In 2002, a Boca Raton (Fla.) accountant named Joseph Lents was accused of securities law violations by the Securities and Exchange Commission. Lents, who was chief executive officer of a now-defunct voice-recognition software company, had sold shares in the publicly traded company without filing the proper forms. Facing a little over $100,000 in fines and fees, and with his assets frozen by the SEC, Lents stopped making payments on his $1.5 million mortgage.
The loan servicer, Washington Mutual, tried to foreclose on his home in 2003 but was never able to produce Lents' promissory note, so the state circuit court for Palm Beach County dismissed the case. Next, the buyer of the loan, DLJ Mortgage Capital, stepped in with another foreclosure proceeding. DLJ claimed to have lost the promissory note in interoffice mail. Lents was dubious: "When you say you lose a $1.5 million negotiable instrument—that doesn't happen." DLJ claimed that its word was as good as paper. But at least in Palm Beach County, paper still rules. If his mortgage holder couldn't prove it held his mortgage, it couldn't foreclose.
Eight years after defaulting, Lents still hasn't made a payment or been forced out of his house. DLJ, whose parent, Credit Suisse, declined to comment for this story, still hasn't proved its ownership to the satisfaction of the court. Lents' debt has grown to about $2.5 million, including unpaid taxes, interest, and penalties. As the stalemate grinds on, Lents has the comfort of knowing he's no longer alone. When he began demanding to see the I.O.U., he says, "I was looked upon like I had leprosy. Now, I have probably 20 to 30 people a month come to me" asking for advice. Lents is irked when people accuse him of exploiting a loophole. "It's not a loophole," he says. "It's the law."
The Lents Defense, as it might be called, doesn't work everywhere. Thousands of Floridians have lost their homes in lightning-fast "rocket dockets." In 27 other states, judges don't even review foreclosures, making it harder for homeowners to fight back. Now, though, allegations of carelessness and outright fraud in foreclosures has become so widespread that attorneys general in all 50 states are investigating. So are the feds.
Even if the documentation problems turn out to be manageable—as Bank of America (BAC) and others insist they will be—the economy will still suffer long-term consequences from the loose underwriting that caused the subprime housing bubble. According to an Oct. 15 report by J.P. Morgan (JPM) Securities, some $2 trillion of the $6 trillion in U.S. mortgages and home-equity loans that were securitized during the height of the bubble, from 2005 through 2007, are likely to go into default. The report says the housing bust will ultimately cause losses of $1.1 trillion on those bonds.
While banks and investors take their hits, millions of homeowners continue to be punished by unaffordable mortgage payments and underwater home values. Laurie Goodman, a mortgage analyst at Amherst Securities Group, said in an Oct. 1 report that if government doesn't step up its intervention, over 11 million borrowers are in danger of losing their homes. That's one in five people with a mortgage. "Politically," she wrote, "this cannot happen. The government will attempt successive modification plans until something works."
Wall Street's unspoken strategy has been to kick mortgage losses down the road until an economic recovery reinflates the housing market. The faulty-foreclosure crisis has forced the issue back into the present tense, triggering a fight over who will bear the brunt of those losses. The combatants—all of whom are trying to minimize their share of the damage—include homeowners, lenders and mortgage brokers, loan servicers and the underwriters of mortgage-backed securities, the buyers of those securities, title insurers, rating firms, and the federally controlled mortgage buyers Fannie Mae (FNM) and Freddie Mac (FRD). J.P. Morgan predicts that bondholders will absorb most of the estimated $1.1 trillion loss—but may succeed in foisting about $55 billion on banks. If the bank losses turn out to be steeper than J.P. Morgan and most other analysts expect, taxpayers may be asked to inject more capital into the financial institutions. Fannie Mae and Freddie Mac, already wards of the state, might require more capital as well.
