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Home > Blogs > Anthony Harrington > Foreclosure-gate and the US banks

Foreclosure-gate and the US banks

US subprime | Foreclosure-gate and the US banks Anthony Harrington

Watergate seems to have permanently disfigured US English by requiring a mandatory suffix, “gate”, to be appended to every fresh scandal, “just so’s we knows it's big”. However, US market commentators and financial bloggers are revving their engines big time on foreclosure-gate, and since I dropped an un-elucidated mention of this into a previous blog, now might be a good time to give the topic an airing.

There are basically two versions of the foreclosure saga, namely with fraud and without. We’ll start with the simplest “without fraud” case, but the difference between them ultimately boils down to the fact that in the worst case scenario of foreclosure fraud, an ever widening circle of US home owners wake up to the fact that they can suspend payments on their mortgages without risking the bank foreclosing on their homes (this last point is highly debatable, but as we said, it’s a worst case scenario). In this scenario banks get starved of mortgage repayments and their debt problems mushroom in double quick time. (Think Lehman Brothers, multiply it by a large number and sound the Trumpets of Doom). 

But anyway, let us move to the simple, without fraud case. Chris Walen of Institutional Risk Analytics, speaking at a panel discussion “Living in the Post-Bubble World” organised by the American Enterprise Institute, a Conservative think tank, said that the mortgage foreclosure saga in the US has the potential to make 2008 look like a cake walk.

He presented a chart which graphed the operating efficiency of banks, a key ratio which basically looks at how much it costs the bank to make each dollar. If the banks can operate at 70 cents worth of costs for every dollar they make they are doing all right. If it gets up to 80 cents in the dollar they are in serious trouble. Anything higher than that and it is good night and God bless - time for a US Government, aka US taxpayer, bail out of a broken bank.

The significance of this chart for the mortgage foreclosure issue is that unfortunately for banks, they are geared up to be highly liquid institutions dealing with finance. They are not geared up for handling real assets. Yet they have become, willy nilly, massive property owning enterprises (Whalen humorously calls them “giant not-for-profit REITS”) and they are having to deal with potentially millions of foreclosures, which are complex, time consuming, real world processes. This costs them hugely in man hours and drives up their cost ratios even as foreclosures crystallise their losses. This issue of itself is likely to drive a number of US banks into bankruptcy in the next year or two, he suggests, triggering another massive financial crisis in the US with a global spill-over to follow.

At the same event one of the panellists pointed out that some seven million US home owners are currently in arrears with at least four million being more than 90 days in arrears. Assuming the average cost of a US home to be $200,000 that points to a debt overhang of $800 billion of non-performing loans on bank books and more than £1 trillion if you add in the three million that are not yet at 90 days in arrears, but heading that way. Ouch.

Now let us turn quickly to the “with fraud” example. Space precludes a full discussion but I provide an excellent link or two for those who want to follow the debate. Try John Mauldin’s account in his newsletter entitled: “The sub-prime debacle: Act 2”, or Mike Konczal’s “Foreclosure Fraud for Dummies: Parts 1 – 3”.

The point about foreclosure under US law is that the bank holds the IOU note from the mortgage holder and as the holder of the note, can press for foreclosure if the consumer defaults on payment. Now enter securitization, the process where the mortgages held by the bank are bundled up and sold on to third parties as a securitised investment. This is good for the bank because it replenishes all the capital paid out to borrowers, crystalises some profit for the bank and enables more loans to be made.

However, under US law you can only foreclose if you hold the note. If the bank sells the mortgage to another bank, the second bank adds its name to the note and that constitutes an unbroken chain, making the note enforceable by the second bank. Securitization frequently breaks the chain for two reasons. One is just rush and incompetence. These securitizations were done in a hurry and the proper transfer of documents to the trust vehicle holding the securitization was not done.

The second reason is more logical. It has to do with the fact that while statistics tell you fairly accurately what percentage of loans of a certain quality are likely to default, statistics do not tell you anything about precisely which loans are going to default. Investors are buying a general instrument, not a specific mortgage or even a collection of specific mortgages even though that general instrument is backed by specific mortgages. If you buy a “junior tranche” of a mortgage securitization, then whoever defaults, that flows through to you, not to the senior tranche holder, so it’s not as if you have a bet on 100 specific mortgages. You have a bet against default on all the mortgages in the securitization. In return for this (humungous) risk, you get a higher premium than the senior tranche holder. (From this it is easy to see why banks who took large “junior” slices of subprime debt in order to enjoy high premiums lost their shirts.)

It follows that creating an unbroken chain that leads from the new owner, which is ultimately the investor, to the mortgage note, is complex. If everything is done right there should be no reason why the securitization vehicle can’t go back to the bank, just as Freddie Mac and Fannie Mae do, and demand repayment, which would lead to the bank foreclosing on the loan. However, since in the duff instances the bank no longer has title and it is completely unclear who has, no one is in a position to force the default through the courts against a sharp lawyer, representing the mortgage holder. Hence there is now a movement against foreclosure in the US that flies under the slogan: “Show me the note!” In these instances the lawyer will simply ask for the case to be thrown out since the mortgage chain is broken.

Now the point has been made that in an adult world this should be fixable. You should not get to keep your house even though you default and if it needs a new law written to make it so, then Congress should write it. However, in the US legal system writing and enacting retrospective legislation like this is going to be seriously difficult with a near guaranteed challenge to the US Supreme Court to follow, and I wish you the best of luck on betting which way the US Supreme Court will go. Meanwhile the banks are not going to be collecting payment and they are not going to be foreclosing.

Already many of the major banks in the US have called a halt to foreclosures because it is completely unclear how they should proceed without getting sued. Since foreclosures are all about freeing up blocked money, this chokes up an already rickety system. As a sidebar, it now emerges that some US law firms employed to do the foreclosure documentation by banks, the so-called “foreclosure mills”, have been “fixing” the broken note chain by fraudulently re-documenting things. That is going to create a stink all of its own.

As one of the panellists at the AEI Event noted, in the US the housing sector has always led the economy into a recession and it leads it out of the recession. With four million seriously in-arrears mortgages and three million more heading that way, the housing sector is not leading the economy anywhere, whatever happens to the foreclosure fraud saga. That is not good news for the US or the global economy.

Further reading on the US subprime saga and securitization:

Tags: foreclosure fraud , global economy , mortgage note , regulation , securitization , sub prime fiasco , US Supreme Court
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