What appeared at first to be an isolated problem with home mortgage foreclosures at GMAC has morphed into a serious conundrum for just about everyone involved in the residential home market: homeowners, banks, mortgage servicers, investors, and even the US government. The problem goes beyond finding which lender has legal title to a home, and therefore the right to foreclose on a defaulted mortgage. The problem has become how to prepare for a possible behavioral change among homeowners, if more than a small percentage of them decide to stop paying on their mortgage.
Strategic Defaults are Already On the Rise
What would motivate a homeowner to stop paying their mortgage principal and interest? So far, severe financial problems, combined with a drastic fall in house prices, have been the main causes of most mortgage defaults by homeowners. When the value of the house falls below the mortgage balance due, homeowners are even more liable to default on their loan, and the greater this difference (referred to as the homeowner being ”œunderwater”), the more likely it is that a strategic default will take place. This is an industry term for defaults that occur even though the borrower has the financial means to continue paying down the mortgage.
Strategic defaults are a rational decision by the homeowner, who believes the value of the home is so far below the mortgage balance that it would take years for market values to catch up. Why pay off a loan on a depreciating asset, especially if the homeowner can rent the same size home for much less than their mortgage payment? Depending on the location, strategic defaults represent from 10% – 20% of all defaults. There is also more of a tendency for owners of expensive homes to strategically default than owners of average size homes, so strategic defaults are of serious concern to the banking industry.
The initial reaction of banks to the rising level of mortgage defaults was to foreclose and dispose of the property as soon as possible. When home values were in a free-fall up to the summer of 2009, the banking industry frenetically processed tens of thousands of foreclosures each month, evicting homeowners in every metropolitan area across the US. This process slowed down last year for two reasons. First, the federal government imposed a moratorium on foreclosures, and second, the banks were achieving less and less on foreclosed homes. In previous recessions, banks could recover around 40% of the value of the outstanding mortgage from a foreclosure and bank sale of the property. Today the recovery rate has fallen to an unprecedented low of 5% of the loan value, which is hardly worth the expense, time, and trouble of foreclosing on the property.
You would think, therefore, that banks would be eager to work out a deal with the homeowner, lowering their mortgage balance to some level that meets the financial capabilities of the borrower. This isn’t happening either. To do this, the bank would still have to declare a loss on its books, and even the biggest banks don’t have enough capital to do this on a wholesale scale. Another factor is that the banks may only own a small portion of the mortgage, the rest being sold off to investors in a mortgage-backed security deal. These investors would have to consent to taking a loss as well, and this is almost impossible to arrange.
Where is the Title to the Home?
Now comes a third problem. The GMAC revelations showed that this mortgage company has been foreclosing on thousands of properties each month, filing incomplete or possibly fraudulent documents with the court approving the foreclosures. The process of foreclosing on a home mortgage is complex and governed by both federal and state laws, but in any event the process requires that someone working for the foreclosing bank assert in writing that they are personally familiar with all the documents submitted, and that these documents are accurate. GMAC has not been meeting this standard. A middle level executive has been signing over 10,000 foreclosure documents for GMAC each month and could not possibly have ”œpersonal knowledge” of the details of each foreclosure.
It gets worse. GMAC has been asserting that it is in possession of the lien representing the mortgage, and much more importantly ”“ it is also in possession of the title to the home. It is the title which is of far more importance here, because without clear title a bank has no foreclosure rights. GMAC has been going in front of courts all over the US claiming it holds title to the property in question, when in fact the person making this claim has no personal knowledge of the documents, and GMAC cannot in many cases produce the title.
Who has the title? GMAC may have lost it within its own files, or may have passed the title on to a mortgage servicer when the mortgage was sold off to investors. The mortgage servicer may have sold the title to another servicer, or to a clearing house that supposedly was protecting the legal rights of the lenders and investors in mortgage securities. As the mortgage market became frenzied at the height of the bubble, the financial industry became very sloppy about documentation and is now having serious trouble producing the necessary documents to proceed with a foreclosure.
