A Mortgage Crisis Solution

Photo: Philip Brewer

The latest twist in the ongoing saga of the mortgage crisis is that some fraction of the banks (and other owners of mortgages) didn't manage the paperwork well enough to be able to prove that they actually own each particular mortgage on each particular house. This is bad and sloppy — but it just might contain the seeds to a solution.

I've written before that the root cause of the whole financial crisis was not (as many have suggested) falling house prices; rather it was that housing prices got too high. If you think about it, the average house has to be affordable to the average household — who else is going to buy it? Once prices got too high, they had to fall. The government and many other institutions have done what they can to "fix" the problem of falling house prices, but that's an effort doomed to failure.

Although propping up housing prices is a losing effort, it's a popular one. Homeowners like it — and homeowners tend to be voters. Bankers also like it, and the government has been looking out for them as well, for several reasons: They're a source of political contributions; bank regulators are tasked with preserving the banks (which are endangered by collapsing housing prices); even legislators and regulators who are primarily looking out for the interests of ordinary people know that a collapsing financial sector would be hard on everyone — not just bankers.

The upshot has been that, despite the fact that a lot of people would like nothing better than to stick it to the banks, there's been very little effort to actually do so.

This latest twist in the crisis, though, may give us an opportunity to make the banks do the right thing.

The Right Thing

The right thing would be for the pain to fall where it belongs. A lot of failed mortgages have two culprits. It's as much the fault of the homeowner who bought a house they couldn't afford as it is the fault of the banker who lent them money they'd never be able to pay back. But I'm not too worried about sticking it to the poor homeowner — they're going to suffer plenty. My main concern is that helping them not cost the rest of us a lot more money.

So, to my mind, the right thing to have happen is for the banks who made stupid mortgages to be the ones who lose a lot of money. That's not a popular idea with bankers (who won't get nearly as much bonus money), and it's not a popular idea with bank regulators (who worry that banks that lose money might go under, dragging the rest of the financial system down with it). But the discovery of this record-keeping failure may have taken matters out of their hands.

Banks have been resisting efforts to write mortgages down to the value of the house, even when the only alternative is foreclosure. All those foreclosures are sad. They'd be sad even if the only people being foreclosed on were foolish people who bought houses they couldn't afford — I don't want to see even foolish people turned out of their home. But it's worse than that. Many innocent people are caught up in the housing catastrophe. (You can see the stories of some innocent victims in the comments on my post Six Options if You're Underwater on Your Mortgage.)

Up to now, though, there's been no pressure on banks to negotiate with homeowners to straighten things out. It's been cheaper to just foreclose, write off the loss, and go on.

But now that everyone knows that the banks had been cutting a lot of corners on the paperwork, the situation is very different. A few egregious mistakes aside, in most cases there really is a mortgage and the owner really hasn't been making his payments. But because of the mistakes, it now seems clear that the bankers will no longer be allowed to slide things through quick and easy. Instead, they're going to be forced to cross every t and dot every i.

This changes everything. In the cases where the record keeping has been very sloppy, it may be impossible to prove that the bank really owns the mortgage. Even where it's possible, it may be expensive. The banks, looking for the cheapest solution, just may find that it's cheaper to negotiate with the owner, and then write a new mortgage (and make darn sure that the paperwork for the new mortgage gets filed correctly). Even if they write the mortgage down to fair market value, they'll probably come out ahead of where they'd be if they had to foreclose, maintain the house for a while, and then sell it into a down housing market. (And they'll come out way ahead of where they'd be if the homeowner discovered that the bank can't prove that they've actually got a mortgage on the house at all.)

I see this as a win for everyone except the bankers. Homeowners get to stay in their house, with a new mortgage that reflects the actual value of the house. House prices fall to where they belong, making houses available to ordinary people — but they do so without the dislocations of so many foreclosures and forced sales. Bank profits will suffer, but in exchange the banks get a chance to clean up their paperwork — valid, provable mortgages that will stand up in court. Really, it's just the bankers — whose bonuses will be under considerable pressure until this is all worked through — who lose.

