How housing market might muddle through new foreclosure crisis

Concerns about faulty mortgage and foreclosure paperwork have become a housing-market mess, but many finance experts say it's a manageable one.

Yes, many foreclosures will face delays or new litigation. Yes, the housing market might be hurt by the ripple effects. And big banks could face some big new costs in the form of lawsuits by mortgage investors.

But this doesn't mean the problems will be big enough to shut down the foreclosure process, the housing market, or the banking system. Many housing experts say such dire scenarios are unlikely, despite the current uncertainties about the scale of what some are calling "Foreclosure Gate."

More likely, they say, is a "muddle-through" scenario in which litigation and efforts by creditors to clear up flaws in paperwork gradually calm the storm.

The process of foreclosing and then selling a legion of bank-owned homes is already a slow-moving train, says Joseph Mason, a Louisiana State University finance professor who follows real estate issues. The new level of legal scrutiny puts some new twists in the track. Banks will face new legal fees to get their paperwork right.

But it would be very unusual if there are many cases in which creditors prove unable to foreclose on a borrower in default, says Mr. Mason.

The worries about faulty documentation have grown over the past month, as several large banks temporarily halted foreclosure actions in 23 states where the process is overseen by a judge. The firestorm of concern grew out of instances of "robo-signing" by loan officials who didn't take time to check foreclosure documents, and allegations that mortgage paperwork was mishandled when newly made loans were originally bundled into securities to be sold to investors.

Mason's view parallels those of Obama administration officials, bankers, and industry analysts in recent days:

• Housing Secretary Shaun Donovan sought to ease public concerns earlier this week, telling reporters he has seen no evidence of "structural" problems in the mortgage origination process.
• Bank of America said that, after pausing to review its process, it would move forward with "the process of preparing foreclosure affidavits for submission in 102,000 foreclosure actions in which judgment is pending."
• Investment analysts at J.P. Morgan estimated that banks could lose $55 billion to $120 billion from being forced to buy back troubled loans from investors. These "put-backs" could be caused by faulty paperwork by the banks that created mortgage securities. Analysts at FBR Capital Markets reckon the industry could lose another $10 billion or so from the separate issue of foreclosure delays and litigation related to bad paperwork.

Those cost estimates are big, but not on a scale that would be likely to cause a new round of financial panic. And some analysts believe it will only be a few months before the document snarls fade into the background.

For now, though, one problem is that no one knows for sure the magnitude of the documentation problems – or how the issues will play out in state courts across the country.

One hint that the issues could have a sizable impact: The share price of Bank of America – the large bank most in the spotlight so far in these litigation risks – has fallen nearly 15 percent in the past month. A broader index of financial-company stocks is roughly flat for that same period.

When a borrower takes out a home loan, two documents are considered vital: the note (or promise to pay) and the mortgage (or lien on property, which secures the note).

Karen Gelernt, an attorney at Cadwalader, Wickersham & Taft, argues that creditors who hold the note are generally able to prevail in legal efforts to foreclose, even if paperwork problems (such as in the way the mortgage was assigned) slow their path.

"The principles of commercial law and negotiable instruments, if applied correctly, should ultimately prevail and allow the holder of the note to foreclose to the extent permitted by the mortgage loan documents and applicable state law," she writes in a column for American Banker.

Housing experts say the biggest gaps in documentation are cropping up in so-called private label mortgage securities. Paperwork problems are believed to be smaller for the mortgage securities backed by Fannie Mae and Freddie Mac, agencies now being backstopped by US taxpayers.