Just who owns America’s houses? Maley

Is Ben Bernanke’s siren song promising further monetary easing being drowned out by the rumbles from the increasingly shaky US housing market?

For months, markets have been sustained by hopes that the US Federal Reserve will embark on a fresh $1 trillion quantitative easing (or, less politely, money printing) exercise aimed at boosting US economic growth and pushing inflation higher.

On Friday, the US Federal Reserve boss, Ben Bernanke, pretty much told investors to expect more monetary easing from the US central bank. “There would appear – all else being equal – to be a case for further action,” he said.

As a result, most people expect the Fed to announce that it will resume buying US Treasury bonds after its next meeting in a little over a fortnight.

But Bernanke’s words, which should have been music to the ears of investors in US banking stocks, failed to provide solace. Instead, the shares of the giant US banks – such as Bank of America, JP Morgan Chase, Wells Fargo and Citigroup – were battered as investors fretted about the mounting legal problems the banks are facing when it comes to foreclosing on homes where the owners have fallen behind in their mortgage payments.

Already, some banks – such as Bank of America and JP Morgan Chase – have temporarily suspended foreclosure sales as they review procedures, while other banks are reviewing their files, but have not frozen foreclosures.

And last week, the top legal officers in 50 US states announced a joint investigation into faulty home foreclosures by banks and loan servicers.

Banks argue that their problems will be quickly fixed, and that they’ll soon be back to running record numbers of foreclosures. Even if the banks are correct and the problems are corrected fairly soon, it’s estimated that every month that foreclosures are delayed, the US banking sector bleeds by around $2 billion as a result of interest foregone and higher cost of employing extra staff to review the files.

But there’s also the risk that the legal problems could explode into a full-scale crisis in US mortgage market if major legal mistakes in the mortgage securitisation process end up blighting the multi-trillion dollar US mortgage-backed security (MBS) market.

The banks are facing two different legal problems. The first, which appears the easiest to resolve, involves their use of “robo-signers”, or back office employees, who approved hundreds of foreclosure documents daily without taking the trouble to properly review the mortgage files. This practice has caused problems in those US states where house repossessions must be approved in court. As a result, banks have had to suspend foreclosures in these states because they have not properly proved that they own the loans in foreclosure.

The second, and potentially more perilous issue, is that the banks might not be able to prove that they have the right to foreclose on the properties.

Before banks can foreclose on homeowners, and evict them from their houses, they need to have the mortgage note – the piece of paper that borrowers sign where they promise to pay back the mortgage loan.

Before mortgage-backed securities, loans were made by the local bank, and mortgage notes stayed in the bank vaults.

But this all changed with mortgage securitisation, which has been the main way of financing US housing over the past 30 years.

Securitisation allows different investors to own different parts of the mortgage. So investors with low risk appetites bought the safest MBS bonds with low returns. Investors with higher risk appetites bought the higher yielding, riskier MBS bonds.

Housing loans were “bundled” into special vehicles designed to hold the loans for tax purposes and then “sliced and diced”, split into different tranches, according to their riskiness and interest rates.

But US real estate law requires that paperwork be physically transferred when mortgages change hands, and it’s clear that this frequently did not happen during the frantic years of the US housing boom.

Banks may not have, or may never have had, the mortgage notes. This may mean banks will have to stop foreclosures for months as they track down these notes.

A much more worrying problem for the banks is if US courts decide that this failure to properly transfer the physical mortgage notes associated with their home loan means that the “chain of title” has been broken. This would mean that the person who took out the loan to buy the house no longer owes the loan, and the bank has no right to foreclose.

There are fears that the whole US housing sector could be thrown into disarray if the title insurance companies start refusing to provide insurance. In every sale, a title insurance company provides insurance that the title is free and clear. And there are fears that title insurance companies are beginning to shy away from providing insurance because they don’t want to expose themselves to the risk that the chain of title had been broken, and that the bank had illegally foreclosed on the previous owner.

At the same time, the big US banks face the huge risk that problems with faulty home loan documentation will spread to the multi-trillion dollar mortgage backed securities market. Investors who bought MBS bonds may try to force the investment bank that performed the securitisation to buy back all the bonds.

An unravelling of the MBS market would likely leave the US investment banks saddled with hundreds of billions of dollars in additional losses, and potentially require a new round of US bank bail-outs.

This article first appeared on Business Spectator.