Foreclosure Follies

A Massachusetts Supreme Court ruling deals another blow to an already-reeling housing market.

Economic reality is colliding with legal reality and the results are not pretty.  In 2010, for the first time ever, more than one million homes were seized by banks.  The number of foreclosure filings, which includes default notices, houses sold at auction, and those which were repossessed, hit 2.9 million, also a record.  That's economic reality.  Legal reality came courtesy of the Supreme Judicial Court of Massachusetts, which affirmed a lower court ruling  invalidating two mortgage foreclosure sales by Wells Fargo and U.S. Bank.  Neither bank could prove they actually owned the mortgages in question at the time of foreclosure. Where do we go from here?  According to Fox News "(T)he bleakest year in foreclosure crisis has only just begun."

In order for the housing market to recover, it must first find a bottom.  In order to do so, financial institutions must be able to proceed with foreclosures, repossess the properties, get them sellable and eventually move through the enormous backlog of inventory.  Until this process occurs, the market will remain in a limbo of buyers waiting to see if prices will fall further, and sellers, whether they be financial institutions or individuals, wondering how much of a loss they will incur when buyers start making offers.

The ruling in Massachusetts, while technically correct, will exacerbate the problem.  During the housing boom, banks and other lending institutions took millions of individual mortgages and "securitized" them by cutting them into smaller pieces and bundling them together.  The individual "notes," by which the borrower agreed to put up the property as collateral for the mortgage, were then transferred to a trust, and investors in that trust became the mortgage holders.  During the go-go days of such bundling, it is now becoming apparent that the original owners of a given mortgage became obscured by a trail of questionable paperwork leading from one end of the investment chain to the other.

When Wells Fargo and U.S. Bank attempted to foreclose on two houses in Massachusetts, both were doing so on properties whose mortgages did not originate with those banks, but were part of an overall securities package each bank had purchased.  In order to foreclose, a financial institution must prove they actually own the mortgage on the property in question at the time of foreclosure.  Neither bank could do so, and until such time as they can, the homes remain in possession of their owners.  “For homeowners and foreclosures in general, it means that any mortgage foreclosure which was initiated by a securitized trust, at a time when the trust had not obtained a mortgage assignment which gave it the lawful right to do so, is void,"  said Paul Collier, attorney for one of the Massachusetts homeowners. "Those homeowners..still own the property."

Producing the paperwork necessary to foreclose could be a Herculean task.  Many of these securitized mortgages were sold numerous times, and "due diligence," as in maintaining proper documentation of those sales, was one of the casualties of a red-hot housing market. Unfortunately, real estate law requires the physical transfer of such documents, and only those holding the actual note signed by the borrower have the legal standing necessary to file foreclosure and proceed with evictions.  Massachusetts Justice Robert Cordy, who concurred with the court ruling, characterized the sloppy bookkeeping as "utter carelessness" on the part of banks.  “There is no dispute that the mortgagors of the properties in question had defaulted on their obligations, and that the mortgaged properties were subject to foreclosure. Before commencing such an action, however, the holder of an assigned mortgage needs to take care to ensure that his legal paperwork is in order,” he wrote.

The ruling in Massachusetts is the first by a high state court, one which is likely to be echoed in other states where numerous instances of "robo-signing" documents without reading them have occurred.  "The whole robo-signing scandal has caused many judges to mistrust what servicers are saying in foreclosure petitions," said Patricia McCoy, a law professor at the University of Connecticut.  "Many judges will scrutinize filings more closely."

Exacerbating the problem even further is the Mortgage Electronic Registration System (MERS) in which mortgages once recorded in county offices were both digitized and centralized to facilitate securitization.  According to Christopher Peterson, law professor at the University of Utah, 60% of the nation's residential mortgages are now recorded in MERS' name, and "(A)n increasing number of courts have begun taking a dim view of MERS-recorded mortgages and deeds of trust," he wrote in a paper on the subject.  R.K. Arnold, MERS' chief executive disagrees.  "The MERS process of tracking mortgages and holding title provides clarity, transparency and efficiency to the housing finance system," he countered.

In the Massachusetts case, there is little question that the owners of the two homes in question stopped making mortgage payments and were in default.  Nor is there any question that the two banks involved were sloppy with their paperwork, going so far as attempting to provide a proper transfers of the mortgages after the foreclosures, which is why the courts nixed them.  But there is also little question that a multi-state process of delaying foreclosures, which currently comprise 25% of all exiting sales, could further devastate an already battered housing market.  “If banks can’t prove ownership, it will clog up the foreclosure process,” said Blake Howells, head of equity research at Becker Capital Management in Portland, Oregon. “The inventory on foreclosures will keep a lid on housing prices for some time.”

Right now about 5 million borrowers are at least two months behind on their mortgages, and many of those mortgages are "underwater,"  meaning the owners owe more on their mortgages then their homes are currently worth.  And despite potential court rulings, Rick Sharga, a senior vice president at foreclosure tracker RealtyTrac Inc., predicts "1.2 million of those homes will be repossessed this year by lenders," and prices will dip "another 5 percent nationally" before finally bottoming out.  That decline will put even more borrowers underwater on their mortgages, a designation which currently applies to twenty percent of all homeowners.  "2011 is going to be the peak," Mr. Sharga predicts.

Dragging out the foreclosure process serves no one's interest, save those who get to live payment-free until this process is sorted out.  Rather than allowing it to unwind on a state-by-state basis, perhaps the Supreme Court should get involved for the simplest of reasons:  without a stabilization and eventual rebound in the housing market there will be no economic recovery--period.  The largest investment most Americans make is related to all their other spending decisions, and it's no secret that consumer spending, or lack thereof, is the lynchpin of our economy.

That is the tangible effect.  The intangible effect is that which relates to moral hazard.  Many Americans are furious with the idea that a substantial number of their fellow Americans are "gaming the system" and living rent-free while they themselves struggle to make ends meet.  Perhaps some of those who exploited last week's shooting in Arizona to theorize about the sources of Americans' discontent, might want to consider what really gets people angry.  If one will forgive the expression, the answer may be a lot closer to home than many of them imagine.

Arnold Ahlert is a contributing columnist to the conservative website