How the Foreclosure Fiasco Threatens the Economy

If paperwork flaws turn into something bigger, it could trigger another recession.

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It might seem like a respite for struggling homeowners, but the sudden snags and slowdowns in thousands of foreclosure proceedings could prolong the housing bust well beyond its fifth year—and spell deep trouble for the broader economy.

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Like the housing bust itself, the recent foreclosure mess arrived with little warning, and the main question now is whether it's blowing over or mushrooming into a much bigger problem. On the surface, the issue is paperwork. Problems with flawed affidavits, improper shortcuts, and "robosigners"—bank officials who signed off on so many foreclosures that they couldn't possibly have reviewed all the details—have prompted big lenders like Bank of America, JPMorgan Chase, GMAC Mortgage, and a few others to suspend foreclosure proceedings in many states while banks scour their records and regulators probe the issue.

If these turn out to be minor irregularities that can be easily fixed, they'll merely delay foreclosures that are inevitable. And some of the banks say they've vetted their troubled loans and are ready to resume foreclosures. But even a short delay could threaten a fragile economy. "The foreclosure freeze means that it will take longer to work through the huge backlog of distressed homes, not only delaying the housing market's recovery but also impeding the broader U.S. recovery," write Celia Chen and Chris Lafakis of Moody's Analytics. "Uncertainty created by foreclosure suspensions will hold banks back from lending to both businesses and households."

The foreclosure mess has long tentacles simply because there are so many troubled mortgages. About 1.1 million properties are undergoing foreclosure, according to tracking firm RealtyTrac. Moody's estimates that the foreclosures under review represent about one-fourth of those, which is enough to crimp the overall housing market. Another 914,000 homes have recently been seized by banks, and some of those properties could be pulled from the market too if the foreclosures seem improper. Taking those properties off the market, even temporarily, would reduce the supply of homes for sale, and depress sales by about 8 percent, according to Moody's.

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With a reduced supply of homes, prices would rise. That might seem like a boost for the housing market, but the price hikes would be artificial, and the confusion would perpetuate all the problems that already exist. Once the snafus got worked out, most or all of the foreclosures would resume and a fresh flood of cheap homes would hit the market, driving prices back down. And manic price swings are the last thing the housing or financial markets need.

The price drops could cause a mini-bust inside the bigger bust, as skeptical buyers once again head for the sidelines, waiting for prices to bottom out. Falling home values would push more homeowners underwater, making it harder for them to sell and possibly causing even more foreclosures. Banks could pass on the higher costs of foreclosure processing to borrowers, making loans more expensive. Moody's predicts that home values will finally bottom out in the second half of 2011, but it could take longer if the foreclosure freeze drags on for more than a couple of months.

That's the rosy scenario.

What would make it worse is political or regulatory action that effectively halts foreclosures, as some housing advocates have called for. The Obama administration opposes a moratorium, on the grounds that it would merely delay the inevitable, while harming the overall economy in the meanwhile. They're probably right about that. But a de facto moratorium could happen anyway. Attorneys general in all 50 states are investigating the problem, and bringing lawsuits against lenders and mortgage servicers in a few cases. That could intensify, especially if various probes turn up evidence that banks wrongfully kicked families out of their homes.

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Congress also plans to hold hearings after the midterm elections, and the added visibility is likely to embolden homeowners threatened with foreclosure, leading to more legal challenges against banks. Lawyers will happily oblige, and advocacy groups like the Service Employees International Union are now offering advice about how to challenge a bank attempting to foreclose. If it turns out that the paperwork flaws are concealing widespread fraud, and the morass persists indefinitely, it might bring justice to a few harried homeowners, but it could also roil the housing markets enough to threaten a double-dip recession.

That's troubling enough, but there's also a nightmare scenario. Or two. It's well known by now that during the frothy days of the housing boom, mortgage firms were lending money to anybody with a pulse, pocketing the fees, and selling the mortgages to banks and other investors. Those investors then diced the loans into pieces, rolled them into mortgage-backed securities, and created a variety of exotic derivatives tied to those, all of which became the "toxic assets" poisoning the banks as subprime borrowers began to default en masse. One big question now is whether the "note" portion of each mortgage, which governs the terms of default and a bunch of other things, got properly transferred to the ultimate holders of the mortgages. If it didn't, banks attempting to foreclose may not have the legal right to do so.

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It's a complicated problem (nicely explained by blogger Mike Konczal in a series of detailed posts) that can go unnoticed in foreclosures unless they're challenged in court—which people on the verge of losing their homes usually can't afford to do. But growing awareness of the problem could bring many more challenges, and if this turns out to be a widespread flaw in the foreclosure process, lawsuits and a dizzying array of legal conundrums—like who actually has legal rights to a house if the occupants can't pay their mortgage—could tie the housing market in knots for who knows how long.

Then there are the bank losses tied to foreclosures. The banking sector has been getting healthier since the 2008 financial crisis, gradually absorbing defaults and writing them off. But there's mounting concern that the worst is yet to come, and that largely unsuccessful loan modifications have allowed the banks to hide losses that will be much bigger than they've acknowledged. A few analysts think this might even lead to a second financial crisis and a government takeover of some big banks.

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That's a minority view for now, and lenders like Bank of America and Citigroup insist there's no ticking time bomb behind their books. But there were also some Chicken Littles who said the sky was about to fall at the peak of the housing bubble—and turned out to be right. Given the monstrous mess that the banks have already created, it could take years of convincing earnings before investors fully trust them again. We'll be lucky if housing recovers sooner.