An Investor’s Guide to Housing’s Courtroom Dramas

by Ethan Roberts | December 5, 2011 12:51 pm

Real estate has always been a boom-and-bust market. The last 10 years is no exception, ranging from a frothy sellers’ market to a bubble crash, followed by a dismal buyers’ market, with foreclosures and short sales accounting for a third or more of  the total. Usually, the bust cycles last only a few years, and sales rebound as economic conditions improve and a new wave of buyers takes advantage of lowered prices or cheap interest rates, or both.

Not this time, however. A slew of well-known problems has kept housing in the doghouse: Slow economic growth, heightened anxiety about jobs and incomes and stricter credit qualifications are just a few of the primary weights. But another disruptive force is occurring in courtrooms across the nation as a surge of litigation threatens to extend the current bust cycle even longer. And investors need to watch these legal battles as much as they do the latest moves in the Case Shiller home price index or the monthly housing start reports.

The granddaddy of these suits involves attorney generals from all 50 U.S. states, who have been embroiled in a controversial case against several major banks, including Bank of America (NYSE:BAC[1]), Citigroup (NYSE:C[2]), JPMorgan Chase (NYSE:JPM[3]) and others.

The suit alleges that the banks engaged in “robo-signing” practices, in which banks automatically processed and verified as accurate foreclosure documents without having the required notary present to affirm that the person signing the paperwork was duly authorized to do so, and worse, signed those papers without even reading the documents.

Massachusetts Steps In

As this suit has bogged down, with both sides struggling to negotiate a settlement, the state of Massachusetts last week filed its own robo-signing lawsuit against five major banks and the Mortgage Electronic Registration Systems. MERS is a central record-keeper of which institution owns which mortgages, but has been plagued with charges that its records are often faulty and incomplete.

The Massachusetts suit’s real motive is probably a last-ditch effort to get the state attorneys general and the banks to finally resolve their dispute. However, it could actually undermine the complex ongoing negotiations and may actually delay a broader settlement.

As these lawsuits drag on unresolved, banks have delayed the completions of thousands of foreclosures to protect themselves from further litigation. This only lengthens the time of recovery for real estate markets.

Other kinds of lawsuits are having a similar effect.

Frustrated homeowners who have a history of on-time loan repayments but are struggling to make those payments are now suing the banks that have denied them permanent loan modifications. The suits allege that the banks misled them or broke promises that were made to reduce the terms of the mortgage.

Other homeowners, who were behind on their payments, are now suing banks for stringing them along for several years with no real intention of modifying their loans. Those suits maintain that the banks were trying to get as much money out of borrowers as possible before seizing the homes in foreclosure anyway.

Yet another group of homeowners has begun suing banks for freezing their home equity line of credit , leaving them with no funds to pay for repairs and modifications made to their homes.  Banks routinely have automated the appraisals performed to assess the value of homes with lines of credit on them. When the appraisal spits out a number that falls below the amount of the line, the lenders often freeze the credit line.

The homeowner’s only recourse is to then pay several hundred dollars for a separate appraisal to prove the home’s value is still above the maximum credit line. However, the very next month a new auto appraisal could begin the entire process over again. The homeowners say these loans were made in good faith based on their equity, and regardless of whether values appreciate or depreciate, the banks need to honor their commitment.

Banks Are Also Plaintiffs

On the flipside, the banks are now preparing to sue homeowners and investors who have “strategically defaulted” — those who choose not to repay a loan despite having the means to do so. The Mortgage Forgiveness Act of 2007, which forgives those who have lost a home to foreclosure from having to pay taxes or penalties on mortgage debt, was extended in 2009, but now expires in 2012.

While banks may not go after the homeowners who tried to negotiate short sales or loan modifications in good faith, those who strategically defaulted or purposely damaged their own homes before leaving are likely to find themselves as defendants. Banks may even garnish wages or make claims against borrowers’ asset.

The net result of all of this litigation: an increasing distrust in the real estate market and the lending process, especially among young would-be homebuyers.  Many professionals in their 20s and 30s have little to no positive personal history upon which to formulate their view of homeownership. All they’ve seen is housing crashes and foreclosures — and everyone suing each other.

In addition, bank stocks continue to lag behind the general market, which is yet another weight holding down housing. Bank of America recently touched an intraday low of $5.03, and insiders continue to dump their stocks even at rock-bottom prices. Citigroup , which was $45 after it’s reverse split last spring, closed at only $28.17 last Friday.

Obviously, the litigation needs to run its course, but the ramifications could hinder real estate for the next decade or more.  Although opportunities do exist to profit now from certain corners of real estate investin[4]g,  investors will need to stay cautious — keep close watch for any legal settlements that could cause the foreclosure crises to move to an eventually resolution.

  1. BAC:
  2. C:
  3. JPM:
  4. certain corners of real estate investin:

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