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Friday, October 29, 2010

Houses Of Pain....AKA.... "Forclosuregate"

The whole “Forclosuregate” or as some call it “Mortgagegate” fiasco has got me thinking what are the implications beyond the obvious. I think the best place to start so that you, dear reader, can have more of an understanding of the situation is with the components that make up this type of transaction.

For millions of Americans the dream of homeownership has turned in to the nightmare reality of loss or potential loss of their home.  We all know that the process begins with purchasing a house that will become a home with real people living in it. This post is not about rehashing how homeowners got in to the mess that we as a country face, I am sure dear reader that by this point you have read many articles belaboring this point along with who is at fault, believe me I know after all I live in Barney Frank’s district. Rather I want to delve into some of the aspects that are less well known that affect this “Forclosuregate” issue.

Let’s look at some background regarding the components of the mortgage that are involved in this mess. When a person or family decides it is time to purchase a house to make their own home, they will go find and contract on said property. Without getting in to the specifics of down payments and other factors let us just stipulate that they obtain a mortgage to enable them to buy their newly contracted property. The mortgage is approved, written, executed and the buyer receives the funding for the transaction.  The mortgages is a legal document that details all the terms of the loan including the term, interest rate, payment, and other legal stipulations including actions for nonpayment which include foreclosure.  At the time of the Mortgage, a UCC or mortgage note is filed which gives the holder of the note the ability to secure payment; in other words it allows them to collect the underlying asset to recover the principal loan amount (assuming it is still worth what the loan amount).  The note is filed at the state agency that handles notes, in some states this will be the Department of Licensing, in the same state as the property. The UCC or Note is one of the documents that is signed by the lender or their proxy and the mortgagee at the closing and gives clear legal representation of who owns the loan. The UCC is critical for a lender as it not only establishes the legal precedence for debt collection but also differentiates the lender as being first in line to get paid if there are multiple liens.

As a brief aside UCC stands for Uniform Commercial Code and all fifty states have enacted some version of the UCC, which is far better than the real estate laws which can not only vary from state to state but within each state as well. The UCC was created in 1951 by representatives from the National Conference of Commissioners on Uniform State Laws and the American Law Institute, to help give some uniformity to commercial laws between all the states promoting commerce. The UCC consists of 9 articles each pertaining to specific areas of commercial law, article 9 covers real estate. The UCC is a filing system and the mortgage note, the legal ownership document, is filed within the system and needs to be updated every 5 years or it can be expunged from the records which could cause the lender a problem.



Another key factor of the UCC is that it must be accurate and contain the proper legal name of the mortgagee and the property, as well as it must be filed in the correct jurisdiction. If the Mortgage lender has not adhered to the rules of the UCC and or filed wrong information or in the wrong jurisdiction it could result in the loss of the security meaning the mortgage holder would lose their claim.

The current excitement in the “Foreclosuregate” debacle centers around the idea that documents and who has what document to show legal possession. Many lawyers have been arguing that because of some minor technicality in the process that banks cannot foreclose; however, this is not a true situation. The idea has been further perpetuated by Obama’s threat to use his “pocket veto” to strike down legislation that had very broad bipartisan support that would allow for foreclosure documents to be accepted across multiple states; is it a coincidence that this veto which only serves to slowdown the mortgage clearing problem and begin the healing process comes just before the election. The legislation would not make it easier for banks to win foreclosure per se but it would clear many obstacles to fixing the problem. The bottom line is that if the mortgage is not performing as was stipulated in the contract and the bank that holds the legal right to the loan, meaning they are in possession of a valid mortgage note under the UCC guidelines, wants to foreclose then there is no legal way to stop the process even with notarization issues.

Lately there have been grumblings that Congress should pass a foreclosure moratorium even though the Obama administration is opposed to such a maneuver. The outcry for the moratorium push has grown since the banks themselves declared a moratorium, so that they could get all their ducks in a row before proceeding. The problem for a moratorium is that it is not congress’ place to do so as this is a question of “states” rights. The decision to place a moratorium on foreclosure is only empowered and enforced at the state level, the federal government does not have the expressed powers to enforce this type of moratorium at least not constitutionally (although that has not stopped the FEDs before). In my home state of Massachusetts the attorney general has called on major lenders agree to a moratorium on foreclosures and other states have followed suit which is what prompted the major banks to voluntarily stop foreclosures.

Ok so now dear reader we understand the basics of the issues at the heart of “Foreclosuregate” let us look at the some of the potential consequences and issues.