The last five years of rising foreclosures, to the highest rate since the Great Depression, have exposed the carelessness with which banks lent money. The banks figured they could always seize ownership and resell at a profit, assuming they hadn't already dumped the loan on an unwary investor. And they wouldn't let technicalities impede the process; the website 4closurefraud.com, which is operated by the Carol C. Asbury Save My Home Law Group, has links to documents from Nassau County, N.Y., in which someone entered "BOGUS" as the grantee for the mortgage—i.e., the party entitled to foreclose.
During the housing boom, transactions were flowing so fast that banks couldn't keep up with the paperwork. The mortgage industry depended on a digital overlay of its own invention, Mortgage Electronic Registration Systems, a database owned by Fannie Mae, Freddie Mac, Bank of America, CitiMortgage, Chase Home Mortgage, Wells Fargo, and others, including title insurers. No matter who bought the loan, MERS was purported to be the mortgagee—i.e., the party that would foreclose if a borrower stopped paying. Ridiculous? Of all newly issued U.S. mortgages, 60 percent list MERS—a unit of Reston (Va.)-based MERSCorp that has no employees of its own—as the mortgagee. "It's a total attack on the public system," says Christopher L. Peterson, a law professor at the University of Utah who has consulted in cases against MERS.
As MERS sped up loan processing, it created a giant legal hairball. According to Peterson, state judges in Kansas, Arkansas, and Maine have said that MERS has no standing in foreclosure proceedings under their states' laws if they can't produce the promissory note. In early October a federal judge in Oregon blocked Bank of America as trustee from foreclosing on a home in the MERS system. (MERS spokeswoman Karmela Lejarde says its standing has always been upheld, "either in the initial court proceeding or upon appeal.") Judges also resent that would-be foreclosers show up in court representing themselves as vice-presidents of MERS even though they work for various loan servicers. Fixing the paperwork won't be easy because many of the notes have been lost or even deliberately shredded. The Florida Bankers Assn. told the state Supreme Court last year that in many cases "the physical document was deliberately eliminated to avoid confusion immediately upon its conversion to an electronic file."
As staggering as the projected stakes are in the housing crisis, at least you can put a number on them. What's incalculable is the psychic cost of a legal system that may well have let banks skirt the law. "The whole financial system is becoming a lot less transparent," says Hernando de Soto, a Peruvian economist who has written on the importance of well-defined property rights. "You can't size up risk anymore."
"We are killing our competition!" says Greg Whitworth. It's a perfect October day on the Jacksonville, Fla., campus of Lender Processing Services (LPS), and Whitworth, a division president, is rallying a crowd of 200 employees inside a big white tent on the sun-drenched banks of the St. Johns River. The company is celebrating what it calls "the Year of the Megas"—key customers Bank of America, Wells Fargo (WFC), and JPMorgan Chase—with a picnic of Mediterranean chicken salad, lemon cooler cookies, and sweet tea.
LPS is America's biggest mortgage-and-foreclosure outsourcing firm. Last year its revenue from default services climbed to $1.1 billion; its nearest rival, Santa Ana (Calif.)-based CoreLogic (CLGX), takes in less than half of that.
One gray patch hovers over the celebration: The back-office technology provider's runaway success means it is tangled up in the foreclosure crisis. "I was thinking about the dark clouds over the company," Joe Nackashi, the chief information officer, tells the crowd. "Sure, we have made mistakes. But I don't want to let that cloud this day."
LPS supplies much of the digital plumbing for the convoluted home-finance system. At the start of 2010 it said its computer programs were handling 28 million loans with a total principal balance of more than $4.7 trillion—or more than half the nation's outstanding mortgage balances. With 8,900 employees and total revenue of $2.4 billion, it sells software and manpower to most of the largest U.S. lenders and loan servicers. "The banks were not prepared for this volume of foreclosures, and that has played to the company's advantage as the outsourcer," says Brett Horn, associate director of equity research at Morningstar (MORN).
Consider for a moment the mountains of paper that a buyer signs at closing. The industry uses LPS computer programs and sometimes LPS employees to code, store, and transfer many of these records. When things work smoothly, mortgage servicers rely on LPS software to help monitor payments. When homeowners fall behind, LPS helps assemble the information needed to foreclose.
