Safe as Houses: What happened to the American housing market?
Part one in a series on the housing market and foreclosure crisis
analysis by Gina Hamilton
Last fall, several large banks and even some smaller ones — led by Bank of America, Ally Bank (subsidiary of GMAC) and Chase Bank — temporarily halted foreclosures in states with what is called a "judicial review" — that is, a judge had to approve the foreclosures — because their foreclosure practices were called into question with very good cause. Lawmakers began calling for a freeze to all foreclosures, a move which the Obama administration opposed. In November, the results of the election made that course of action all but impossible, but the problems with foreclosures still remain.
Events began to take on a life of their own, with many foreclosed homeowners taking their banks to court — and winning the occasional large judgment — if they convinced a judge or jury that their bank had engaged in one or more nefarious types of behavior, from having "robo-signers" sign off on their mortgages, to losing the original notes, to forging signatures on replacement documents. Foreclosures, though still in record numbers, are moving much more slowly through the long, sad process. That's good, or at least a temporary reprieve, for homeowners in delinquency. But for individuals and mutual funds and hedge funds that hold pieces of the paper on these loans, it has been, and will continue to be, a long, cold, financial bath.
But how did this mess come about in the first place? Foreclosures had been a sad, but orderly, process for many years. A homeowner lost a job, or got in trouble in some other way, and after a period of months or years, the bank repossessed the house.
What changed the playing field was something that has become sort of a dirty word in the financial markets: securitization. In securitization, one bank no longer owned the house. First, mortgage loans are purchased from banks, mortgage companies, and other "originators." Secondly, these loans are assembled into collections, or "pools." These pools are known as mortgage-backed securities (MBS), and come in a few different varieties, mostly residential single-family and commercial — which includes rental housing, schools, industrial and commercial real estate of all types. From there, the securitites are "securitized" through various legal methods dependent on the type of MBS and jurisdiction. Residential MBS are usually sold as bonds, which offer the investor a regular, expected income, for instance.
However, financial innovation has created a variety of securities that derive their ultimate value from mortgage pools. In the United States, most MBSs are issued by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Some private institutions, such as brokerage firms, banks and homebuilders, also securitize mortgages, known as "private-label" mortgage securities.
For simplicity's sake, we began this flowchart from the point at which the loan is signed, but other organizations — mortgage brokers, for instance — often do the initial paperwork and shop the loan to banks and mortgage companies.
This process is going on for all the mortgages sold in the country. So the ultimate product is a bond or security that contains pieces of many different mortgages. No single investor — for instance, the Bank of America — owns the mortgages in question. Instead, many owners hold percentage shares of different mortgages, and not all of them have the same rights or responsibilities toward the homeowner.
The original purpose of securitization was to free the originator to make more loans. For instance, Bank of America makes 100 home loans, then uses Fannie Mae or FHA to issue bonds to create a liquid secondary market, freeing up Bank of America’s capital to issue 100 more loans. The idea was a simple one: Home ownership was a national goal for most citizens, and the way to do that was to make enough capital available so that people could obtain loans at attractive rates.
That system worked well for many years, indemnifying banks enough to take chances on mortgages at a time (after the Great Depression) when, as now, banks are unwilling to lend to anyone but those with the most pristine credit history. Despite FHA and Fannie Mae’s support, for several decades, banks remained essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and occasionally on the insured debt that FHA and Fannie Mae secured.
By the 1970s, investors were clamoring for a bigger return on mortgage investments. Pools began to be rated by credit agencies, and those willing to take the biggest chance (on subprime lending) stood to reap the greatest reward. Creative financing — that is, without a 20 percent stake in the home — soon became a larger percentage of the mortgages offered, because those were the ones for which there was investor interest. Not much money stood to be made on AAA mortgages, although they were "safe" and the investment would be at least returned intact. Instead, investors wanted a little risk, because more money was to be earned on slightly more risky ventures.
A Bubble Grows
With relatively easy credit to be had, even for people who couldn’t or wouldn’t show documentation such as proof of income, a lot of dollars were chasing a limited supply of houses (even with a building boom in hot markets), and prices inevitably rose. The real estate bubble that ensued was not unheard of in the past, but the bubble of the '90s and into the new century seemed to have no end. Prices of existing homes tripled in hot markets such as California and Nevada and Florida, and even prices in relatively staid locations (like Maine) increased. People stopped thinking of a house as a home and began to consider it a lucrative short-term investment.
