Faulty Foreclosures May Prolong the Slump

Howard Cohen hasn't paid the loan on his Tukwila (Wash.) home in a year, and when he heard in mid-September that Ally Financial's (GJM) GMAC Mortgage unit was suspending foreclosure evictions in 23 states, it gave him hope. "Maybe I'll stay in my house, too," says Cohen, a 57-year-old commercial-loan broker whose business fell off after the financial crisis. Cohen was encouraged even though his mortgage servicer, Bank of America (BAC), hasn't reported any irregularities.

Attorneys general in Iowa, Illinois, and Texas started investigating Ally's GMAC unit after it disclosed that one of its employees said in a December 2009 deposition that he had signed thousands of foreclosure documents without verifying their accuracy. The company also faces inquiries from officials in Ohio, Colorado, and North Carolina. A JPMorgan Chase (JPM) executive has said she signed thousands of documents without checking loan records, according to a deposition she made in a court case in Palm Beach, Fla., in May. JPMorgan spokesman Thomas Kelly declined to comment. On Sept. 29 the bank asked judges to postpone rulings in pending foreclosure cases while it reviews and possibly resubmits statements.

"Regrettably, a procedural error was found to have occurred in certain affidavits required in certain states," GMAC said in a Sept. 24 statement, adding that the problem "is not related to the accuracy of the underlying transaction." The "error" was the employee's failure to sign the documents in the presence of a notary public or signing them without "direct personal knowledge of all the information," GMAC said. The U.S. government, which has been pressing lenders to reduce foreclosures as evictions hit record levels, owns 56 percent of Detroit-based Ally. The company, formerly known as GMAC, has benefited from more than $17 billion in bailouts.

No one can say how widespread the problems are. "The suspicion is that there might have been shortcuts taken by every mortgage servicer who had extraordinary numbers of foreclosure documents to go through," says Rick Sharga, senior vice-president at RealtyTrac, a housing data provider in Irvine, Calif. In August, lenders took possession of a record 95,364 homes and issued foreclosure notices to 338,836 homeowners, according to RealtyTrac.

If uncovering deficiencies halts thousands of pending foreclosures or voids ones that have already taken place, the courts could be tied up with cases for years, says Stuart Saft, a partner at New York-based Dewey & LeBoeuf. That could further postpone a recovery. "You can't get the economy moving until this whole situation gets straightened out," Saft says. "Dragging out foreclosures doesn't help."

"Shadow Inventory" Problem

The foreclosure foul-ups highlight the "shadow inventory" problem—the vast number of homes now in default or foreclosure that may flood the market, further depressing prices. "Buyers know [prices haven't] hit bottom," says Joshua Shapiro, chief U.S. economist at Maria Fiorini Ramirez, a New York forecasting firm. "So they're sitting on the sidelines."

In the 23 states where judges must approve foreclosures, the average time between borrowers falling behind and sales of their properties has climbed to almost 25 months from fewer than 18 at the start of 2007, according to data compiled by Austin (Tex.)-based Amherst Securities. The increasing time between default and foreclosure may encourage more homeowners to stop paying, says Cameron Findlay, chief economist at LendingTree.com (TREE) in Irvine, Calif. Overwhelmed lenders are likely to address the worst cases first, leaving many delinquent borrowers in their homes for longer periods, he says.

Other paperwork problems could also keep homeowners in limbo. Cohen, who is 12 months behind on his mortgage payments, says he's been trying to negotiate a loan modification. He anticipates difficulties down the road, he says, because "nobody can tell me who owns my mortgage."

The bottom line: Problems with the paperwork surrounding foreclosures threaten to delay the housing recovery and prolong the economic slump.

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