Is a looming wave of disputed foreclosures about to hit the banks?

It is widely accepted that some homeowners facing foreclosure are turning to foreclosure defense as a means to avoid eviction. The scope and depth of this trend is not fully known, but there are some facts which shed light on how severely this will determine the future of the real estate market.

Borrowers and their attorneys are increasingly fighting back against lenders using techniques such as quiet title actions, slander of title claims, mortgage fraud investigations, and inquiries into the mortgage assignment chain through nominee trustees such as MERS. In the past the success rate was mediocre. I suspect that for the most part this was due to the fact that foreclosure defense was a relatively new field of law, and attorneys practicing in this area were still learning how to navigate this process with the courts. As more cases are adjudicated either for or against the borrowers, foreclosure defense attorneys are building a better playbook on how to win these cases. Lenders are finding it more difficult to prevail as foreclosure defense attorneys learn the weak points of their positions which the courts are forced to rule on in favor of borrower.

We observe that in about 75% of mortgages, there is some “technical” defect in the origination, processing, recording, or assignment of the instruments. Not all of these defects are fatal to the validity of the mortgage, but in the aggregate they pose a serious problem. How serious could it be? I ran a rough calculation earlier which came up with a figure of over a trillion dollars in potential loan loss liability for lenders. That was based on  the current rate of loans being challenged by mortgage borrowers. This does not take into account the possibility that more property owners may contest their mortgages using foreclosure defense strategies.

This appears more likely. Last week a US Senator wrote that the court cases challenging mortgage assignments within the securitization system are gaining momentum. He quoted FDIC exec Sheila Bair, who said in congressional testimony that “while the legal challenges under the representations and warranties trust requirements remain in their early stages, they could, if successful, result in the ‘putback’ of large volumes of defaulted mortgages from securitization trusts to the originating institutions.”

Senator Ted Kaufman concluded that court rulings are no longer in their “early stages,” and the ultimate cost to the banks could be staggering. How staggering? His figure was “ hundreds of billions”. He noted that it was starting to appear that “the whole mortgage system is as rife with mistakes, abuses, and fraudulent activity”. It looks like MERS and the system set up to legalize securitization was jerrybuilt at best, he said. The Florida Attorney General released this report on fraudulent mortgage foreclosure which would seem to agree.

What does this mean for the real estate and banking industries? The banking industry is unlikely to survive a hit that large, and may need another bailout he said. The pent up volume of foreclosures and bankruptcies is an invisible liability unmeasured in the current economic climate. An analysis of the rate of bankruptcy filingscan be helpful in predicting future developments.

The number of bankruptcies may be artificially low because people can’t afford to file and because there’s little pressure from creditors. There is a potential for looming bankruptcy cases, like the shadow foreclosures feared in the real estate business. Those who have been teetering on the brink of bankruptcy eventually will be forced to file.

Jack Williams, a Georgia State University law professor, said “In the future we’ll see a lot more people who have weathered the storm so far but cannot hold on any longer.” He refers to the group  as “the invisible class of debtors who can’t afford to file.” ”There will be a time when we will see a very large increase in bankruptcy filings,” he said. “The pipeline is stocked up with them.”

The shadow inventory of real estate and bad debt may be much larger than traditional calculations sum up.