The Next Banking Crisis: The Foreclosure Mess May Force a Solution to the Deeper Economic Drag of Underwater Mortgages and Zombie Banks

By Kuttner, Robert | The American Prospect, January-February 2011 | Go to article overview

The Next Banking Crisis: The Foreclosure Mess May Force a Solution to the Deeper Economic Drag of Underwater Mortgages and Zombie Banks


Kuttner, Robert, The American Prospect


Last June, Thomas Cox, a legal-services lawyer representing a Maine homeowner named Nicolle Bradbury, took an extended deposition from a clerk for the mortgage giant GMAC, which was trying to foreclose on Bradbury's house. GMAC, once the financing arm of General Motors, received a $17.3 billion bailout in 2009 and became 56 percent government-owned. The clerk, Jeffrey Stephan, admitted that he signed over 400 affidavits a day attesting to documents that were supposed to be in files but were not. The case brought to light a widespread industry practice known as robo-signing.

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Cox, summarizing the deposition to Judge Keith Powers, declared, "When Stephan says in an affidavit that he has personal knowledge of the facts stated in his affidavits, he doesn't. When he says that he has custody and control of the loan documents, he doesn't. When he says that he is attaching 'a true and accurate' copy of a note or a mortgage, he has no idea if that is so."

When the judge ruled against the bank's request for summary judgment in September, all hell broke loose. Judge Powers reprimanded GMAC, noting that the lender had been warned to cease such practices in a Florida case four years earlier. This prompted GMAC to temporarily suspend foreclosures in the entire country. JPMorgan Chase followed suit, suspending foreclosures in the 23 states where foreclosures must be approved by a judge.

The banking industry contends that these are isolated problems, but evidence is accumulating that such lapses are pervasive. Robo-signing and other careless practices occurred not just on the back end, when a bank tried to foreclose, but on the front end, in the creation and packaging of the original mortgages.

Evidence coming to light suggests that as subprime loan-origination mills went into overdrive during the boom, they got very sloppy. As loans were turned into securities, many of the trusts that supposedly hold the documents have neither the actual promissory notes nor the liens that give the lender the right to foreclose. The problem was compounded when lenders created an electronic database called the Mortgage Electronic Registration System, or MERS. Often, physical notes were eliminated in favor of electronic ones; however, the law in most states requires that the original note be endorsed--in "wet ink"--to each new owner at every step of securitization.

Katherine Porter, a law professor at the University of Iowa and an expert in mortgage servicing, recently testified to the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP) that according to lawyers for both homeowners and banks, "a very large number (perhaps virtually all) securitized loans made in the boom period in the mid-2000s contain serious paperwork flaws, did not meet underwriting or other requirements of the trust, and have not been serviced properly as to default and foreclosure."

So, this legal morass doesn't just gum up foreclosures; it calls into question whether several trillion dollars worth of mortgage-backed securities are worth anything close to their face value. Confronted with this incipient crisis, the Treasury Department is in a dither, torn between the need to take aggressive steps to prevent the mess from accelerating into a full-blown banking panic and the desire to reassure money markets that all is well.

ON OCT. 18, THE FEDERAL RESERVE Bank of New York joined two large investment companies, Pimco and BlackRock, in sending a remarkable letter to Bank of America. The letter demanded that the bank make good on some $47 billion worth of securities with documentation problems similar to those revealed in the Maine case. Some of these securities had been purchased by the New York Fed as part of its bank-bailout program.

When a bank turns mortgages into securities, investors are given a "put back," or a right to demand that the bank buy the securities back if they turn out to be legally flawed. …

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