The recent Massachusetts Supreme Court ruling against Wells Fargo and U.S. Bancorp is likely to bring foreclosures to a crawl, resulting in a further destabilizing of housing markets. The Court ruling is a major win for debtors and a severe blow for creditors trying to clear a backlog of millions of defaulted mortgages.
The Massachusetts Court set aside two foreclosure sales, citing failure by the banks involved to prove that they actually owned the mortgages at the time of foreclosure. The Court’s ruling stated that “We agree with the judge that the plaintiffs, who were not the original mortgagees, failed to make the required showing that they were the holders of the mortgages at the time of foreclosure. As a result, they did not demonstrate that the foreclosure sales were valid to convey title to the subject properties, and their requests for a declaration of clear title were properly denied.”
The court ruling centers on paperwork errors made when mortgages were purchased from lenders and combined into pools that were assigned to a trustee to be converted into mortgage backed securities (MBS) which were then sold to investors. During this securitization process, mortgages were commonly assigned multiple times before winding up in a trust. Often times, the assignment did not follow proper procedures or was not done at all, calling into question the legal right of the trustee to take title in foreclosure.
Due to the vast numbers of mortgages that were securitized during the mortgage mania, the foreclosure mess could become catastrophic for the banks, housing market and financial system. According to Wikipedia, “There is about $14.2 trillion in total U.S. mortgage debt outstanding. There are about $8.9 trillion in total U.S. mortgage-related securities. The volume of pooled mortgages stands at about $7.5 trillion. About $5 trillion of that is securitized by government sponsored enterprises or government agencies, the remaining $2.5 trillion pooled by private mortgage conduits”.
Bloomberg’s assessment of the situation is equally bleak:
The best scenario is that the disputes are deemed as legal technicalities, which would cause a one-year delay in foreclosures. In the medium case, years of litigation will ensue. In the worst case, the problem becomes systemic, causing “the mortgage market to grind to a halt as title insurers refuse to insure mortgages involving existing homes.”
The extent to which there’s a documentation problem is unknown to investors, Jeffrey Gundlach, chief executive officer of DoubleLine Capital LP in Los Angeles, said in an interview. If widespread flaws are found in the paperwork for mortgage- backed securities, it could roil a housing market already struggling with a freeze in foreclosures prompted by legal challenges to the documents mortgage servicers used to seize homes of delinquent borrowers, he said.
“If people say that you cannot prove that you own the loan, it could be really cumbersome to untangle,” said Gundlach, whose firm manages $5.5 billion in investments, mostly mortgage-backed securities. “It has the potential to spiral into much, much more. There have been many twists and turns to the foreclosure process since the credit crisis started and this is one more turn of the wheel, and it can spin out of control.”
FDIC Chairman Bair recognized this brewing disaster last December. In a statement before the Committee on Banking, Housing, and Urban Affairs, FDIC Chairman Bair discussed the potential adverse impact of foreclosure deficiencies on the financial system and housing markets. According to Ms. Bair, shortcomings in the mortgage-servicing system indicate the need for major reform in order to prevent unnecessary foreclosures, stabilize the housing markets and limit potential losses to major financial institutions. The FDIC’s review to date of supervised state-chartered banks indicate “limited exposure” but the FDIC remains concerned about the potential adverse impact among the largest servicers, most of which are FDIC insured.
The legal confusion descending on the foreclosure process is certain to prolong the housing crisis for many years as the multiple parties involve file lawsuits which will drag on for years. Class action suits by homeowners against banks to delay the foreclosure process will encourage strategic defaults, especially by homeowners with negative equity who become increasing pessimistic about a future recovery in home values. The financially compelling option of default will be chosen by many as the solution for improving cash flow and eliminating the problem of paying on a mortgage that exceeds the value of the house.
The incentives for homeowners to default was recently addressed by Joseph Tracy, Vice President of the Federal Reserve Bank of New York.
The growing inventory of defaulted mortgages continues to weigh down any recovery in the housing market. According to the most recent Mortgage Metric Report by the Office of the Comptroller of the Currency and the Office of Thrift Supervision, there were 598,000 newly initiated foreclosures in the third quarter of 2010.
The combination of declining house prices and increasing delays in the foreclosure process will put upward pressure on default rates as well as losses on defaulted mortgages. CoreLogic estimates that in the third quarter of 2010 there were 10.8 million borrowers in negative equity where the balance on the mortgage exceeds the current value of the property. They estimated that there were an additional 2.4 million borrowers estimated to be in “near negative equity” where the borrower has less than 5 percent equity remaining. Declining house prices will push these near negative equity borrowers into negative equity. This increases the risk that these borrowers will default on their mortgages either out of necessity—say as the result of a job loss—or out of choice, which is called strategic default as borrowers determine that there is little economic advantage to keep paying the mortgage. Longer delays in the foreclosure process further increase the incentive for a borrower to strategically default by extending the period of time that they can live “rent free” in the house. In addition, declining house prices increase the expected losses on those mortgages that do default.
According to Realty Trac, bank foreclosures have accounted for about one out of every three home sales as investors and first time homebuyers purchase foreclosed properties at substantial discounts. In states hit the hardest by the real estate crash, home purchases account for 50 to 75% of total sales. Although the sale of foreclosed properties at discount prices pull down values of comparable homes, there can be no lasting recovery in home values until the huge overhang of foreclosed homes are sold.
With the legality of clear title by banks on foreclosed properties put into doubt by the recent Massachusetts court case, the sale of foreclosed properties is likely to plunge, putting further price pressure on home values. Unless banks can definitively prove ownership of foreclosed properties, title companies will not have a clear chain of title and will refuse to issue mortgage insurance. Without title insurance, lenders will not approve a mortgage loan. Banks could be stuck holding empty foreclosed houses that cannot be sold. Active foreclosure cases will drag on for years in the court system.
With the banks’ legal right to have foreclosed on homes now in question, past purchasers of foreclosed properties are facing the nightmare of being unable to sell or remortgage their home until title issues are resolved. This is no small issue since over 3 million homes have been foreclosed on since 2007 which the banks have been selling as quickly as possible. Purchasers of foreclosed homes who thought they got a bargain are now likely to conclude they got burned instead.