The Mortgage Crisis – Now With Extra Crime

Maybe you have been hearing something in the news about the banks halting foreclosures and the “robo-signature” problem. It’s the latest chunk of fraud to squeeze out the hind end of the banking industry.

First, a few basics. If I get a mortgage with Bank A, and Bank A sells my mortgage, risks, benefits, and all, to Bank B, there are signatures involved. It’s a transfer of a contract, after all. Somebody in authority at Bank A has to place a notarized John Hancock on the mortgage so as to say “Yup, this now belongs to Bank B,” and the same is required from someone in authority at Bank B, saying “Yup, now we own it.” This can happen multiple times, with my mortgage changing hands over and over.

Let’s suppose I stop paying my mortgage. The mortgage holder can go to court to foreclose on my mortgage and evict me. Fair enough.

With all the backfield motion, fakes, and handoffs during the mortgage securitization boom, this process got confused in several ways.

First, the chain of ownership got fuzzy. The mortgages passed through investment banks into REMICs, Real-Estate Mortgage Investment Conduits. A REMIC is basically a huge bundle of mortgages. Then investors would buy sub-groupings, called tranches, of these mortgages. Various tranches were rated according to their risk. Some investors with a taste for high risk and high return bought what were essentially junk tranches, while more conservative investors bought highly rated ones. Here’s where it gets weird.

The ownership of the mortgages didn’t really transfer to the investors. The REMIC held them, and if a mortgage defaulted then the junk tranche owners were first in line to take the hit. This worked as long as there wasn’t too much defaulting going on. When the tsunami hit and homeowners started going down in windrows a few started asking questions about who actually owned their mortgage, and therefore had the right to foreclose on them. The REMICs kinda did, and the investment trusts kinda did, because, after all, they paid for them. But nobody can assign a particular mortgage to a particular investment trust. Confused yet?

The investment banks that handle the mortgage backed securities are supposed to review each foreclosure case to make sure that a) the mortgage is actually in arrears, and b) all the paperwork is in order. Duplicating the rush and rule breaking on the way into the crisis, the banks had people signing thousands of foreclosure documents without looking at them. Some homeowners got foreclosed accidentally even though they had kept up payments. The whistle blowers turned out to be the title insurance companies, who are insuring that there is a clear title and solid chain of ownership. No such luck, and foreclosure sales stalled.

Another little problem that has popped up is multiple sales of the same mortgage. (On the ever-useful site Naked Capitalism) Either by negligence or design, particular mortgages were sold to multiple buyers. It’s a great living if nobody finds out. Again, this complicates the ownership issue.

Enter the foreclosure mills. These are law firms specializing in foreclosing. Again, fair enough, somebody has to do the dirty work. Next problem: Because of all the mysteries of ownership and missing paperwork, these firms got into the forgery business. Again, Yves Smith at Naked Capitalism covered this. Apparently there is a company called DocX that has a published price list for forged mortgage documents, and banks have been ordering one from column A and two from column B, like good accessories to felony.

The upshot of all this? Nobody is sure exactly who owns what and who owes what to whom. Without nailing that down foreclosures can’t go forward and foreclosure sales can’t go forward. The whole process of working out the financial crisis can’t go forward. There is also the erosion of trust in land titles. One of the foundations of finance in this country is credit based on collateral. The confusion and outright fraud involved in the housing bubble damages the credibility of the whole market.

So what should we do? I offer the following with no confidence that our corrupted government will do what is right and necessary for the general welfare. It isn't actually all about corruption. Our politicians navigate wearing ideological blinders and act according to mythological economic theories.

It all goes back to a simple saying I came up with for debunking the oxymoronic idea of a free market. "No rules, no trust. No trust, no transaction." The investment banks wanted to get away with stuff, break rules, bypass safety steps, and generally flail about like Joe Cocker. That works for a limited time. Now we face massive loss of trust and the resultant freeze on transactions. It is chilling.

Ok, trust. Trust requires three things, in this case. 1) Prosecute the crooks 2) Mitigate the fraud perpetrated on homeowners 3) Rebuild the chain of title in an equitable way.

1) Prosecuting the guilty is the easy part - arrest everybody in the mortgage investment business and let the courts sort them out. The loan originators handed out mortgages to anyone with a pulse and conned people with decent credit ratings into time-bomb subprime loans. On the other end the banks held their noses and collected their fees as they passed on the stinkers to investors.

2) I don’t subscribe to the “blame the deadbeat homeowner” theory. I don’t know what relationship other people have with their banks, but I can’t demand a mortgage. I have to ask for one, and the loan officer behind the desk is supposed to find out if I am a good credit risk and say “no” if I’m not. Any ding-dong can apply for a mortgage, but the responsibility for due diligence lies with the bank. From the late 90s through the collapse in 2007 the banks were doing no such thing. They were flooding the market with low interest capital and progressively lowering their lending standards to rope in more suckers on both ends.

Mitigating the fraud means restructuring the loans, both in terms of price and interest. 1997 was the last year that housing prices corresponded to reality, that is, compared to median income. There would have to be geographically adjusted price modifications, because not all areas inflated the same. Look at a graph of the Case-Shiller index and you'll see that the hockey stick curve has to return to the historical mean. Returning home prices to their inflation adjusted 1997 level is just speeding up what is inevitable. It will mean an average 40% haircut for the banks, but my heart bleeds. All those interest-only, interest rate bomb, and balloon payment mortgages also need to be turned into 30-year, 5% interest, dull vanilla mortgages.  Making $400,000 mortgages into $220,000 mortgages at 30/5% means a lot of people won't need foreclosing. Better for the banks to have 60% of something than 100% of nothing. The problem is that these crooks are like that guy who shot a dummy deer (set out by the VT Fish and Game) from his truck, out of season, and still had the balls to ask if he could keep the deer. They want 100% of everything, despite their fraud and stupidity. Sorry, you get 60%. That would give the mortgage backed securities actual value.

3) Rebuilding the chain of equity will involve some legwork, due to those notes separating from the mortgages at the REMIC stage. Nevertheless, there are houses and home buyers on one end and investors on the other. I'd be inclined to just take over the dozen or more biggest banks (in terms of CDO exposure) and start doing the paperwork. Start assigning individual mortgages to specific tranches based on predicted risk, regardless of the actual state of the mortgage. Essentially do it results-blind. A junk tranche would end up with a lot of NINJA loans, most of which predictably went south and some of which miraculously are still being paid. Point 2, above, would help. Rebuild the chain between the homeowners and investors and let the chips fall. It isn't a flawless solution, but we'd end up with someone holding the note on each mortgage, good or bad. People who bought into lower rated tranches would tend to get a shittier batch of loans and more cautious investors would get better ones.

Did I mention prosecuting all and sundry for fraud? Let me reemphasize that. Orange jumpsuits for everybody.

As I said, I don’t expect the government to do any of this. Congress, with an eye on campaign donations, will try to wangle something in between craven public obeisance to the banks and halfhearted regulatory fixes. The Obama Administration, caught between public opinion and the private convictions of the former (?) bankers in their midst, will dither. In 2011 another round of mortgage rate resets will hit. At some point several major banks will be revealed as completely insolvent and keel over, forcing the government, finally, agonizingly too late, to take them over. Housing prices will continue their march towards 1997 and beyond.

We’re in this hole for another few years. Get used to it.