By the 1990s, mortgages were beginning to be "bundled" into MBS consisting of a few safe AAA mortgages, combined with a majority of subprime mortgages, and sold to increasingly unwary institutional investors, such as retirement plans, municipal funds, and more.
All of this worked out OK as long as housing prices continued to go up. Homeowners who were in financial difficulty typically had no problem selling a home, most likely for far more than they paid for it, and even getting into another home within a short period of time. The investors who had been willing (or who didn’t know what they were doing) to take the greatest risks were seeing the greatest payoffs.
The Housing Bubble Bursts
Of course, the party couldn’t go on forever. Housing prices peaked in 2005, and began a slow decline that turned into a steep cliff by 2008. By 2009, nearly 3 percent of all mortgages in the U.S. were at some stage of foreclosure. Compare that to 2007, when just over 1 percent were in foreclosure.
Because prices were falling, people in trouble couldn’t get out from under mortgages as they had in the past. Banks that had been cheerfully willing to refinance just a few years before were suddenly not interested. Even with government trying to lend a hand, most banks dithered at the prospect of helping underwater homeowners cut their principal, or allow a short sale to go through. So many mortgages were in foreclosure that the banks started to cut corners, just as they had during the heady heyday of subprime lending and securitization. And the truth was, in many cases, no one really knew who held the note on the house.
‘Show Me The Note’
In 2007, a federal judge held that Deutsche Bank lacked standing to foreclose in 14 cases because it couldn’t produce the documents proving that it had been assigned the rights in the mortgages when they were securitized.
This decision was followed by similar rulings in other states stopping foreclosure proceedings. Typically the judges would find that the banks that were servicing mortgages pooled into bonds weren’t able to prove they owned the mortgages.
Every time a mortgage changes hands, the new owners are supposed to receive an assignment of the mortgage notes from the originator or previous owner. The assignment is typically a short document signed by both the seller and buyer of the mortgage acknowledging the sale, which is then attached to the mortgage documents themselves and delivered to the new owner.
When a mortgage is securitized it is typically sold to a Wall Street firm, which pools the mortgage with thousands of others. Investors buy slices of the pool, entitling them to cashflows from the mortgage payments. The actual mortgages are assigned to a newly created investment vehicle. A servicer is tasked with ensuring the payments to borrowers get divided up properly and that delinquent borrowers get foreclosed upon.
Here’s where things get tricky. When a mortgage is securitized, the investors in the mortgage bonds don’t get assignments or notes. The investment vehicle doesn’t get the assignments or notes either. Instead, the physical notes are typically sent to a document-repository company. The transfer of interests is noted in an electronic database.
But during the height of the housing bubble, investment banks were churning out mortgage bonds in such a frenzy, sometimes the assignments never got executed and mortgage notes never got delivered. It was inevitable that the fast and loose and slightly documented culture would not stop at the mortgage originator but stretch all the way through the process.
For most mortgages, the note probably still exists somewhere. One problem that has arisen, however, is that some of the original mortgage lenders have gone under or been acquired by a larger bank. This can make tracking down the notes difficult, if not impossible. For instance, one of the largest mortgage issuers in the country, Countrywide Financial Corp., was acquired by Bank of America, which outsourced its mortgage collection to a third affiliated company called BAC Mortgage. Whether notes underwritten by Countrywide (and securitized) can be found in either Bank of America or BAC is questionable, and where the notes are is also in some question.
As homeowners realized the problem, a new way of combating foreclosure arose: the "Show Me The Note" movement. This certainly prevented a fair number of foreclosures, and some 23 states began to require judicial signoff of foreclosures, which worked to slow things down in those states.
But what really gummed up the works was the deposition of a GMAC loan officer, Jeffrey Stephan, who admitted in a sworn deposition in Pennsylvania that he signed off on up to 10,000 foreclosure documents a month for five years. He said that he hadn’t reviewed the mortgage or foreclosure documents thoroughly. He quickly became known by the pejorative term “robo-signer” for this way of getting mortgages through. This prompted Ally, which owns the GMAC mortgage company, to halt foreclosures in the judicial states.
