Things are getting very interesting out there for those interested in reality, not just trading. And the new reality is a mess in the foreclosure process that could delay the healing of the housing market two years or more and will certainly hit bank earnings if the mess stays a mess. This mess will savage bank earnings if it evolves into a full-blown crisis.
The mortgage and housing boom that led us to this point was fueled by third party processing of mortgages and maintenance of mortgage paperwork. From 2005 to 2008, 97% of mortgages started with and passed through something called MERS, the Mortgage Electronic Registration System. MERS was formed and is owned by the big banks including Bank of America Corp. (BAC), Citigroup (C), HSBC (HBC), Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB).
Twenty-three states require a judge to sign off on a foreclosure. Some have worked around this, such as Florida, where a judge can process a foreclosure in minutes. Other states have other rules that require some sort of process that requires proof of ownership by the mortgage holder, such as a bank and proof the owner is in default. Last year I wrote how a court in Kansas ruled MERS did not have standing in the foreclosure process as it did not actually own a mortgage.
The biggest danger facing the banks is this ruling will be adopted, by popular demand and judge shopping, in the 22 other states requiring judges to sign off on foreclosures and become the basis of populist and political support for similar actions in states with more streamlined foreclosure processes.
The second danger facing the banks – and this is in the bag – is a serious lowdown in the foreclosure process as each procedure is now going to be legally perfect. With between 6-7 million more homes to be foreclosed before we begin to return to historical levels of default – this is my estimate but I am not alone – foreclosures may not now peak until 2013. I have been assuming peak foreclosures by yearend 2012 and a bottom in the housing market in the summer of 2013. I now see this, at minimum, pushed out another year. The longer it takes to foreclose a home, the worse shape it is in, the less value the bank reaps from the asset and the bigger the hit to the balance sheet.
Most banks have instituted a voluntary moratorium and regulators have given them until October 18th to assess how well their foreclosure is working. That is not enough time. The Obama administration has rightly said a national moratorium would be a disaster – a true fact given that in some markets foreclosed homes are up to 40% of all homes sold. But the populist groundswell and the legal dangers are increasing quickly with 40 states attorneys general now saying they want to jump on the bandwagon. The states attorney generals smell blood and money. The blood is political – anything that slows down a foreclosure, whether the person deserves to lose their home or not, is seen as a political plus against “the big bad banks.” They are also making noises about regional and national settlements with the banks that would involve write downs of mortgages, which could end up pulling some homeowners out of the foreclosure process. The tort attorneys are circling, smelling serious money. They may get involved and present a national or multi-state class action lawsuit against banks who a) foreclosed without proper legal paperwork and process and b) banks who then sold the foreclosed home to a buyer who may now be, uh, shafted.
The process may also have an unintended consequence – the exposure of shoddy paperwork leads to a wave of lawsuits against the banks that bundled the mortgages together and put them into securitized bonds. The SEC (Securities and Exchange Commission) could and will join in the process if it smells a big win.
The two banks with the most exposure are, in my opinion, Bank of America (BAC) and Wells Fargo (WFC). BAC inherited busted mortgages from Countrywide and Merrill; Wells got them from Wachovia, which in turn had bought them hen it purchased Golden West. I also think Citi (C) could take a hit – one analyst believes defaulting homeowners already stay in their homes an average of 17 months before foreclosure hits.
Last point – take a look at three publicly held title insurers. Their stocks have been it but not as hard as you would imagine. They are exposed to the mortgages of purchased homes out of foreclosure that may not have been legally foreclosed to begin with. The three national companies that are publicly held are Fidelity National (FNF), First American Title (FAF) and Old Republic Title (ORI).
The Street, right now, is spinning this as possible good news for homebuilders – total zombies right now. Some believe a slowdown in foreclosures will boost the prospects of the home builders for there will be less competing inventory. This is nonsense – the current rate of new home building is down more than 80%, inventory is almost double historical norms (as measured by months of sales). Of course, the Street has always been adept at putting lipstick on any pig they want to trade.
Disclosure: None