The business has a fast metabolism; as described in an in-house newsletter published in September 2006 by Fidelity National Foreclosure Solutions, a predecessor of LPS, a single 18-person "document execution" team brings Henry Ford's mass-production techniques to the foreclosure business. "The document execution team is set up like a production line, ensuring that each document request is resolved within 24 hours," the newsletter said. "On average, the team will execute 1,000 documents per day." That was four years ago, when the foreclosure rate was a quarter what it is now.
It was when some of those documents proved difficult to track down that trouble set in. If a foreclosure lawyer working on behalf of a bank or servicer asked LPS for an errant mortgage, for example, some company workers may have gone to extremes to keep the foreclosure assembly line moving, according to prosecutors and plaintiffs' lawyers. The Florida attorney general's office has alleged that in some cases, corners may have been cut, signatures forged, documents backdated. Industry employees have said in sworn depositions that "robo-signers" executed paperwork without reviewing it.
The U.S. Attorney's Office in Tampa and the state of Florida are investigating whether LPS and affiliated companies have fabricated documents and faked signatures. LPS employees "seem to be creating and manufacturing 'bogus assignments' of mortgage in order that foreclosures may go through more quickly and efficiently," the Florida Attorney General's Office says in an online description of its civil investigation. "We're concerned that people might be put out of their houses unfairly and unjustly," Bill McCollum, the attorney general, told Bloomberg Businessweek. In a third investigation, the U.S. Trustee Program, the branch of the Justice Dept. that polices bankruptcies, is looking into whether LPS is "improperly directing legal action" to hasten foreclosures, according to a 2009 opinion issued by the bankruptcy court in Philadelphia. A Trustee spokeswoman declined to comment.
On Sept. 29, U.S. Representative Alan Grayson (D-Fla.) denounced LPS on the House floor. "The system is so organized that there is a company, Lender Processing Services, who allegedly has created the means to systemize fraud," he said. Foreclosure-defense lawyers have filed suit against LPS in Mississippi and Kentucky, seeking class-action status and accusing the company of improperly splitting fees with pro-foreclosure lawyers. LPS shares have fallen sharply on the New York Stock Exchange and as of Oct. 20 were down 33 percent for the year.
LPS executives acknowledge slip-ups, but nothing amounting to fraud. In a federal securities filing in February, the company said it had "identified a business process that caused an error in the notarization of certain documents, some of which were used in foreclosure proceedings." LPS says it fixed the problem and closed the subsidiary in Georgia where it occurred. As for the processing team described in the in-house newsletter, LPS spokeswoman Michelle Kersch says the company decided such affidavit-execution services were "not an appropriate use of resources," and ended them in September 2008. Still, she adds, LPS "signs a limited number of documents for clients," including assignments of mortgage.
"We are dealing with sensationalism vs. facts," Jeffrey S. Carbiener, the company's chief executive officer, told analysts in an Oct. 6 conference call. "Isolated instances of errors" are bound to occur, but they "are now being brought out and pointed back to that robo-signing, making it sound like a large percentage of these transactions are invalid. That is just simply not the case." He called the class-action suits "fishing expeditions."
To keep the paperwork moving, LPS uses a variety of incentives. Top-performing workers receive monthLY "Drive for Pride" awards that sometimes include $500 in company stock and a spot in an underground parking garage. LPS also devised a coding system to grade outside foreclosure attorneys based on their speed in completing tasks. Fast-acting attorneys receive green ratings; slower lawyers are labeled yellow or red and may receive fewer assignments. "Bill will move quickly and expect you to be there to pull your weight," says Jerry Mallot, executive vice-president of the Jacksonville Regional Chamber of Commerce. "I wouldn't call the environment at his company kind and genteel."
