Too-Big-For-Paperwork: Fixing Wall Street's Foreclosure Fraud Disaster
Anybody looking for a primer explaining why the current foreclosure fraud issue is a major systemic risk for the financial system should check out Mike Konczal's new post for the Roosevelt Institute. I'm going to try and simplify it even further here, and present the only serious avenue available to solve the problem. Three parties stand to lose big. The most obvious is homeowners—they're being slapped with enormous, illegal fees invented by fraudulent documents, and frequently being illegally exiled from their homes. Next are the mortgage servicers. These are the mortgage industry's debt collectors, and their mere existence often creates huge conflicts of interest that have made the foreclosure mess much harder to clean-up. The dominant servicers are owned by megabanks—Bank of America, JPMorgan Chase, Wells Fargo, Citibank and GMAC control the vast majority of this work. A massive loss for a mortgage servicer means a massive loss for a massive bank. Mortgage servicers are supposed to collect payments and negotiate with troubled borrowers in order to maximize the returns to investors. Who are these investors? Hedge funds and banks that bought mortgage-backed securities during the housing bubble. The basic job of a mortgage servicer is to collect payments from borrowers, and pass them on to investors. If borrowers stop paying, servicers have to make those payments to investors out of their own pocket—until they actually foreclose. At foreclosure, the servicer gets to recoup its costs. So in many cases, servicers have a very strong incentive to cut whatever corners they can in order to recoup their costs and avoid forwarding more money to investors (This is only part of the story—since the servicers are megabanks, the other assets of the servicer bank can give the servicer wing an incentive to stall the foreclosure process like crazy—more on that in another post). The point is, in many cases, servicers have a clear incentive to cut corners to speed up the foreclosure process, and stand to lose a lot of money if they don't. Servicers should have a set of key documents for every mortgage that has been bundled into the securities they operate. But they don't. Why? Because the original bank who sold the original mortgages to homeowners never handed over the documents when the security was created. That brings us to the investors. Mortgage-backed securities involve different levels of risk—investors don't just buy one security composed of lots of mortgages. Instead, the pool of mortgages is cut into different pieces according to how risky they are. The riskiest bits fetch the highest monthly payments for investors, but are the first to take losses if the mortgages go bad. The safest parts bring in lower monthly payments, but are the last to take losses. Investors who have the safe parts of the security want to see the foreclosure process burn through as fast as possible. The faster it goes, the lower the expenses for the servicer, and the more these investors will be able to recoup after foreclosure. But investors who have the risky parts of the security have the exact opposite incentives. They want foreclosures stalled for as long as possible, so that the servicer has to keep forwarding them payments for as long as possible. The servicer doesn't take its cut from the investors after foreclosure, it takes them from the sale of the house. So the risky investors (junior bondholders in finance-speak) are hoping to delay foreclosures, while the safer investors (senior bondholders) are hoping to stall for time, since time means more payments. So there's a war going on right now between risky and safe investors, many of which have different risk positions in different securities. But servicers don't have the necessary documents, and they can't get them. The Florida bank lobby says that destroying mortgage documents was standard operating procedure during the bubble years. If you can't provide the documents, then in many cases, you simply do not have the right to foreclose at all. That means catastrophic losses for both safe investors and servicers, since they never get to recoup any losses. So no matter what happens, the most obvious, immediate losses and the most serious long-term legal liability are at the big mortgage servicers. These are all megabanks. And investors of all stripes are going to do everything in their power to stick the investment banks who created these securities with the bill. These are also megabanks. As Mike emphasizes, there are $2.6 trillion worth of mortgage-backed securities out there. That's more than enough in potential losses to sink every major bank and hedge fund in the United States. There are two ways to deal with this. One is to bailout the banks for engaging in systematic, documented fraud, and further screw over the homeowners they're defrauding by changing the legal standards for mortgage documentation. This is what the bank lobby wants, and it is obviously unacceptable. This won't only hammer homeowners, it'll also blast investors who hold the risky end of mortgage-backed securities. The other is to adopt a massive principal-reduction program which creates new, real documents for every troubled borrower in the country, and reduces their debt burden so that they don't end up in foreclosure. This solution means catastrophic losses for investors, but not as catastrophic as being unable to foreclose. But barring another massive bailout, our biggest banks are right back up against the wall again, no matter what happens. And they'll keep coming back to the brink of insolvency so long as they remain too-big-to-even-file-their-damned-paperwork. Break up the banks.