Quite a few real estate lawyers believe that what GMAC did, whether through sloppiness or deliberately, constitutes a fraud upon the court, which is subject to criminal penalties. GMAC has halted all foreclosures until it straightens out the document mess, but there is increasing suspicion in the mortgage market that these problems are not going to be solved in just a month or two, if at all. JP Morgan Chase has admitted that it too has a middle level executive who was submitting personal attestations to the foreclosure courts, when she could not possibly have known the facts behind each mortgage. Chase is probably in very good company with Citigroup, Bank of America, and Wells Fargo, all of which are likely to have similar processing problems.
It seems, therefore, that millions of foreclosures that have occurred in the past two years may be invalid. Investors who were part of the $8,000 tax credit program may not have valid mortgages and may not legally have the right to live in their home. Title insurance companies have stopped accepting mortgage titles from GMAC and other financial firms implicated in this situation.
Foreclosure Market is Coming to a Halt
The foreclosure market in the US is slowly grinding to a halt, with all this uncertainty about past and future mortgage rights, and with banks now recovering only 5% of the mortgage value in a forced sale. Professionals in the market are now speculating that the federal government may be forced to outlaw all home foreclosures, since there is so much doubt on whether banks have any legal right to foreclose on residential property. If this were to happen, the market mechanism essential to clearing defaulted properties from the market would cease to exist. Lost too would be the process known as price discovery, wherein neighboring properties can be appraised, making it much harder for any homeowner wishing to sell to do so. Not only is the foreclosure market subject to a freeze, but the entire home resale market could be crippled as well.
In fact, there may be yet another incentive for homeowners to strategically default, if theoretically the defaulter could live in the home free of charge should the party holding the mortgage be unable to produce the title. Already there are thousands of homeowners in the US who are living ”œrent free”, so to speak, while they wait for the bank to foreclose or for the courts to honor a bank’s foreclosure claim. These people are socking away tens of thousands of dollars in savings, or spending it for that matter, while the disposition of their property is in limbo. Even when the bank is finally able to proceed with the foreclosure, they are not suing the homeowner for back principal and interest due, in part because the delay may have been caused by the bank itself, and in part because some states do not allow banks to go after other homeowner assets once a default occurs.
As the months go by, the difference between a homeowner living rent free in their home, and de facto owning the home free and clear through a form of squatters rights, is becoming very gray. This is not going to sit well with the people who continue to pay down their mortgage even if they are underwater, nor will it sit well with those who paid off their mortgage. Good financial stewardship, a virtue in the past, is looking more and more like foolhardiness. There is both a legal and social breakdown that is occurring here, upending over a century of contract law and prudent behavior that underlay the housing market.
If strategic defaults spread in part because of this new uncertainty over foreclosure and who has the title to the home, the banks and the mortgage backed securities market would be put in a dreadful position. The day in and day out cash flow expected from millions of mortgage principal and interest payments would be impacted far more than it is already, with the banks unable to access their collateral to stanch the bleeding. Insolvencies among the banks and the investors holding mortgage securities would certainly rise.
The Federal Government is Ultimately Going to Own this Problem
How bad this could get is anyone’s guess, but continued deterioration will inevitably drag in the US government, which owns both Fannie Mae and Freddie Mac, by far the biggest issuers and guarantors of mortgage backed securities. The federal government also has an ownership stake in Citigroup and is sitting on billions of dollars of mortgage securities bought from all the big banks and from failing institutions like Bear Stearns. If the largest US banks are pushed into technical insolvency because of this problem, the federal government would inevitably own them too.
What is currently a legal problem could turn into a behavioral problem affecting the entire mortgage market, which in turn creates a massive political problem for the federal government. It is the behavioral problem which has to be of most concern for the government, because if people who could pay their mortgage decide it is uneconomic or unfair for them to do so, the relationship between borrower and lender is broken. Currently it is slightly fractured, and the government as well as industry leaders will do everything possible to downplay this situation, characterizing it as a technical matter that will be easily and quickly cleared up.
So far, though, the courts aren’t buying the quick fixes being proposed by the industry. The foreclosure laws that have arisen over the past 100 years are designed to protect the homeowner from hasty and incomplete processes, and as well from fraudulent foreclosures. The courts are saying that the banking industry not only was hasty and reckless in its mortgage securitization process, but that homeowner rights are being trampled upon, and the courts themselves are being defrauded along with the homeowners. More and more judges across the country are coming to this conclusion, and if they believe the rule of law has been seriously undermined in the mortgage market, why should any homeowner feel a moral or legal compulsion to continue to pay down their mortgage?
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