Bill is William P. Foley II, a 65-year-old West Point graduate, real estate lawyer, and wealthy vintner. He made a fortune assembling the country's largest title-insurance company, beginning with his purchase in 1984 of Fidelity National Title. By 2003, Fidelity National, then based in Santa Barbara, Calif., had $10 billion in annual revenue and 32 percent of the U.S. title-insurance market. Frustrated by the high cost of operating in California, Foley was convinced by Mallot and then-Florida Governor Jeb Bush, an occasional golfing companion, to relocate to Jacksonville. A spokeswoman said Foley, who left the LPS board last year, wasn't available to comment.
Spun off in 2008, LPS is one of the city's largest employers, with 2,400 local workers. Its headquarters is in a 12-story office building on palm-lined Riverside Avenue, part of a complex that also houses Fidelity National Financial, the original title insurer, and Fidelity National Information Services, a 2006 spin-off now called FIS. Foley and his wife, Carol, split time between a home in Jacksonville's Ponte Vedra Beach, a ranch in Whitefish, Mont., and California, where Foley owns seven wineries. His compensation last year from LPS and the Fidelity National companies was $45.9 million, according to company filings.
The growth of LPS and other foreclosure outsourcing has dismayed even some professionals deeply involved in the process. Judge Diane Weiss Sigmund of the U.S. Bankruptcy Court in Philadelphia last year published an unusual 58-page opinion scrutinizing LPS because, she said, she wished "to share my education" with others in the system "who may be similarly unfamiliar with the extent that a third-party intermediary drives the Chapter 13 process." Her opinion described an attempt by the multinational bank HSBC to foreclose on the home of Niles and Angela Taylor, who had filed for bankruptcy protection from their creditors. Judge Sigmund ruled the bank's outside attorneys mistakenly tried to take the Taylors' home because of three disputed flood-insurance payments totaling $540. She blamed lawyer incompetence, exacerbated by a "slavish adherence" to an LPS computer system called NewTrak.
What bothered the judge, she wrote, was the way HSBC and its lawyers entrusted "the NewTrak system [with] the management of its defaulted loans in bankruptcy....With the HSBC data uploaded to an LPS system, LPS responds to the perceived needs of retained counsel....The retained counsel does not address the client directly." Overreliance on LPS contributed to six months of unnecessary hearings, the judge wrote. After she ordered the parties to settle the issue in person, they did so in just an hour. HSBC acknowledged that the property did not require flood insurance after all, and the truce cleared the way for resolution of the Taylors' bankruptcy plan.
Judge Sigmund, who has since retired, scolded one of HSBC's outside lawyers for being too "enmeshed in the assembly line" of managing foreclosures and ordered her to take extra ethics training. The judge instructed HSBC to remind all of its lawyers in writing not to defer excessively to computerized data systems. LPS, the judge added, did not deserve punishment because the outsourcer had merely provided tools that others misused.
McCollum, the Florida AG, suspects that in other cases LPS is more than an innocent facilitator. In April, he says, "a homeowner contacted us," alleging that LPS paperwork had been "forged in some way." His office opened a civil investigation. While McCollum, a Republican, would not provide specifics, subpoenas his office issued on Oct. 13 demand information on six employees of an LPS subsidiary called Docx. The attorney general's office is investigating whether the employees had the authority to execute mortgage documents for lenders and servicers. One employee, Linda Green, at various times identified herself as a vice-president or representative of more than a dozen different banks and mortgage companies, according to the subpoena. "Docx has produced numerous documents, called assignments of mortgage, that even to the untrained eye appear to be forged and/or fabricated as the signatures of the same individual vary wildly from document to document," the AG's office says on its website.
LPS disclosed in February that the Tampa U.S. Attorney's Office is "reviewing the business processes" of the Docx unit. April Charney, a senior attorney with Jacksonville Area Legal Aid and an outspoken critic of LPS, says she was contacted by a federal prosecutor about the company earlier this year. The prosecutor informed her in April, she adds, that the Justice Dept. was seeking depositions from LPS and Docx employees.
