Foreclosures the real US time bomb

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This was published 13 years ago

Foreclosures the real US time bomb

By Adele Ferguson

AS INVESTORS await some crucial US economic statistics this week the better to judge the chances of a double-dip recession, a more frightening bomb sits under the US residential market, with the potential to blast off the next chapter in the subprime debacle.

It has profound implications for Australia and the rest of the world in terms of the direction of the US dollar, the health of the US economy and the havoc it can wreak on the many financial services institutions around the world that got caught up in US residential property investments - both directly and through exotic derivatives such as collateralised debt obligations.

From an Australian perspective, it is being monitored closely by a few consumer advocacy groups, one of which represents 200 families that are allegedly the victims of fraudulent mortgage documents in Australia. If the cases get up, there could be hundreds of millions of dollars in exposure for local banks, mortgage brokers and financial institutions. While this is not insignificant, it does not appear to be systemic, as it is in the US.

In the US, the situation has been brewing for the past few years, but it gathered momentum on Friday when the country's biggest bank, Bank of America, halted all foreclosure sales across the US to review its entire foreclosure process, raising pressure on other lenders to do the same. At least two other banks, Ally Financial's GMAC Mortgage unit and JPMorgan Chase have announced similar reviews of their books in the past two weeks.

Not surprisingly, the virtual breakdown of the foreclosure system has created a political storm because it could threaten the liquidity of the banks, particularly the smaller ones.

Reports out of the US over the weekend are that up to 40 state attorneys-general, as well as members of Congress, plan to meet and will call for an across-the-board moratorium on foreclosures to sort out alleged irregularities in foreclosure documents submitted by the banks.

US courts are choked with cases where notes and mortgages were missing from bankruptcy mortgage claims, despite a clear rule that they should be attached. It seems the many mortgage originators which encouraged people to lie about their financial capacity when taking out loans, also didn't bother with the paperwork.

Put simply, some mortgages changed hands many times without the full chain of documents completed. Upon challenge, many companies have been unable to show they had the paperwork, leading to their cases being dismissed.

On September 27, the Department of Justice in North Carolina wrote to Ally Financial: ''This office has received information regarding Ally Financial/GMAC Mortgage's questionable preparation of documents to support home mortgage loan foreclosure actions. In particular, the information indicates that GMAC Mortgage employees routinely signed off on large numbers of affidavits without personal knowledge of the accuracy of the contents of the affidavits. The allegations of improper verification of affidavits are supported by sworn deposition testimony by a team leader of GMAC Mortgage's document execution team for foreclosures.''

The Washington Post reported a day later that millions of people were working their way through the US court system in the wake of the financial crisis. It described the foreclosure process as a system rife with shoddy documents, forged signatures and, according to some state law enforcement officials, outright fraud by lenders eager to rid themselves of bad loans.

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The subprime collapse had already wreaked havoc globally as house prices began to fall and the loans became worthless, with millions of borrowers walking away from their obligations. This pushed property prices lower and resulted in the collapse of Bear Sterns, Lehman Brothers, Merrill Lynch, Wachovia, Washington Mutual and hundreds of smaller banks.

While it had a huge impact on the banking system in the US, it didn't destroy it, because lenders were able to foreclose or obtain possession of a property by evicting the borrower and selling it, albeit at a fraction of the loan.

But with question marks hanging over the legality of many foreclosures, the bomb could be about to go off in the US.

As Hugh McLernon at IMF, who has been an avid observer of the subprime crisis, said: ''The central question in any foreclosure is whether the person seeking foreclosure has the standing to ask for it. This is usually done by producing to the court the documents showing that the applicant made the loan and is entitled to the mortgage rights, including the right to foreclose and sell when the borrower stops paying interest.''

For McLernon, the answer is to change the legislation so as to dispense with the need to produce documentation, which is the ad hoc position so far adopted by the court system without legal authority. However, with elections looming in the US, the speedy passage of difficult laws will be difficult.

The alternative is to clog the courts and erode the fragile confidence in the US government and the US financial system. With such a mess bubbling away, the release of consumer sentiment figures, trade figures and US consumer prices is a sideshow to the true health of the US economy.

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