What's This Foreclosure Mess? (October, 2010)

By Alan Gaylor

It is impossible to watch the news these days without hearing stories about our country’s continuing real estate bust and the resulting wave of foreclosures. The number of foreclosures in the US hit 1.65 million in the first half of this year. That is an increase of 8% from the same period a year ago, and a 5% decrease from the previous six months. As one would expect, with this many people losing their homes, there has been a lot of talk about finding a way to keep these people in these homes by restructuring their loans and instituting a foreclosure moratorium. In addition, there has also been a lot of controversy surrounding the foreclosure process. A big part of this controversy pertains to who owns the loan and thus who should be initiating the foreclosures. On the surface, this would seem to be an odd problem to be faced with. To understand how this came about, you have to first understand the modern mortgage process.

Many years ago, homebuyers would borrow money directly from their bank to finance their home. The bank would make the loan and the homeowner would directly make mortgage payments to the bank. The bank would hold the home as collateral and keep the loan in their portfolio for the full term of the note. Nowadays, bank and mortgage brokers originate loans but do not keep them. They package these loans and sell them to investors in a process called securitization. This is where the government entities Fannie Mae and Freddie Mac and Wall Street come into play. They group hundreds of similar loans together to create a mortgage backed bond. These bonds are then sold to investors in the private market. Typical investors are mutual funds, insurance companies, pension plans, individual investors (our clients included), etc. It takes so much money to finance all the homes in this country that mortgage backed bonds is now the largest segment of the bond market, currently 9 trillion dollars.

Most people think that the financial institution they make their payment to is the same company that holds their mortgage. In most cases, this is just the loan servicer and instead the homeowner’s debt is part of a mortgage pool and is owed to the bondholders. This confusion lends itself very well to politicians with an agenda and the media who likes to portray this as a “Main Street” verses “Wall Street” issue.

There is no dispute that in almost all cases, foreclosures have been initiated on homeowners who have defaulted on their loans making this a “failure to pay crisis” rather than a foreclosure crisis. In fact, a lot of the mortgages have been past due for more than a year, or in some cases, two years before foreclosure proceedings occur. The controversy surrounding the foreclosure process involves how the paperwork was filed when the loans were securitized and procedural errors during foreclosure. In either case, these are mere technicalities slowing down the inevitable and preventing the property from being owned by individuals who can afford it.

As painful as the process appears, we need the foreclosures to continue before we can move forward as a country. These losses are felt throughout the economy and not just by the banks. Property values in general will not begin to recover until this large inventory of distressed properties are back in the hands of responsible owners. The longer it takes to turn over the property, the bigger the losses. There are real expenses associated with holding property such as insurance, maintenance and taxes.

Another fallacy is that the banks and Wall Street are the ones bearing the brunt of these losses. In reality, these losses are being felt by almost all the citizens of the country directly as taxpayers and indirectly as investors and pensioners. So far the taxpayers are on the hook for $213 billion to bailout Fannie and Freddie. These two government-backed mortgage finance companies own or guarantee over half of the $12 trillion U. S. mortgage market.

There are many structural changes that will take place in the mortgage market as a result of this crisis. Underwriters will have an incentive to have higher underwriting standards, there will be fewer types of loans available, borrowers will be subject to higher credit standards and home ownership will be less viewed as a right, all changes that will be very helpful and need to take place. What is not helpful is for Washington to continue to demonize the very mortgage market participants, bankers and investors that make housing affordable in this country.