The 2006 peak of property prices in the United States and subsequent free-fall was sparked by low interest rates, rampant speculation and irresponsible lending practices. Inevitably, borrowers started to default, speculators began to pull out and prices plummeted. The foreclosure crisis may well be the second coming of this debacle.
Traditionally, banks were responsible for giving out mortgage loans and assessing the credit-worthiness of borrowers. Under this system, if a borrower defaulted, banks foreclosed the property in order to recoup their debt.
Investment bankers decided to join the party and securitised thousands of these mortgages into a Mortgage-Backed Security (MBS) which gave other investors and speculators exposure to the mortgage markets.
Banks increasingly began to focus on approving and selling mortgages without heeding the creditworthiness of the borrowers in exchange for handsome commissions, while investors assumed the risk of mortgage defaults in exchange for quick returns.
Each time a mortgage is transferred, signatures of both the buyer and seller are required to complete the transaction. During the housing boom, mortgage-backed securities were heavily traded and the rightful owners of the thousands of underlying mortgages were tracked and recorded through an electronic database.
This task is the domain of a ‘servicer’ who is responsible for not only tracking these records but also collecting mortgage payments and disbursing them to investors.
During the speculative frenzy, irresponsible recordkeeping caused as many as 27 per cent of these mortgage records to be rendered obsolete. When the need arose to foreclose a property, servicers were unable to trace rightful owners and forged documents started emerging to avoid foreclosure delays and loss of income.
Most recently, Bank of America (BoA) was asked to halt all foreclosures until it cleared up the situation. GMAC, another servicer, also came under heavy fire since the deposition of one of its entry level loan managers gave insight into the roughly 10,000 foreclosure documents being notarised each month by him alone.
Delayed foreclosures have also had other interesting side effects. A MBS is divided into junior and senior debt tranches where investors in junior tranches take on the highest risk for a higher return but in case of foreclosure are the last to receive the proceeds.
Each time a foreclosure is delayed, both senior and junior investors continue to receive payments even though the home owner has defaulted. This means that junior tranches receive payments they would not have if the foreclosure happened swiftly, while the senior tranches end up compensating for this when in fact the opposite should be the case.
Between the struggle of junior and senior debt holders, falsified foreclosure documents and negligent notarisations, the Federal Reserve has stepped in to rein in the situation.
The servicers include the four largest US banks and a total of $2.6 trillion held in residential MBS could come under scrutiny. Most recently, the Fed has asked BoA to buy back part of its $47 billion in mortgages it has originated. BoA estimates that these buybacks may amount to $13 billion or 27 per cent of the total.
Other servicers face similar liabilities and yet another bailout may be required to rescue the banks from their own negligence. Tax payers will once again foot the bill and the global economy will take another blow on the road to recovery.
The writer is heading Online Strategy and Development at Express Media
Published in The Express Tribune, October 25th, 2010.