Because Stephan also signed foreclosures for hundreds of other mortgage companies, including JP Morgan Chase, Bank of New York and Deutsche Bank, the problem is not limited to GMAC. In fact, JP Morgan Chase also halted foreclosures in the judicial states. For a time, Bank of America halted foreclosures across the country, not just in the judicial states.
In these states, which includes Maine, banks are typically required to produce a sworn and notarized affidavit of a loan officer and submit the mortgage documents. Often, however, judges will issue foreclosure orders without the mortgage documents so long as the borrower doesn’t contest this point.
In both judicial and non-judicial states, there are strong legal presumptions that favor the banks. So long as they have the mortgage note and the loan is delinquent — or so long as no one argues that they aren’t the owners of the mortgage or that the borrower is not in default — the bank will almost always get the foreclosure.
But as the “show me the note” movement took off, more and more homeowners began to contest foreclosures by demanding to see the notes and, if the loan had been transferred or securitized, the assignment agreements. This typically was not fatal to banks seeking foreclosures. They could make up for the lost notes with lost note affidavits and retroactively build an assignment chain. The worst that would happen, from the bank’s perspective, was that the foreclosure would be delayed.
In some cases, however, banks seem to have not been able to manage even this kind of corrective action. Evidence has been produced to show that notarizations have been faked, documents forged, and people like Stephan functioned as rubber-stampers who didn’t even bother to look at the documentation.
If the problem truly is just sloppy work on the part of robo-signers, foreclosure rates will resume, and rise during 2011 and 2012. But many suspect that the reason banks were falsifying their knowledge about the possession of loan documents is that the banks do not actually have the documents in a whole lot of cases, and don’t know where to find them. This could permanently impair their ability to foreclose on some properties.
And that’s assuming that the government doesn’t step in and halt foreclosures until the banks get their collective acts together. In some states, notably in Connecticut, the attorney general sought a halt to any foreclosure. In 40 states, including Maine, the attorneys general are conducting investigations that could well lead to foreclosures being halted.
That Long, Cold Bath
Banks were hoping desperately to move these foreclosures through the system very quickly, because the investors are not getting paid by homeowners in default, which means the banks have to make up the difference on the bond income — for now. Even if they had to sell the homes at a serious loss, the loss would either be taken as a tax loss against profits, or in many cases, would be covered by mortgage insurance, and the banks would come out OK.
But if they can’t foreclose, neither option is available to them. And investors are getting not only restless and impatient, they are turning to other investments that are less risky, including a rebounding stock market.
Part of what ForeclosureGate did was, ironically, to stabilize house prices, since the pool of available houses can be forecast to be less than the banks intended. Without millions of houses being dumped onto an already depressed housing market, the price of houses began to settle down in the fall and winter of 2010. However, in the news as late as today, there are ominous signs of property values plummeting owing to resuming foreclosures, and the number of properties now on the market.
Home prices continued to fall during the first three months of 2011, falling 4.6% from a year earlier. The U.S. median price, according to the National Association of Realtors (NAR), dropped to $158,700 for a single family house. Condo prices fell even harder -- 10.4% to $152,900.
The median home price has now slumped 30% from its 2006 high of $227,100, and prices have fallen nearly 7% so far this year.
This is very bad news for homeowners who were hoping, one day, to recoup their investments. For banks, however, in a market with historically low mortgage rates and decreasing housing prices, and a securities market that is falling apart at the seams, there is no real incentive to lend for housing, regardless of the creditworthiness of the applicant.
And because so many of the notes and assignments may be gone for good, it will be difficult to sell any house, in foreclosure or not, in the future. If clear title can't be obtained, how can these places be sold — ever? No lender will grant a mortgage against a quit-claim deed. Some title insurers are refusing to write title insurance on foreclosures at all, while others have raised their rates sky-high.
People in the market to buy a home may take a risk on a foreclosure, or buy a home with depressed value because of local foreclosures. The real estate market won't be coming back, at least not as strong as it has been in years past.
Most analysts suggest it will take between six months to a year to obtain all the actual documentation on a home in foreclosure, if it can be done at all. In the meantime, banks — and mortgage investors — are in limbo. But mortgage investors have other options. Banks have far fewer options, and that means that more and more banks are going to find themselves in financial trouble, too.