LPS says it shut the Docx unit in April and is cooperating with investigators. "We feel like we have taken all appropriate corrective actions," Carbiener, the CEO, told analysts on Oct. 6. "We don't feel like this is going to have or will have a material impact on our financial results."
Quite the contrary, he added, the foreclosure chaos could be good for business. Dogged by foreclosure-defense attorneys and government investigations, lenders and servicers will have to retrace their steps. "Those services that we provided initially we'll provide again," Carbiener said. "For those loans that are held in review, we have the opportunity to earn additional revenues."
The big banks continue to insist that documentation problems are the legal equivalent of rounding errors. On Oct. 18, Bank of America, which suspended foreclosures in all 50 states, played down that suspension and said it would resubmit foreclosure affidavits in 23 states after completing a speedy review of 102,000 files. Citigroup (C) said its foreclosure process was "sound." JPMorgan Chase Chief Executive Officer Jamie Dimon told investors on Oct. 13, "If you're talking about three or four weeks, it will be a blip in the housing market." He added, "If it went on for a long period of time, it will have a lot of consequences, most of which will be adverse on everybody."
The "blip" scenario may be too rosy. Ohio Attorney General Richard Cordray on Oct. 19 expressed deep skepticism that Bank of America had managed to complete its internal review in just 21/2 weeks, saying, "I would caution that they still have significant financial exposure in many, many cases." Even if the homeowners deserve to be foreclosed on, paperwork problems could stand in the way. Mark J. Grant, a managing director for structured finance at Dallas-based Southwest Securities, wrote on Oct. 18 that what may lie ahead is a "Whangdepootenawah," a word from Ambrose Bierce's Devil's Dictionary ("disaster; an unexpected affliction that strikes hard"). Wrote Grant: "I doubt that you have followed the contagion down the path to the end because if you had, if anyone had...there would be a lot more retching in the streets and on Wall Street's trading desks."
Even if the I.O.U.s can be straightened out quickly, the fighting won't stop. Quoting unnamed sources, The Washington Post reported on Oct. 19 that the Obama Administration's Financial Fraud Enforcement Task Force is investigating whether financial firms committed federal crimes in filing fraudulent court documents to seize people's homes.
Meanwhile, a high-stakes fight is breaking out between the banks that made loans and the investors who bought them. A shot was fired on Oct. 18 when a group of major investors claimed that Bank of America's Countrywide Home Loan Servicing had failed to live up to its contracts on some of more than $47 billion worth of Countrywide-issued mortgage bonds. The group said Countrywide Servicing has 60 days to correct the alleged violations, such as failure to sell back ineligible loans to the lenders. According to people familiar with the matter, the group includes Pimco, BlackRock (BLK), and the Federal Reserve Bank of New York.
For banks that have just started making money again after near-death experiences in 2008, mortgage losses could delay the return to good health. Chris Gamaitoni, an analyst for Compass Point Research & Trading, a Washington financial advisory firm, estimates losses for the big banks of $134 billion from having to buy back bad loans from private investors and another $27 billion in losses from buying back loans from Fannie Mae and Freddie Mac. Other estimates are lower—from $20 billion to $84 billion—in part because those analysts are less certain than Gamaitoni that investors will succeed in court.
Bank of America, the nation's largest lender, has resorted to tough tactics in resisting repurchases of bad loans. Facing pressure from Freddie Mac, one of the two government-controlled mortgage financing companies, to buy back money-losing home loans with problems like inflated appraisals, overstated borrower income, or inadequate documentation, Bank of America issued a blunt threat, according to two people with direct knowledge of the incident. If Freddie Mac did not back off its demands for the buybacks, Bank of America officials said, the bank would take more of the new, more profitable mortgages it is originating these days to rival Fannie Mae, these people said. Freddie and Fannie, known as GSEs (government-sponsored entities), need a steady supply of healthy new loans to climb out of their financial hole.
