The Fraud-Closure Gate

What’s at stake: The issue of fraudulent foreclosures and potential large scale compliance failures by banks during the foreclosure process is raising major concerns for the financial system and for the recovery in the US housing market. Indeed, the prospect of irregularities in the millions of already foreclosed homes opens the doors for litigations and class action of an unprecedented scale potentially crippling banks balance sheets while expected delays and suspensions in present and future foreclosure could freeze the housing market and delay the adjustment of this vital sector to the recovery of consumer confidence and demand.

A status report

Brad Delong has a map of the US as a foreclosure nation showing the percentage of foreclosure per state. In September 2010, more than 15% of houses in Florida and in Nevada are Nevada are in foreclosure.

Mother Jones takes us back to the chain of events that led its reporter Andy Kroll to unearth the first evident cases of fraudulent foreclosures in Florida which hit the mass media in the beginning of august and soon became the fraudclosure gate. This article from the Washington Post turned what was then a few foreclosure failures into a real scandal by showing how frauds was effectively at the heart of hundred of thousands of foreclosures which couldn’t have occurred if the due process had been followed.

Mike Konzcal from Rortybomb blog offers a very didactic series of 5 posts on the fraudclosure gate and the different aspects of the frauds and the technicalities governing the foreclosure process. It highlights the lacks of checks and balances and the relative absence of clear ownership of the mortgages due to the securitisation process.

Calculated Risk writes that one of the interesting questions is why several (but not all) mortgage servicers used "robo-signers". "Robo-signers" are individuals who signed affidavits stating that they had "personal knowledge" of the facts in a foreclosure case, when in fact they did not. There are several reasons: the flood of foreclosures, the lack of experienced staff, rampant corner cutting – and also the fact that several of the servicers seemed to use the same service providers to set up their processes (probably the lowest bidder). In a response to this post, a blog reader argues that refusing to ask “Why did the servicers prepare so many fraudulent documents?” is evidence of a very advanced stage of denial. Robo-signers were just a manifestation of a much larger issue that was already becoming a problem.

The cost for lenders and to the economy

According to Paul Miller, the bank analyst at FBR Capital Markets Faulty, faulty foreclosures may cost U.S. lenders $2 billion for every month that home seizures are delayed and the tab could reach $6 billion. Investigations of how banks are seizing homes may prolong foreclosures by as much as three months, at a rough cost of $1,000 per month for each property in the pipeline. He also noted that the real true cost is not the expenses; it’s the drag in the foreclosure system.

Zero Hedge argues that banks, and especially regional banks, are about to experience the mother of all delinquency-to-foreclosure cliff events, as delinquent borrowers now certainly will have no intention of ever paying down their mortgage if they have doubts in the foreclosing process.

James K. Galbraith argues that we don’t know what the real implications of this will be. We don't know the full extent of the frauds. We don't know the effect of the ongoing exposure of fraud on the behavior of people with mortgages. We don't know the full extent of the losses by banks and investors in mortgage-backed securities as delinquencies mount and foreclosures fail. What we know is that prospective losses to the banks are of three separate types: (i) losses due to foreclosure sales that cannot be realized on defaulted homeowners because foreclosures are blocked up. (ii) losses due to additional delinquencies taking advantage of the breakdown in the foreclosure process. (iii) losses due to suits by investors (and to actions by Fannie Mae and Freddie Mac) forcing banks to take defective residential mortgage-backed securities back onto their own balance sheets, and to absorb losses they thought to have passed along to those investors.

James K. Galbraith argues that the most likely effect on most home prices is to push them down, increasing the number of underwater mortgages and the temptation to strategic default. Some houses previously foreclosed may become unsalable, owing to doubts about the integrity of title. This effect could impair the sale of all houses with mortgages registered electronically, since the release of a mortgage at time of sale can be definitive only if, in fact, the system reliably tracks the claims. However, there may be a contrary price effect for some homes – those with clear title and especially those not mortgaged – as potential buyers seek to protect themselves from title risk.

The FRBSF Economic Letter describes how changes in house prices lead to changes in the probability of default. It argues that the rational default point is below the "underwater" point where house price equals the remaining loan balance, and depends on prospects for future house price appreciation and borrower default costs. Analysts must be careful in calculating the precise default point on mortgages. We should not expect a discrete jump in default rates once house prices fall to the threshold at which home value equals the remaining book balance on the mortgage. Barring life events, borrowers are likely to stay in their houses until they are well beyond the book value underwater mark.

ETF guide argues that residential mortgage backed securities (MBS) are likely to become embroiled in the mis-foreclosure mess. What if mortgage securities contained within a mortgage sausage pool were created with inadequate loan documentation? What are the securities worth? And if they’re worthless, how and when will it be reflected in bank’s balance sheets? When will credit agencies begin their wave of credit downgrades or will they be late to the party like last time? Will this finally be the end of financial engineering or will it create a new chapter in financial perversity?

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