As a bonus: Going on the theory that there's considerable overlap between the banks most prone to screw up the paperwork and the banks most prone to lend money to people who couldn't pay it back — I'm thinking that the worst of the pain will tend to fall right where it's most deserved.

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Guest's picture

I probably agree with you for the most part, but I'd make a couple changes. First, I'd say that the root cause was that people bought things they couldn't afford and defaulted. Then I'd agree that they shouldn't have done that and that the banks shouldn't have let them borrow that money, but I'd also point out that the government told the banks to do it and made it really easy for them to do so.

I think that if the government had left its hands out of business to begin with, the problem either wouldn't have existed or would have been much, much easier.

The government also just makes it worse every time they try to "fix" it. Let failures fail. People need to learn from their mistakes, not get rewarded from them.

Great article.

Philip Brewer's picture

People buying things they couldn't afford and then defaulting is bad, but if it were just that the situation could have played out without endangering the whole financial system. (Because if housing prices hadn't been in a bubble, banks could have foreclosed and sold the house for enough to cover the debt.)

But you're right that the combination of unwise borrowing and unwise lending was what drove the bubble in the first place.

Guest's picture

But the banks don't own the mortgages, they sold them off as slices in mortgage backed securities. Now the bank is just the servicer of the loan. The only way to punish the "bad" bank is to force it to take back, or repurchase, the faulty loan it originally made. But how do you reconstitute that loan that was sliced into a hundred different pieces and sold to a hundred different investors/institutions?

Philip Brewer's picture

Ah, but that just puts the banks doubly at risk. When they sold off the bundles of mortgages, they made assurances that they were selling a valid mortgage—with all the necessary assignments and documentation to enable foreclosure.

If those assurances were false, the bank has defrauded the investors who bought those pools of mortgages. (That is, they're not only on the hook for the money, they could also go to jail.)

Guest's picture

8:54 said: "But the banks don't own the mortgages, they sold them off as slices in mortgage backed securities. Now the bank is just the servicer of the loan. The only way to punish the "bad" bank is to force it to take back, or repurchase, the faulty loan it originally made. But how do you reconstitute that loan that was sliced into a hundred different pieces and sold to a hundred different investors/institutions?"

I guess that is right but then all the banks and financial institutions (and a few regular joes) bought those mortgage-backed securities back. That is what makes it so weird, one part of the bank is thanking their lucky stars for being able to package up these risks and sell them to agents who sell the same risk back to another part of the bank (and that part of the bank thinks they are buying AAA stuff).

Maybe the bad banks will get to share the pain with other banks but in effect the pain will be felt primarily by the banks. From what I've read the few regular joes have been protected. So the banks are trying to get what they can out of these high risk mortgages because it will in the end help their own bottom lines. If it becomes better (cheaper) for them to renegotiate instead of foreclose then the price differential is the added hit that will have to be shared by the banking community.

Philip Brewer's picture

There were several things going on that resulted in the banks ending up owning a lot of the debt they'd thought they were going to sell:

  • The banks were keeping the riskiest slices of their complex mortgage-backed securities (because those slices were harder to sell).
  • The banks were making assurances about the quality of the loans in the packages—and promising the buy the package back if those assurances turned out to be false.
  • The banks were lending money to the people buying the mortgage-backed securities—letting them use the securities as colateral. When the investors defaulted, the banks got their securities back again.

The result was that the banks hadn't unloaded nearly as much risk as they'd thought they had.

Guest's picture

There is no way to incentivize the loan servicer to modify the loan. Only the owner of the loan has the authority to modify the loan. But with the ownership being so fractionalized and convoluted, how do you reach agreement on a particular modification? There is no way to run through that process for each of the millions of mortgages in question. How long would that take? How many months should some one be able to live in a house without making a mortgage payment before they need to leave?

