this to be what we see until the pressure hits the breaking point.
Below is the text of the Grayson letter, which is addressed to Timothy Geithner, Shiela Bair, Ben Bernanke, Mary Schapiro, John Walsh (Acting Comptroller of the Currency), Gary Gensler, Ed DeMarco (FHA) and Debbie Matz (National Credit Union Administration):
October 7, 2010
Dear Secretary Geithner and members of the Financial Stability Oversight Council (FSOC),
The FSOC is tasked with ensuring the financial stability of the United States, which includes identifying and addressing possible systemic risks. There is a well-documented wave of foreclosure fraud sweeping the country that presents such a risk. Bank of America and JP Morgan Chase have both suspended foreclosures in 23 states where that fraud could be uncovered and stopped by the courts. Connecticut has suspended foreclosures.
I write to encourage the FSOC to appoint an emergency task force on foreclosure fraud as a potential systemic risk. I am also writing to ask the members of the FSOC to use their regulatory authority to impose a foreclosure moratorium on all mortgages originated and securitized between 2005-2008, until this task force is able to understand and mitigate the systemic risk posed by the foreclosure fraud crisis.
So far, banks are claiming that the many forged documents uncovered by courts and attorneys represent a simple ‘technical problem’ with foreclosure processes. This is not true. What is happening is fraud to cover up fraud.
The mortgage lending boom saw the proliferation of predatory lending and mortgage fraud, what the FBI called at the time ‘an epidemic of mortgage fraud.’ Much of this was lender-induced.
When lenders – many of whom are now out of business – originally lent money to borrowers, they often did so knowing that the terms of the loans could not possibly be honored. They sought fees, not repayment. These lenders put people in predatory loans, they induced massive amounts of fraud, and Wall Street banks misrepresented these loans to investors when they moved through the securitization chain. They were stealing money from investors, and from homeowners.
Obviously these originators and servicers didn’t keep good records of who owed what to whom because the point was never about getting paid back, it was about moving as much loan volume as possible as quickly and as cheaply as possible. The banks didn’t keep good records, and there is good reason to believe in many if not virtually all cases during this period, failed to transfer the notes, which is the borrower IOUs in accordance with the requirements of their own pooling and servicing agreements. As a result, the notes may be put out of eligibility for the trust under New York law, which governs these securitizations. Potential cures for the note may, according to certain legal experts, be contrary to IRS rules governing REMICs. As a result, loan servicers and trusts simply lack standing to foreclose. The remedy has been foreclosure fraud, including the widespread fabrication of documents.
There are now trillions of dollars of securitizations of these loans in the hands of investors. The trusts holding these loans are in a legal gray area, as the mortgage titles were never officially transferred to the trusts. The result of this is foreclosure fraud on a massive scale, including foreclosures on people without mortgages or who are on time with their payments.
The liability here for the major banks is potentially enormous, and can lead to a systemic risk. Fortunately, the Dodd-Frank financial reform legislation includes a resolution process for these banks. More importantly, these foreclosures are devastating neighborhoods, families, and cities all over the country. Each foreclosure costs tens of thousands of dollars to a municipality, lowers property values, and makes bank failures more likely.
I appreciate your willingness to assess possible systemic risks to the country, and would again encourage you to suspend foreclosures until this problem is understood and its ramifications dealt with.