Let’s start with the FEDs since that is the last item discussed. If Washington were to step in to the fray here and force a moratorium on foreclosures it would have unintended consequences that could be very detrimental to our economy long term. Aside from the fact that the banks would stand to lose money which they should as they made poor decisions and should have to pay the consequences, the entire way we do business would be altered. The United States has enjoyed the most robust economy and deepest financial markets because of the way in which business was conducted in the past and the fact that we are a country of laws. Our economy was predicated on fair rules of trade, private property ownership and contract law. A moratorium on foreclosures would be yet another sign post on the road to banana republicville for the world to take note. The foreclosure ban would be an abrogation of contract law, and it would be the second large occurrence of it in the past couple years. The first very public incident of abrogation occurred during the financial crisis in 2008 when the Obama administration essentially demonized the bond holders of GM and Chrysler and violated the legal contract of the bond by forcing them to accept a settlement as opposed to being made whole as the law stipulates. The bondholders were made out to be greedy speculators, where as the truth of the matter is the bondholders were people like you and me as well as pension and mutual funds, you know dear reader typical enemies of the state. Not that I have any great love for the banks, but upholding the law is one of the key differentiating facts that separates us from a Russia or Central American economy. People buy in to America because they know what they can expect and their property rights are defended, unlike say a Russia who invites in oil and gas companies then takes over their discoveries and kicks them out. If the FEDs step in, it will have the unintended consequence of diverting investment and capital flow to other places on the globe out of fear that the US no longer respects the rules of the game and if it something is not to the US’s liking they will just change the rules. It does not just apply to foreign investment in our markets but also to investing in our government debt, which as you know dear reader, currently rings the register to the tune of $175 billion a month. Foreigners may not be inclined to invest in any of our markets and our own citizens may question if it is a good idea too. It is just a dangerous precedent to set.

Secondly, if we don’t let the system clear itself of all this debt and misallocated investment our economy will be stuck in low gear for years to come, just look at Japan who propped up their real estate sector after the burst of 1989. Granted things are different here in the US and will play out in different fashion than in Japan since we are a great debtor nation versus Japan being a great creditor nation; we will see much higher rates of inflation as opposed to the deflation Japan has experienced. In the late 80’sthe United States went through the S & L crisis and had experienced a steep run up in housing as well, but we dealt with that situation. The RTC or resolution Trust Company was set up and handled the liquidation process to clear the bad stuff out and in a short while things were moving again. Today it is more complicated only because the numbers are far larger but the solution is the same. The sooner we get the process moving the sooner house assets re-price and new owners who will pay the notes can buy and move in to stabilize real estate at an affordable level. I know no one, me included, wants to see the value of their home reset, but it is inevitable in this environment and lower prices will bringing the stabilizing factor of new buyers.

Third, because of all the slicing and dicing of mortgages and creating the mortgage backed securities and CDO’s there are bound to be ownership issues and many people and institutions will be hurt. Depending on how the UCC\Notes were filed or transferred will determine who owns what and who can collect. The securitization process of the CDOs and the selling and reselling has created a Pandora’s box that will have to be opened in the process. This in turn will come back to bite the banks and mortgage originators as people and institutions will sue to recover whatever funds they can. The precedent has already been set for the owners of the CDOs and mortgages to put the mortgage back to the bank when the FED and other banks filed suit against Bank Of America. This a problem that is measured in the trillions of dollars and mortgage put backs could be the death knell for some of the banks but will surely impact financial stocks going forward, and with the aforementioned institutions opening the door it will produce a torrent of claims as more institutions come out of the woodwork to sue lest they be sued by their investors.

Fourth, if a foreclosure moratorium was implemented it could have the unintended consequence of compounding the foreclosure situation. There are currently people living in houses that are behind in their payments, however, they have just made the conscious decision not to pay as opposed to not being able to pay. These are people gaming the system, living rent free and using the mortgage money to buy things, vacation or just fuel general consumption. It is reprehensible that people would take that kind of action and regardless of their rationale it is wrong, but none the less a moratorium would more than likely expand this type of behavior as there would be no consequence to acting in this manner; this is a classic moral hazard.

Fifth, this whole mess puts states and particularly municipalities at risk and relates back my “Municipal Jenga” post because it impacts budgets. If a foreclosure moratorium is imposed then Municipal revenues will decline. The reason revenues will decline is because if someone is either not paying their mortgage or in foreclosure then chances are they are not paying property tax either. This will add further strain to both state and municipal budgets as municipalities will collect less so their expenditures will have to go down via job cuts or the state will have to step in and help at  a time few states have the fiscal means to do so. At least if the foreclosures proceed and new people buy the houses at reasonable prices they are more likely to have a vested interest in keeping and financial means to pay for their new home, which includes property taxes.

So as you can see dear reader, there is no silver bullet and there are no painless answers. There are opportunities still to go short various segments of the market related to this mess as I do not believe that the market has priced in the true extent and impact of the problem. You can look at things like inverse ETFs that track the financials, individual vulnerable bank shares to short or even title companies. Additionally, homebuilders are going to struggle, so any that are too richly priced they will probably disappoint the markets and you can position for that.

We cannot forget that while this is a difficult problem to solve and is and will be painful for many there are real people that live in these homes. The whole foreclosure mess is a highly emotionally charged issue but it has to be dealt with in a way that will be beneficial for the well being of America’s future not just the unfortunate souls who are trapped in their own “houses of pain”. A phrase that Obama has used applies here, this is a “teachable moment” and hopefully many people, institutions and government can learn from this mess ; let us hope that they do.

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