Bank of America's announcement last week that it was placing a moratorium on foreclosures suggests the financial sector is finally taking seriously widespread reports of document fraud in the buying, selling, and servicing of mortgages. While the full implications of the problems are still unclear, evicted homeowners may see some compensation, even if they probably can't get their homes back. Banks will at least see delays in foreclosure and potentially serious sanctions. They could also see loans they thought they sold boomerang back and end up on their balance sheets.
It's nice to see predatory lending practices -- whose risks banks thought they passed on to the public or the "sophisticated investors" they made a habit of taking advantage of -- come back to haunt big financial firms. But if the worst case scenario comes to pass, we'll essentially be facing Subprime Pop 2.0: major banks faced with huge, unexpected losses, and one more disaster for a weak financial system when we desperately need lending.
But, to borrow a phrase from a certain former White House official, in every crisis there is opportunity. The revelation of this negligence offers the Obama administration and Congress an opportunity to capitalize on the lessons of TARP. Namely, if the public once again steps up to bail out the banks, we will get something -- something big -- in return.
At the heart of the newest twist in the foreclosure crisis are the same bad incentives that blew up the bubble in the first place. Mortgage originators made as many loans as they could to meet the demand from banks, which bought them, crafted them into complex securities, and sold them up the chain. The quality of the loans was practically irrelevant once the banks got done with them, so underwriting standards dropped.
Other standards slipped, too: The legal chore of transferring the ownership of those mortgages up the line requires careful paperwork, and the people in charge were in a bit too much of a hurry. This story blew up after a loan officer revealed in a deposition that he had personally signed off on 10,000 foreclosure documents a month for more than five months -- over 300 a day if he was working weekends. It's unbelievable, and it likely means that investors who bought those mortgages never, technically, owned them. It also means that they didn't, technically, have the right to foreclose on defaulting borrowers.
Ohio Attorney General Richard Cordray sued GMAC, the bank that employed the above "robo-signer," to find out the extent of problems in the document chain and seek sanctions; other state attorneys general are following suit. While banks are downplaying this as a simple mix-up, Cordray is deadly serious, noting that in Ohio and 22 other states where a judge has to certify foreclosure, the oversight is the equivalent of filing false evidence with the courts. (In non-judicial states, these problems still offer an opportunity for foreclosed borrowers to sue the servicers.)
Addressing the legitimacy of foreclosures will primarily occur through litigation between troubled borrowers and their servicers. Determining the extent of the fraud will slow ongoing foreclosure proceedings as borrowers seek to figure out who actually owns their loan. It's also possible that people who bought foreclosed homes will have their purchases undone -- a prospect that could freeze the housing markets.
Perhaps most worrisome to the financial sector is that the mortgages could end up being transferred back to banks. This is already happening on a small scale as government-owned Fannie Mae and Freddie Mac, the mortgage giants that subsidize the housing markets by purchasing mortgages, seek to return those loans they can prove were fraudulent. In 2009, that was at least $2.7 billion in loans. But new questions about servicer practices could mean that many more bad mortgages end up in the banks.
"The quality of the paper that would come back to the balance sheet, if it indeed comes back, is not great," says Geoffrey Rubin, a financial consultant and the executive director of the Cambridge Winter Center for Financial Institutions Policy. "The banks never really anticipated having to deal with it. That's going to be the real shock if it starts coming back in earnest."
It's in no one's interest to see banks take more losses even as simple delays in the foreclosure procedure exacerbate resale and recovery. But we should have learned enough about the financial sector to know that blackmailing the country with financial disaster isn't an option anymore. It's time for a deal.
Experts say the most obvious method for handling these losses is to employ Fannie and Freddie, which took on the brunt of the losses from the subprime crisis -- hundreds of billions and counting. Fannie and Freddie own or insure most of the mortgages in the U.S., and the government could overlook the paperwork irregularities so that Fannie and Freddie can absorb the losses rather than send them back to the banks.
But what does the public get? While the Obama administration has been criticized for its focus on keeping the system flowing, it's true that at least some of these foreclosures are necessary ones, on speculators or people who never should have received a home loan in the first place; halting those hurts everyone. But people suffering from employment problems, those whose mortgages are underwater due to the drop in home prices, and the victims of fraud should have the opportunity for deep principle write downs and substantial loan modifications. Those have been hard to access because servicers devote few resources to working out sustainable loan agreements with borrowers. That could change if the government has the option of putting a serious package of bad loans back onto the banks – primarily Bank of America, J.P. Morgan Chase, Wells Fargo, and Citibank.
"Fannie and Freddie have a huge amount of leverage over their servicers, and they haven't used it thus far," says Alan White, a law professor at Valparaiso University and expert in mortgage law. "There's an opportunity for the GSEs and Treasury to go to the servicers and particularly the big four banks and say, 'You need to do this job and do it properly. Staff up in a serious way, and start showing us some results.'"
Many of the mortgage-title issues will need to be resolved by state governments, which have jurisdiction over real-estate law. State officials like Cordray see an opportunity to force servicers to act in the public interest.
"It would be my desire to have us work on some kind of broader resolution," Cordray told the Prospect. "Certainly loan servicers, now that it begins to dawn on them the exposure they've created for themselves, they need to get more serious about working out loans and loan modifications. To date, they've paid lip service and done very little."