The claimed threat from Bank of America, which was not put into writing, according to one of these people, was taken seriously enough that it has been discussed at several Freddie Mac board meetings, including one in mid-October. Some officials have urged the Federal Housing Finance Agency—the government conservator that has controlled Fannie and Freddie since they were bailed out in 2008—to confront Bank of America and prevent it from trying to play one against the other, which may be infuriating but is not illegal. "If the tactic worked, I'd be shocked and appalled," said Thomas Lawler, a former portfolio manager at Fannie Mae and now an economic consultant. "The GSEs are supposed to be run now to minimize losses to the taxpayers. Freddie ought to ignore the threat." FHFA Acting Director Edward J. DeMarco declined to comment, as did officials of Freddie Mac. Bank of America also declined to comment.
For policymakers, the dilemma is this: Enormous losses will cause problems wherever they end up. They could further harm Fannie and Freddie, which insure the vast majority of the nation's mortgages and have already received nearly $150 billion in taxpayer support. Or, if Fannie and Freddie succeed in pushing the burden back to the banks, the losses could cripple some of the major institutions that have just emerged from a government bailout. Bank of America faces $12.9 billion in buyback requests, and mortgage insurers have asked for the documents on an additional $9.8 billion on which they may consider seeking repurchases, according to regulatory filings. (Bank of America has put aside $4.4 billion for buybacks, and CEO Brian T. Moynihan says the costs will be manageable.) "The Treasury is very aware that they can't push too hard on this because if you do push too hard it might put the companies in negative capital again," says Paul J. Miller, an analyst at FRB Capital Markets. "There's a lot of regulatory forbearance going on."
Aside from ignoring banks' bad debts, Washington hasn't done much to fix the crisis. Both houses of Congress easily passed a bill this year that would have undermined centuries of law by requiring every state to recognize MERS-type electronic records from other states. Only a pocket veto by President Barack Obama kept it from becoming law.
One option, opposed by the Obama Administration and most Republicans in Congress but favored by Senate Majority Leader Harry Reid and others, is a national moratorium on foreclosures. It would last until regulators assure themselves that lenders have straightened out their foreclosure procedures. Opponents say it would delay the recovery of the housing market by preventing qualified buyers from getting their hands on foreclosed homes. Supporters of the idea, such as Dean Baker, co-director of the Center for Economic and Policy Research, say there are plenty of already foreclosed homes available for sale and thus no urgent need to add to the supply.
Goodman, the Amherst Securities analyst, says banks need to reduce the principal that people owe on their homes so they have an incentive not to walk away. "Ignoring the fact that the borrower can and will default when it is his/her most economical solution is an expensive case of denial," Goodman writes. If the home whose mortgage was reduced happens to regain value, 50 percent of the appreciation would be taxed, she says. Meanwhile, to discourage people from sitting tight in homes while foreclosure proceedings drag on, she would have the government tax the benefit of living in the home rent-free.
CitiMortgage is testing an innovative alternative based on the legal procedure known as "deed in lieu of foreclosure." The owner turns the deed over to the bank without a fight if the bank promises not to foreclose, lets the family stay in the house after the agreement for six months, and gives relocation assistance.
Other ideas: In a New York Times blog post on Oct. 19, Harvard University economist Edward Glaeser suggested federal assistance to overwhelmed state and local courts, as well as $2,000 vouchers for legal assistance to low-income families that can't afford to fight foreclosures. Bloomberg News columnist Kevin Hassett, who is director of economic policy studies at the American Enterprise Institute, says in his Oct. 18 column that the newly created Financial Stability Oversight Council should make the foreclosure mess its first big project, "take authority for solving it, and do so as swiftly as possible."
Speed is essential. The longer it drags on, the more the foreclosure crisis corrodes Americans' faith in their financial and legal systems. A pervasive sense of injustice is bad for the economy and democracy as well. Take Joe Lents. The Boca Raton homeowner hasn't made a mortgage payment since 2002, but he perceives himself as a victim. "I want to expose these guys for what they're doing," Lents says. "It's personal now."
With James Sterngold, Jody Shenn, Bob Ivry, Thom Weidlich, and Dakin Campbell