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A major factor driving the housing bubble were the complex mortgages-- subprime mortgages, reverse amortization loans, etc. --which were difficult for consumers to understand. The homeowners’ problems were exacerbated by banks which then securitized bundles of these complex loans in an effort to garner them the imprimatur of a “AAA” investment-grade rating. As home prices crumbled beginning in mid-2006, defaults and foreclosures escalated and thanks to the extensive securitization of the faltering mortgages, the entire financial system began to collapse and credit dried up.

Now, we find that the ongoing foreclosure process has been based on just as much shoddy paperwork and complexity and we see that many of the largest lenders have been cutting legal and ethical corners in order to push homeowners out to the streets.

Homes owned by banks and in the foreclosure pipeline are called the hidden inventory of unsold homes across the country. Since the end of 2007, this “Other Real Estate Owned” (OREO) has ballooned by 338.2% to a record $53.2 billion. This OREO figure may be nowhere near its peak and some experts say that there are up to two million additional homes in the foreclosure pipeline.

The foreclosure mess is now making headlines once more with the news that major lenders such as Bank of America (BAC) have suspended foreclosures due to issues such as “robo signers,” false affidavits, missing mortgage notes, etc. In many cases, it seems that major lenders-- who did little to no investigation before giving buyers mortgages they could neither understand nor afford-- are kicking them out of those homes with a similar lack of due diligence.

This period of “Foreclosure Limbo” is not good for the fragile housing market or the banking system. Since the expiration of the home-buyer tax credits, distressed home sales have risen to 30% of the market for existing homes—and this figure is still rising. While bankers holding billions in packaged mortgage products and homeowners remain in limbo, the market for new homes and non-foreclosed existing homes suffers as builders struggle to get fresh Construction & Development Loans and banks drag their feet on providing additional credit.

Unemployment and underemployment makes it difficult for homeowners to make ends meet and stay in their homes. Meanwhile, prospective home buyers cannot take advantage of record low mortgage rates because banks are requiring more and more paperwork and tighter credit standards. For many underwater home owners, the “just walk away” option becomes more attractive as the “Foreclosure Limbo” means that they may not be evicted from their homes for years after the cessation of mortgage payments.

Three Steps to end the Main Street Recession which I call “The Great Credit Crunch”:

1. A Stress Test for Community Banks – To be covered on Tuesday

2. Real Estate Housing Asset Bank (REHAB) – To be covered on Wednesday

3. A National Mortgage Modification Program for all Americans – To be covered on Thursday

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: On Foreclosure Limbo and Ending the Main Street Recession