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"Mortgagegate" Could Crush the US Banking System - Outside View by Shah Gilani

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"Mortgagegate" Could Crush the US Banking System
Oct 22, 2010

What most Americans don't know about "Mortgagegate" is that "robo-signing" of foreclosure documents is the tip of the iceberg.

The breadth and depth of this newest mortgage crisis is so dangerous that the U.S. Federal Reserve last month pre-announced another potential round of quantitative easing (pundits are calling it "QE2") to address "potential negative shocks."

In fact, the fallout potential is so numbing and the actions that birthed it so scandalous that commentators have given the crisis the Watergate-esque title of "Mortgagegate" (or, as some prefer, "Mortgage Gate").

Here's what the news-story headlines aren't telling you.

Foreclosure Follies

The Fed can't admit that the potential shocks it's worried about have already materialized, because that would trigger the very panic the central bankers hope to avoid.

But the odds that a financial tsunami will result from Mortgagegate are building each day. If this storm strikes with its full fury, it could be the kind of credit-crisis aftershock that undermines the tentative handhold that the U.S. recovery is so desperately clinging to.

On the surface, the problem looks like foreclosures have been conducted based on improperly processed paperwork. That is a gross understatement.

Here's what's wrong. When a homeowner buys a property with a mortgage, the property title lists them as the rightful owner and their lender as the mortgage-holder. The named lender possesses an encumbrance on the title. If the homeowner doesn't pay his or her mortgage, the lender can rightfully repossess the property and sell it.

In order to take the home back, the lender must first foreclose on the property. The problem begins with the fact that lenders, in order to make trading mortgages between themselves easier so they can be packaged into mortgage-backed securities (MBS) pools and sold to investors, assign their rights on titles to a "nominee." (How that happens is the part of the story that news outlets aren't talking about and will both shock and sicken you).

To take homes back, lenders or mortgage services start by filing court documents in "judicial foreclosure states" (most states in the U.S. require foreclosures to be court-processed). Filings against homeowners must include signed affidavits attesting to the relevant facts and demonstrating the lender's legal status to foreclose. Affidavits must be notarized.

But here's what's been uncovered: The people who are signing the necessary documents on behalf of the lenders aren't even reviewing documents - which means there's absolutely no way they followed the prescribed procedures. It turns out that signers are basically "rubber-stamping" legal documents.

In the case of IndyMac Bank FSB (since purchased by a private equity group and renamed OneWest Bank), The Wall Street Journal reported that Erica P. Johnson-Seck routinely signed as many as 6,000 documents a week. In another instance, employees of GMAC Home Mortgage and the mortgage unit of JPMorgan Chase & Co. admitted in sworn testimony that they each signed 10,000 documents per month, without properly reviewing and notarizing them.

Similar instances of what's become known as "robo-signing" are now coming to light in relation to hundreds of thousands of other documents. And by the time it's all said and done, it's likely that we'll be talking about millions of documents.

Fraud was clearly rampant in the notarization of documents that were part of the foreclosure process. The fact that document signers weren't reading and reviewing the paperwork, and weren't contacting homeowners - all of which was mandated by lenders - there clearly was no way that the proper due diligence was observed.

Questionable legal notarizations include pervasive findings that documents were notarized even before they were signed and dated. A notary is legally designated to verify the identity of the signer of a document and affix their notary stamp along with their signature that they have witnessed the signer executing the document, and that the signer is who they say they are.

Some notarizations on suspect documents are affixed by notaries that don't live or work anywhere near where documents were signed. Indeed, many of them live across state lines. That makes it highly unlikely that signers were verified or that the documents properly notarized by law.

Congress, in its inimitable way, was made aware of this problem. Legislators tried to solve the problem by ramming through - without debate (highly unusual, but they did it) - legislation that partly addressed some of the notary issues.

In a bill that was supposed to facilitate interstate commerce, our elected representatives made it legal for notarizations to be accepted across state lines. How high up is the knowledge of this crisis? Apparently pretty high. After all, it was none other than U.S. Sen. Patrick Leahy, D-VT, the chairman the Judiciary Committee, who on Sept. 27 rammed through the Interstate Recognition of Notarizations Act, the bill in question.

In case you miss the egregious irony of the timing of the bill, it came up for a vote only a couple of weeks after the initial disclosure in courts around the country that GMAC had robo-signers falsely notarize foreclosure documents. Last Thursday, U.S. President Barack Obama refused to sign the bill.

Circle of Deceit

Here's a key question: If these foreclosures aren't being legally executed, are homeowners being kicked out illegally? And what about the buyers of foreclosed properties: Are they rightful owners if the previous owner still has a legal claim to the home?

