the audit

Why Care About the Banks’ Foreclosure Scandal?

The blame-the-borrowers spin has begun
October 14, 2010

The pushback on the foreclosure scandal has already begun along predictable lines and amongst the usual suspects. It’s blame the borrowers all over again! Time to wheel out Rick Santelli’s “losers.”

According to variations of this spin, the scandal is a “paperwork” (WSJ) problem involving “clerical errors” (ex-Goldman dude) but at base it’s still about “deadbeat” (John Carney) borrowers hoping to get a “house as a freebie” (Megan McArdle).

First, forgery is pretty much by its nature a “paperwork problem.” Funny how the Journal glosses over the bedrock functions of the property system when its convenient for Wall Street. As Barry Ritholtz said the other day in knocking down this line:

It is a legal impossibility for someone without a mortgage to be foreclosed upon. It is a legal impossibility for the wrong house to be foreclosed upon, It is a legal impossibility for the wrong bank to sue for foreclosure.

And yet, all of those things have occurred. The only way these errors could have occurred is if several people involved in the process committed criminal fraud. This is not a case of “Well, something slipped through the cracks.” In order for the process to fail, many people along the chain must commit fraud.

That it is being done for expediency and to save a few dollars on the process is why the full criminal prosecution must occur.

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Second, nobody is “lionizing deadbeats,” and it’s unfortunate that the millions of folks who’ve lost their jobs or whatever and are down and out have a CNBC journalist call them what they’ve already been called a hundred times by two-bit bill collectors. Carney:

The vast majority of people (say, 88 percent) behind on their mortgages aren’t strategic defaulters and would pay if they could.

Further, most, I’d bet, would be able to keep paying these mortgages if the banks worked to modify them like they’ve said they would. But how can you modify the mortgage when you don’t even know if you own it? And why would you restructure it if you have no incentive to do so?

Carney, who wrote a very good primer on the scandal the other day, and McArdle need to go read Mike Konczal on the servicers’ role here (emphasis mine):

… we need a system of rules and a process for collecting and presenting evidence in order to kick a family out of their home. And we need a system where this process sets the ground rules that in turn allow for lenders and borrowers coming together and negotiating a situation that is best for both of them.

Because the first rule of mortgage lending is that you don’t foreclose. And the second rule of mortgage lending is that you don’t foreclose. I’ll let Lewis Ranieri, who created the mortgage-backed security in the 1980s, tell you: “The cardinal principle in the mortgage crisis is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fudiciary. The bank, or someone like a bank owned them, and they always exercised their best judgement and their interest. The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary.”

Get it? The same Wall Street-created system that’s responsible for the paperwork foreclosure mess is the one that’s responsible for the families-on-the-curb Foreclosure Mess (not to mention the creation of the bubble in the first place and the key role predatory lending played in it). It’s feeding on itself. You don’t have one without the other. And it may be worse than that. Konczal again:

Many of the servicers work for the largest four banks – Wells Fargo, Bank of America, Citi, and JP Morgan – and these four banks have large exposures to junior liens. These are second or third mortgages or home equity lines of credit that would have to be wiped out before the first mortgage can be modified. The four banks have almost half a trillion dollars worth of these exposures and, from the stress test, are valuing them at something like 85 cents on the dollar. Keeping a homeowner struggling to pay the second lien would be more worthwhile to these middlemen banks than getting him or her into a solid first lien to the benefit of the bond investor.

So keep these in mind as you read about the servicers here. There have been worries that they, as a designed institution, were simply not qualified for this job going back a decade. They have massive conflicts with the investors they are supposed to be working for. They profit when homeowners collapse and lose money when they are brought up to a normal payment schedule (made current). And if the instruments don’t have the notes necessary to bring standing to carry out the foreclosures they have to take a massive tax hit in order to take the note into the trust. And regulation to handle this isn’t in place.

And the straw teetering precariously on the camel’s back is this: Nobody has any confidence that Wall Street will have to pay for any of this.

This scandal is just one more major piece of evidence that the deck is stacked against regular folks in favor of the financial interests. And people are already highly pissed off. They wonder why they haven’t been able to get their mortgages modified while Wall Street has lined its pockets with public money. They wonder why homeowners got a pitiful, bank-friendly $75 billion bailout program (most of which hasn’t been used) while the banks got $750 billion, plus a few trillion dollars worth of guarantees, direct and indirect subsidies, and other benefits.

But, of course, the biggest problem here is the systemic financial risk that smart folks say may be looming. Carney, to his credit, was on to this (as he’s on to the WSJ‘s foolishness, too) in his primer. McArdle, who thinks that the “real scandal of the foreclosure mess” is our “antiquated title system”—and, oh, and in case that didn’t work, hey, look over there: Fannie and Freddie!—doesn’t mention it.

The Washington Post, which has done as good or better a job covering the foreclosure scandal than any other paper, had this on page one today:

Beyond sloppy documents, the foreclosure debacle has exposed one of Wall Street’s little-known practices: For more than a decade, big lenders sold millions of mortgages around the globe at lightning speed without properly transferring the physical documents that prove who legally owned the loans.

Now, some of the pension systems, hedge funds and other investors that took big losses on the loans are seeking to use this flaw to force banks to compensate them or even invalidate the mortgage trades themselves.

Their collective actions, if successful, could blow a hole through the balance sheets of big banks and raise fundamental questions about the financial system, financial analysts and a lawmaker said.

If judges rule in favor of such lawsuits, “it could be 2008 all over again,” said Josh Rosner, managing director at Graham Fisher & Co., referring to the Wall Street meltdown that occurred after Lehman Brothers collapsed.

Bloomberg’s on the same track:

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.”

The banks have dug themselves a really big hole here. Whether they’ll be buried in it remains to be seen, but these cats may be on life No. 9 if the worst-case scenario arises here.

TARP II just ain’t gonna happen.

Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR’s business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.