The foreclosure crisis is heating up. Will it all come crashing down, or can we find a way out of the mess? **This is Part 3 in a series giving a basic explanation of the current foreclosure fraud crisis. You can find Part 1 here and Part 2 here.
Right now the foreclosure system has shut down as a result of the banks' own voluntary actions. There is currently a debate over whether or not the current foreclosure fraud crisis could explode into a systemic risk problem that imperils the larger financial sector and economy, and if so what that would look like.
No matter what happens, the uncertainty about notes and what is currently going on with the foreclosure crisis is terrible for the economy. Getting to the heart of this problem so that negotiations can be worked out is important for getting the economy going again. There is little reason to trust whatever the servicers and the banks conclude at the end of the month, and the market will know that. Only the government can credibly clear the air as to what the legal situation is with the notes and the securitizations.
But I want to get some unlikely but dangerous scenarios on the table in which this blows up. Bangs, not whimpers. The kind where Congress is pressured to act over a weekend. I had a discussion with Adam Levitin about how this could explode into a systemic problem.
Title Insurance Market Breaks Down
The first scenario involves title insurance, specifically a situation wherein title insurers decide to take a month off from writing title insurance even on performing and current loans to investigate what is going on with note transfers.
If that happened, there would be no mortgage sales (except for those involving cash) in the country. The system would simply stop. Everyone with an interest, from realtors to Wall Street to construction to huge sections of the economy, would face a major crisis from this short-term pinch. There would be a call for Congress to step in immediately.
You can tell that the title insurance market, which is largely concentrated and also holding very little capital to deal with a nationwide crisis, is investigating the current problems. They are holding off on certain types of foreclosed properties; if they decide to hold off altogether, things could get seriously bad.
Lawsuits a Go-Go
The second would be a wave of lawsuits. As we discussed in Part Two, many of the servicing agreements allowed for the trustees to force the depositors and sponsors to purchase mortgages without notes. That would be 100 cents on the dollar for mortgages worth pennies. If the trustees don't take action, the investors could sue them. And the tranche warfare on this issue is intense, as foreclosures versus a few more payments radically change the balance between junior and senior tranche holders (See Tracy Alloway on tranche warfare here).
Here's what this could look like. Read left side up for what the lawsuit screaming looks like and the right side down for the response:
Much of the activity would center around the four largest participants in these areas, the Too Big To Fail institutions of Wells Fargo, Bank of America, Citi and JP Morgan.
And many of these mortgage-backed securities are cheap. So in an interesting scenario, you could see hedge funds buying them for pennies just for the option to sue firms that are likely backstopped by the government.
If title insurance froze, or if the financial markets had a panic over fears of waves of lawsuits, there would be pressure for Congress to do something. Much of the law is New York trust law, so it isn't clear Congress can act. But there will be pressure.
Because if this bad-case scenario happens, and there is a small but reasonable chance it could, progressives need to have a clear sense of what they want in exchange for negotiations when the financial industry comes flying in over the cliff -- a list of demands and questions to replace the in-large-part steamrolling of TARP over anyone's interests but the banks. Even if that doesn't happen, and the slow bleed of the current dysfunctional mortgage market continues, progressive wonk policy initiatives that fix this crisis and get the mortgage market going again should be at the front of the debate.
What's likely to happen
Here's a guess: In one month, the large banks will conclude that there are no problems with its foreclosure processes. They'll say that the massive fraud that was committed on the courts was the result of a few bad apples, but those are now gone and it's back to business as normal.
At this point, either as a citizen or as a financial market participant, would there be any reason to believe them? Is there any reason to believe that the servicer and foreclosure mill fraud is over? That securitizations actually have the proper legal documentation necessary? That borrowers and lenders are actually getting a chance to come to mutually beneficial situations? Is there any reason to believe they aren't lying?
Because servicers aren't currently regulated. They have a patchwork of state regulators and the OCC may regulate their parent company if it is a bank or thrift, but there's no government agent to provide any accountability here. So without action, there's going to be no one to confirm or deny that anything has actually changed in the housing market.
In some ways this narrative already reminds me of the BP oil spill in the Gulf. The Obama administration largely left it to BP to tell the government and the public what was wrong, hire the contractors and then also to tell everyone what the environmental damages were. It will surprise no one that the information BP sent out was wrong (see, for example, Kate Sheppard, "Not an Incidental Public Relations Problem"), but for better or worse, the Obama administration is now linked to whatever course and information BP chooses to pursue.
Why not choose a different course for this case? One that emphasizes social justice by requiring powerful banks to follow the rule of law, demands corporate responsibility not to commit fraud, provides a space where those who are weak and poor get a fair say instead of being bulldozed by the rich and strong, and actually starts to dig out of the mortgage crisis that we are in? Check out Mike Lux's Exploding foreclosure fraud issue: An opportunity for Democrats to turn the tide. Not only is it relevant, but it demonstrates that there's a good chance this is going to get worse before it gets better. Why not get in front of it and change course from the disastrous path we've been taking?
What Just Went Wrong in the Government Response?
Because what we've done to this point hasn't worked. Shahien Nasiripour and Arthur Delaney wrote the definitive account of the failure of the HAMP program, Extend AND Pretend: The Obama Administration's Failed Foreclosure Program. Instead of continuing HAMP, it's time for a fresh response.
Pat Garofalo of the Center for American Progress has The Fix Is Over: Mortgage Foreclosure Scandal Offers New Hope for Homeowners, which has a lot on what a new foreclosure relief program could look like:
...allowing housing counselors and other public entities to approve mortgage modifications directly, and if the borrower’s servicer doesn’t challenge the modification in 90 days, it automatically becomes permanent. Such a step would go a long way toward streamlining the program and getting borrowers who qualify through the maze of bureaucracy in a timely, clear fashion without leaving them in limbo for months on end.
Mortgage mediation programs—in which a bank must meet with a borrower, in the presence of a judge and housing counselors, before finalizing a foreclosure—should also be expanded.
And here's another new favorite policy option everyone should start considering, from the same piece: "REMICs bestow enormous tax breaks to investors; these breaks should be revoked for any residential home mortgage loan holding entity that forecloses on more than a specified percentage of all of its mortgages."
We have to remember what went wrong with HAMP: the servicers were in the driver's seat. We need a process that is involuntary, government-run and is standardizable on both the modification and on the foreclosure end. After this is instated the current crisis is cleared out in a way that confirms change has actually happened, we can start on a way out of this crisis.
Mike Konczal is a Fellow at the Roosevelt Institute.