Is everyone going to sue everyone? What will a nationwide moratorium on foreclosures do to the inventory and prices of unsold homes? And what effect will all this have on homes situated near foreclosed properties?

What will happen to all the mortgage-backed securities that contain all these properties and that banks still hold? What will happen to the economy if these problems take years to work through?

And that's not even the worst of it all.

There's actually a much deeper problem that could lead to troubles far worse than anything you can imagine.

The whole mess begins at Square One. And "Square One" is a circle of fraud and deceit so large that if civil and criminal charges and fines were eventually levied against the perpetrators, there isn't a big bank in this country that wouldn't be insolvent.

Naturally, it's about money.

Frightening Fallout

In order to easily buy and sell mortgages between themselves so that these loans might be repackaged, securitized and then sold to investors as mortgage-backed securities, banks and other lenders needed a quick way to "trade" individual mortgages. They created a company called Mortgage Electronic Registration Systems. This group includes Bank of America Corp., GMAC LLC, Wells Fargo & Co., Washington Mutual (now owned by JPMorgan Chase), the United Guaranty Corp. unit of American International Group Inc., Fannie Mae, Freddie Mac, mortgage-servicing companies and other similarly interested members.

You may not realize it, but at your home-purchase "closing," you sign a document that appoints MERS as the "nominee" for the lender that granted you a mortgage. That gives the nominee the right to flip your mortgage to any other bank or lender it chooses. That's how banks move mortgages around to package them into different securities.

But that brings us to the crux of the controversy: Every time there's change on the title (a change occurs when the nominee switches the lender on your title out for another), local governments require that a new title be recorded. Of course, those governments - the county or municipality that you live in - also charge a "recording fee." MERS also charges a fee, but it's a lot less than government recording fees.

Here's the problem. In creating MERS, these institutions actually changed the land-title system that this country - for much of its history - has relied upon to determine legal ownership status of land titleholders.

Not only did the lenders sidestep (read that to mean avoid) paying billions of dollars in fees to local governments, they paid themselves from the fees that MERS collected.
MERS is facing class-action lawsuits and civil racketeering suits around the country and their members are being individually named in all these suits. One suit alleges that MERS owes California a potential $60 billion to $120 billion in unpaid land-recording fees.

If suits against MERS and all its members are successful, unpaid recording fees and fines (that can be as much as $10,000 per incident) would make every one of them insolvent.

And you wonder what the Federal Reserve meant when it warned of "potential negative shocks?"

The bottom line for investors is that until all these issues are cleaned up (which might take years, or even decades) - or until there's perhaps some sort of legislative clarity that eases uncertainty - investors face the threat of a severe "correction" in any or all of the markets that have risen on the hope that the long-hoped-for U.S. recovery is finally taking hold.

It makes sense, as it almost always does, to have stop orders in place on all your investments and consider the ramifications of these problems whenever your investments have real-estate (or mortgage) exposure.

Actions to Take: On Wednesday, Gilani detailed his "Mortgagegate" concerns, and concluded by recommending that readers "Immediately place a stop loss on all positions, 10% below [Tuesday's] closing prices."

Writes Gilani:

"Banks still own most of their toxic assets. They're just buried (with the consent of the Fed and Treasury) waiting for an economic recovery and low rates to let borrowers re-finance and pay them back. Speculators, assuming low rates will generate economic growth have leveraged themselves up buying everything in sight, including mortgage-backed securities for their high yields.

Because of moratoriums put in place, if homes can't be foreclosed on until this mess is straightened out, inventories will build up, and prices could crash again later when that inventory hits the market. If homeowners who bought foreclosed homes find that the validity of the titles they now hold are challenged, lawsuits will fly. People who were foreclosed could sue to get their homes back. Title insurance companies that protect buyers of their insurance policies from title lawsuits could never make good on their policies, and would go belly-up. Governments could (and will) sue banks for potentially hundreds of billions of dollars of recording fees they were cheated out of. Criminal fines could add hundreds of billions of dollars more to their tabs.

What happens if there's widespread panic that this new round of mortgage-related stress won't be fixed quickly?

Markets could tank as leveraged players see their holdings drop and get margin calls. All the speculative, leveraged momentum trades based on a slow-but-upward recovery (especially hoped for in housing) could get upended as speculators rush for the doors.

Is this going to happen?

I certainly hope not. But it is a real, very real, possibility.

If the U.S. Federal Reserve is worried, I'm worried. And you should be, too.

If I'm wrong, great. Markets should continue their recent uptrends. But my job, first and foremost, is to protect you from devastating capital losses.

Here's hoping that I'm wrong."

This article is authored by Money Morning, a leading source of investment news research for the global markets.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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