Why foreclosure-gate matters

In my last post we took at look at Australia's latest investing fad: buying up foreclosed properties in US states like California, Nevada and Florida. We've already examined how anybody who thinks this is a good idea probably needs their head checked, but there is one additional risk that I didn't even mention: the risk of getting sued by the previous owner of a property that you've bought if he or she claims that they were wrongfully thrown out of their house.

On this front, a Massachusetts court delivered a very important decision last week that could have huge implications for the US housing market and mortgage securitization. From the NY Times:

The highest court in Massachusetts ruled Friday that U.S. Bancorp and Wells Fargo erred when they seized two troubled borrowers’ properties in 2007, putting the nation’s banks on notice that foreclosures cannot be based on improper or incomplete paperwork. Concluding that neither institution had proved it had the right to evict the borrowers, the Supreme Judicial Court voided the foreclosures, returning ownership of the properties to the borrowers and opening the door to other foreclosure do-overs in the state.

To explain why this is important, we have to go right back to the root of the global financial crisis of 2008, which can be found in the securitization of US subprime mortgages.

During the boom years leading up to 2008, American banks packed together millions of mortgage loans, and sliced and diced, or "securitized" these into thousands of securities called MBS. To create an MBS, the banks would first sell the loans to a trust, which then sold bonds backed by those mortgages to investors all over the world. But there was a minor problem. In their rush to issue as many of these securities as possible and pay themselves gargantuan bonuses, the bankers didn't bother to do the paperwork properly, and now it's unclear who actually holds the mortgage notes. Oops. 

Of course, at the time these loans were made nobody ever thought this would be a problem because, as we know well in Australia, house prices double every 7 years and borrowers never default on their mortgages. Now, a few years later, there are millions of Americans delinquent on their loans.

"Foreclosure-gate" started brewing late last year when it became evident that having stuffed up the paperwork, many of the banks had hired thousands of "robo-signers" to write false affadavits claiming that they had reviewed the loan documents (which they hadn't even seen). These affadavits were then being used to evict people who had stopped paying their mortgages. 

So, the court case above puts an end to this kind of nonsense from the banks, at least in Massachussets. Until they get their paperwork in order (if that is even possible) they will have to stop turfing people out of their homes. The real estate experts cited here here say that this delay in the processing of foreclosures would be a good thing for the housing market.

If the slowdown continued through this month and into the spring, it could be a boost for the economy. Reducing foreclosures in a meaningful way would act to stabilize the housing market, real estate experts say, letting the administration patch up one of the economy’s most persistently troubled sectors. Fewer foreclosures means that buyers pay more for the ones that do come to market, which strengthens overall home prices and builds consumer confidence in housing. 

This is the optimistic view. If it becomes harder for lenders to foreclose, then they might become more willing to restructure loans instead (for example cutting the interest rate on the loan and/or reducing the principal that has to be repaid), which is probably the only eventual way out of this mess. At the end of the day, the banks are going to have to take a hit for making stupid loans that were never likely to be repaid.

But loan restructurings are tricky, because if the lenders offer attractive loan modification terms to delinquent borrowers, then even people who are able to pay their mortgage will start "strategically" defaulting in order to become eligible for debt forgiveness. And this would probably make some lenders insolvent. On top of this, securitization makes the whole process even more complicated because there are so many parties involved. In an MBS deal, there are strict contractual limits on loan modifications, which usually can't be changed without the consent of 100% of the MBS holders, who could number in the thousands and are usually spread all over the world. Obviously getting all these parties to agree is pretty much impossible.

In the meantime,  there could be enormous potential for chaos, because the Massachusetts legal decision is going to be followed by waves of lawsuits in other states all over America. Felix Salmon of Reuters has a great post addressing this issue which I will quote at length from:

The legal craziness that this decision sets in motion is going to be huge, I’m sure. Anybody who was foreclosed on in Massachusetts should now be phoning up their lawyer and trying to find out if the foreclosure was illegal. If it was — if there was a break in the chain of title somewhere which meant that the bank didn’t own the mortgage in question — then the borrower should be able to get their deed, and their home, back from the bank. This decision is retroactive, and no one has a clue how many thousands of foreclosures it might cover.

Similarly, if you bought a Massachusetts home out of foreclosure, you should be very worried. You might not have proper title to your home, and you risk losing it to the original owner. It might be worth dusting off your title insurance: you could need it. And if you ever need to sell your home, well, good luck with that.

Going forwards, every homeowner being foreclosed upon will as a matter of course challenge the banks to prove that they own the mortgage in question. If the bank can’t do that, then the foreclosure proceeding will be tossed out of court. This is likely to slow down foreclosures enormously, as banks ensure that all their legal ducks are in a row before they try to foreclose.

What’s more, courts in the other 49 states are likely to lean heavily on this decision when similar cases come before them. The precedent applies only in Massachusetts for now, but it’s likely to spread, like some kind of bank-eating cancer.

If a similar decision comes down in California, which is a non-recourse state, the resulting chaos could be massive. People who are current on their mortgage and perfectly capable of paying it could simply make the strategic decision to default, if and when they find out or suspect that the chain of title is broken somewhere. They would take a ding to their credit rating, but millions of people will happily accept a lower credit rating if they get a free house as part of the bargain.

The big losers here are the banks — of course — as well as investors in mortgage-backed securities, including of course Fannie and Freddie, a/k/a the US taxpayer.

 This could get very ugly.