Foreclosure Fraud For Dummies, 4: How Could This Explode into a Systemic Crisis?

(This is a series giving a basic explanation of the current foreclosure fraud crisis: Here is Part One, Part Two, Part Three, this is Part Four and Part Five.)

Right now the foreclosure system has shut down as a result of banks’ own voluntary actions. There is currently a debate on whether or not the current foreclosure fraud crisis could explode into a systemic risk problem that perils 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 what comes out of the servicers and the banks in whatever they conclude at the end of the month, and the market will know that. Only the government can credible clear the air here as to what the legal situation is with the notes and the securitizations.

But I wanted 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

First scenario involves title insurance. Specifically if 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 through 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 for a nationwide crisis scenario, is investigating the current problems.   They are holding off on certain types of foreclosed properties;  if they decide to hold off all together you could see a scenario where Congress is pushed to act immediately.

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 MBS 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, which 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, but 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.  We’ll cover this in Part 5.

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19 Responses to Foreclosure Fraud For Dummies, 4: How Could This Explode into a Systemic Crisis?

  1. zsa says:

    Thanks for this … clear and informative …

    And thanks for the term “tranche warfare” …

  2. Laurence says:

    Hi Mike,

    Thanks for this excellent work. The one thing that has always puzzled me is the tranche welfare. It’s very difficult to figure out what each of the borrower/junior/senior/servicer wants and the political implications. To think about policy options what we really need are a rough sense of the payoffs. It might be a start to look at the lobbying and legislative history – TARP, EESA, HAMP, cramdown failure – to get a sense of who wants what.

  3. NYT says:

    Whats to stop Congress passing a law allowing the MBS Trust a “one-time” exemption to allow them to take in the notes without having to pay tax?

    • Lollipop says:

      The rule of law? The fact the it would be the equivalent of tarp 2? My pitchfork?

    • Nathanael says:

      The fact that the Trust doesn’t want to take in mortgages which are already in default? The lawsuits by the investors who would rather recover 100% of their money?

      Or the fact that the servicers and sponsors don’t have any records and can’t even find the notes?

      Take your pick. Or use both.

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  5. D Cortex says:

    I smell askance for a Bankster bailout!
    The fact that it is a voluntary bank action speaks volumes.
    They decided that more foreclosures would ruin them.
    So now they’ll receive deliverance just in time to wrap the bonuses!

  6. Ann G. Kramer says:

    I think the Title insurance issue is the great unknown….Banks we know are in panic and investors are rightfully interested in the fraud portion of these MBS…. But Title insurers are just realizing how their liability for millions of properties could be seriously compromised due to MERS and the confusion over who actually owns what. This industry has remained untouched by and large throughout this housing/financial crisis but if this issue wakes them up to the point of realizing THEIR investors will be sucked into huge losses—they could easily put a hold on everything and that would be amazing. Then, banks who have a title policy on every note could potentially say “its the Title insurers fault” –and try to file claims too.

  7. Jack Straw says:

    Even before this, the title insurers were up to their noses in claims. New construction with now-bankrupt builders is a major source of claims for mechanics liens. Bankruptcies, in general, produce their share of catastrophic “lien avoidance” claims, and unlike typical claims which can be delayed for years sometimes in ordinary courts, bk courts move lightening fast.

    Now, with this problem, I saw one of the Big 4′s bulletin last Thursday. They aren’t overtly stopping issuing insurance, but the hoops to jump through now are the practical equivalent. I haven’t seen FNF or FAF’s guidelines, but I suspect they all about the same. Until courts decide that judgments based entirely on evidence admitted with falsified foundational affidavits are not void, these properties aren’t insurable without exception (and no lender will permit an exception). Experienced cash buyers, in particular, won’t want an exception to coverage. They are the ones who are really hosed.

    This isn’t going to be fixed until state supreme courts get these cases and decide the issue doesn’t matter, say about when hell freezes over.

    • marilyn lane says:

      Whether its a MERS issue or a VOID JUDGEMENT ab initio the end results are the same, property was illegally taken from the true owner.

      After Astoria Federal Savings and Loan’s attorneys said in NEW York Supreme Court
      “It’s , indemnify. indemnify, indemnify – we are stepping aside and the title companies are taking over.

      Thomas Malone, esq. of Fidelity National Title and David K Fiveson esq. of Coronet Title did not want to indemnify but wanted to be intervenors instead.

      I should not hve had to spend additional years in court fighting Fidelity National Title so that they can hide from their investors how they have really run their business , knowingly insuring Forged Deeds . The time for title companies to do due dilegence is before they issue a policy.

      the rule of law says a forged deed conveys no title.

      Only because of the title companies power, connection and money can they get judges to join with them and perpertrate title fraud.

      this is absollute fraud by these title companies and these kind of companies are destroying property rights in this country.

  8. Jack Straw says:

    This was posted to a real estate lawyers list today:

    From: Titlelaw [titlelaw@comcast.net]
    Sent: Monday, October 11, 2010 11:52 AM
    To: Pamela D. Simmons
    Cc: Patrick Randolph (UMKC Dirt); DIRT – Real Estate Lawyers Listserv; BROKERDIRT-request@LISTSERV.UMKC.EDU
    Subject: Fw: [DIRT] FW: [BROKERDIRT] FW: [BROKERDIRT] Strategic Default in California; Potential exposure for Title Insurers

    Pam and David,
    Thanks for your thoughts. What everyone has failed to recognize so far is the potential consequences to title insurers if any of the loans in question presently being investigated by the DOJ are unwound and title is determined to be unmarketable by reason of “a lenders poor judgment, sloppy execution or improper loan assignment” and, a claim is thereafter tendered to the title insurer to “defend the title as insured”. Even if the title insurer wins under the terms, conditions and stipulations in the policy it loses the premium it earned in expending considerable defense costs. That concern exists well beyond the borders of the state of California. That’s one of the reasons why most underwritiers haven’t made a profit on the title operations and production side of the ledger since 2005 or 2006. If anyone wants to verify that statement just look at the Form 9 Statement the title companies have to file each year with NAIC. While some claims counsel may contend that loss payments seem to be unchanged from last year, the argument that claims will begin to decline due to slack activity in the RE market during the continued recession may not apply in such a worse case scenario.

    Distribution list A, B, C, D

    William C. Hart
    CEO and Principal
    Title Law Associates
    Editor: Title Management Today
    P.O. Box 7137
    Elkins Park, PA 19027

  9. Texas Reader says:

    I feel quite certain that AFTER the election Congress WILL pass a law to address this – 1 -the law will give the servicers x days or months to get the proper documents drafted and executed to transfer those notes and mortgages into the trusts with no tax consequences for having failed to do it within x days as was previously required under IRS law and 2 – the law will somehow exempt the originators of those loans because they are “too big to fail”. Of course, many of the originators have already failed so the law will probably allow the transfer of those notes and mortgages into the REMICS without a requirement that assignments be executed in those instances.

    Of course this will mean stomping all over state real estate laws and New York trust law but it will be necessary in order to “avoid complete destruction of our system of home financing.” You can just bet on this as our reps and senators are beholden to their most important campaign contributors – financial firms.

    • Rebel Cole says:

      Congress can pass and the courts can, and would, find such law to be an unconstitutional violation of states’ rights.

      The only solution to this problem created by MERS and Wall Street is a series of million “quiet title” actions for each and every affected property that MERS touched.

      • Bill says:

        Here in Seattle I can’t find a attorney who thinks this is an issue. I want to start a quiet title action because MERS is on my DOT and the reply I receive most often is a shrug of the shoulders.

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