Like Captain Renault in "Casablanca," bankers were "shocked-shocked!" to find instances of foreclosure documentation problems when the robo-signer scandal erupted last fall. So shocked, it seems, that they didn't bother taking a critical next step: checking documentation on the millions of mortgages embedded in securitizations.
By narrowly addressing robo-signer incidences only, the banking community missed the chance to get ahead of the broader problem—the inability to produce the basic lien, title and note documents that prove a bank's property rights. The task of sorting this out has now been taken up by the attorneys general of New York and Delaware, who have launched investigations into the documentation underlying mortgage-backed securities.
When the legal link between a mortgage loan and its real estate collateral is broken or lost, the loan's value falls dramatically. Foreclosure brings this problem to the fore, but it impacts all loans, whether they are delinquent or not. Banks are currently sitting on billions of dollars of loans and securitizations with no collateral value at all, because property rights are no longer tied to the mortgages.
Banks have been delaying action on many delinquent loans because of the absence of clear legal claims on the properties. I am finding astronomically high levels of loans (e.g., more than 20 percent of all subprime loans in the state of Florida) that are more than 90 days delinquent, but are not foreclosed or resolved by the banks. I call these "limbo loans," since they are not paying interest, but cannot be modified or worked out because of possible deficiencies in the backup documentation.
The implications of this problem are dire for the prospects of an economic recovery. Not only is the housing market directly affected, as delayed foreclosures impact housing supply, but the private label securitization market remains lifeless—in large part because buyers are unsure whether some of these limbo loans will be mixed into the pools of underlying securities-stymying the ability of banks to resume lending.
The health of the economy depends on reassigning lost property rights. But in many cases there is no way to trace back the rights. Many of the originators and underwriters no longer exist, and their records were shoddy in the first place. After years of worrying about the bad lending decisions and illiquidity that started the crisis, we must finally face the fundamental structural problem that is prolonging the crisis and preventing the economy from making a full recovery.
What can be done? The only entity that can reassign lost property rights is the government through the right of eminent domain. We must find a way to get these limbo loans into government hands, so as to allow the case-by-case reassignment of lost property rights. The glaring omission of regulatory reform thus far is the absence of any plan to resolve Fannie Mae and Freddie Mac. Here is where their current government-owned status can be useful.
We could organize a massive program of swaps of mortgage loans with backup documentation that are currently on the books of Fannie and Freddie in exchange for limbo loans held in the banking system. Since ultimately the government will reassign the property rights to the limbo loans, the swap could be one-to-one payment in kind, or banks could be forced to take a haircut for government processing costs.
A successful swap would provide the banking system with documented loans that could be worked out through modification, foreclosure or private label securitization, while reassigning Fannie and Freddie to the business of loan resolution. As property rights returned to the mortgage market, Fannie and Freddie could be gradually phased out. In "Casablanca" terms, this would be the beginning of a beautiful reform effort.