Philip Brewer's picture

There have been some rule changes, making it easier for loan servicers to agree to modifications on behalf of the investors. But they haven't had the desired result, because (as you say), actually negotiating the modifications is too much work.

But that's where the recent news comes in. Yes, it'll be very expensive to renegotiate all these mortgages—but perhaps not as expensive as tracking down all the paperwork and getting all the reassignments properly documented.

And I think the servicers may be more incentivized than you think. There are apparently rules requiring that they cover payments to the junior tranches when there are delays in the things that they're supposed to be handling (such as foreclosures).

Guest's picture

much as I hate to admit it because I have owned my home for a long time, I think you have hit the nail on the head. Quite possibly this will be the straw that breaks the camel's back, banks will be forced into reducing their customer's financial liability to the home's market value and we can all get on with selling real estate at reasonable prices.

Guest's picture
L. Bowser

When the dust settles, not having physical evidence of the mortgage will not allow home-owners to get out of their mortgages or create a real problem for the banks --other than reducing foreclosure velocity. Most judges will be reluctant to find that there is no mortgage due to poor records management. There is prima-fascie evidence in all these trials that there was in fact a mortgage agreement in place. That evidence is the fact the homeowner was paying the bank every month until they fell on hard times. So long as that is the fact, in general, courts should rule in favor of the banks that there was in fact a mortgage regardless of whether proper notarization or lien filing occurred.

The real question will be whether or not there is an enforcable lien against the property. Remeber, a lien is not about securing ownership in a property, rather it is a legal procedure securing the rights of a service provider (lender, contractor, etc...) to collect proceeds from the sale of the home in the case of debt default, by communicating the homeowner's obligation to the world at large. Failing to file or incorrectly filing the lien does not nullify the bank's interest in a property, because the borrower signed a collateral agreement when the mortgage was written --the evidence the bank uses when perfecting their first position lien. Where the bank will run into trouble, is if they didn't perfect a lien, and someone else perfected a lien against said property for a valid service or debt. That party's payment rights will then supercede the bank's in a foreclosure proceeding around a process technicality dealing with proper notification.

Given what I've just said, it probably won't change a bank's mind set when dealing with the consumer. They do not want to set a market precedent for principal modification except in cases of extreme fraud on the part of their own agents. The problem is, due to most market appraisals having been done by independent entities, you will have a hard time making a legal case the bank did not perform appropriate due diligence on the asset before making the loan, or that they committed fraud by offering an inflated appraisal. You will also have a hard time making the case that the banks inflated the housing market. They were not making the offers. At best you can conclude they looked the other way in the face of rapid inflation that seemed to have no real-world basis. But then again, so did the home buyer.

Philip Brewer's picture

In general it's true that defects in the paperwork don't cancel out the actual intentions of what people agree to do—other evidence (such as you delivering goods and me sending a check) is enough to support the contention that we'd made an agreement and then fulfilled it.

Over the years, though, the courts and the legislature have determined that there are certain things where just providing evidence that there must have been an agreement isn't good enough: the paperwork has to be right. One such category (for over 300 years) has been the conveyance of land. That must be done via a signed writing, and it's not good enough to provide other evidence of our agreement (such as that I'd been paying on the mortgage until I lost my job).

Exactly how this will all sort out, I don't know. As I understand the law, in cases where there isn't good evidence that a signed writing ever existed, the debt still exists, but it isn't secured by the property.

I agree that the courts probably won't like coming to that result—but they also won't like coming down in favor of the banks, given that it was the banks that systematically screwed everything up. The upshot is that about anything could happen.

But the fact that the uncertainty cuts both ways is what makes me think that we might see a real effort made to negotiate new mortgages with reasonable terms (very carefully documented with a signed writing).

Guest's picture

You place equal responsibility on home owners and the mortgage industry. I have argued that is in fact incorrect and the responsibility (fiduciary to be specific) lies upon the mortgage companies. This is not to deny the culpability of owners but only to state that responsibility takes priority: