Another ticking time bomb in the realm of real estate bad behavior is bound to go off sooner rather than later, and it is likely to impede normalization of values of residential property.

As readers no doubt know, there is a lot of actual and shadow residential real estate inventory in the US. The time from serious delinquency to foreclosure has lengthened considerably, due not just to crowded court dockets, but also bank/servicer disinclination to take possession (reasons include that investors take a dim view of bank real estate holdings; the bank is liable for expenses, most important real estate taxes, once it takes possession; more foreclosures would lead banks to have to write down clearly overvalued second mortgages, leading to losses and lowering bank capital levels).

Most analysts have argued that it would be preferable to accelerate the process of clearing the overhang of housing inventory, since prices need ultimately to return to price level in relationship to incomes and rent rates more in line with long standing historical norms. And the officialdom seems to accept this view, since Fannie and Freddie are pressuring servicers to move faster on foreclosures.

But what if this resolution process has new land mines planted in it? What if there are not widely understood impediement to foreclosed properties ending up with new owners? If there are good reasons buyers will have reason to be leery of buying houses out of foreclosure, we could have a lot of homes sitting vacant, a blight on neighborhoods and a source of even greater losses to banks and investors.

Yet it appears that the very same sort of corners-cutting that led financial firms to shovel money to weak borrowers could impede working through the inventory of seized residential real estate. An article discusses an analysis by AFX Title, a title search company, that shows problems with title on foreclosed properties to be widespread:

As the number of real estate foreclosures skyrockets, the odds are higher that a home you live in today, or at some point in the future may have had a foreclosure in its history. Even if the foreclosure has long since passed, a loophole in the way mortgages are recorded can create a serious title defect for future owners. Title analysis performed this month by AFX Title has detected this error to be common in random samples of properties it reviewed. “This could affect the property ownership of millions of homes nationwide” said David Pelligrinelli, of AFX Title. “The mortgage recording method which created this title flaw did not exist until recently. As title abstractors are just seeing this problem emerge now but a wave of title claims is coming over the next year or so.”…. The problem is created through a break in the chain of mortgage ownership. Until the 1980’s, most mortgages were loans between the homeowner and a bank, who lent the money directly. More recently, the mortgage financing system transformed into an international system of securitization, with mortgage lenders packaging their loans into securities, bought and sold by investors like stocks. These transactions even split individual mortgages into sections, where each loan could have parts owned by different investment banks. The transfer of ownership in these mortgage backed securities (MBS) was done with contracts on the balance sheets of Wall Street investment banks, such as Morgan Stanley and Goldman Sachs. The company who originally appeared to make the loan was normally a retail lending company such as Countrywide or Lending Tree, who typically acted as a sales company, and sometimes remained contracted to service the loan. In the event that the loan goes into foreclosure at a later date, the then-current owner of the loan files the foreclosure and sells the property to a new owner, often at auction. The land records would show a deed of transfer from the investment bank to the new owner. This creates a break in the chain of ownership of the mortgage rights. In many cases, the transfer of ownership of the mortgage loan has gone from the original lender, through several owners, and then to the foreclosing bank, none of which is recorded on the property title history. Technically, the foreclosing bank has no recorded title rights to foreclose in the first place… There are reports that some title insurers are indicating that they will not insure for this title defect.

Yves here. Some readers may take this all to be unduly alarmist. But confirmation that this problem is real and potentially serious comes via a new “gotcha” practice by Wells Fargo on foreclosure sales. Wells is sufficiently concerned about the risks of selling properties out of foreclosure that it is springing an addendum on buyers, shortly before closing, which effectively shifts all risk for any title deficiency on to the buyer.

Now why is this a big deal? Go reread the boldfaced sentence above. If a bank like Wells does not have the right to foreclose, it cannot have clean title to the property. So the bank could conceivably be selling something it does not own.

Let’s say you buy a vase from a store. You open the box when you get home and find out the box is empty. You’d clearly be within your rights to get your money back.

With the Wells Fargo addendum, even if the bank has sold you the equivalent of an empty box, you have no recourse to Wells. Zero. Zip. Nada.

Let’s go back and give a bit of context. Wells is encouraging buyers in foreclosures to use its attorney and title insurers and reportedly offers to split fees. So the bank is taking steps to steer buyers not to get legal advice. This matters because the problems in this document would not be evident to a layperson. And it’s not even evident to lawyers not expert in real estate; I learned about this situation because a lawyer I know who does a fair bit of real estate work had been contacted by a friend of his, a lawyer looking to buy a house over foreclosure. Wells had presented the prospective buyer with this supposed “standard” addendum on the day of closing and said they would not negotiate it (you can read it in full at ScribD). The buyer was advised not to sign it.

On the surface, this document may not seem all that troubling. But what it does, in effect, is say “Warning, warning, you are buying a property out of foreclosure, there is risk here, and you can’t hold us responsible for anything we told you in the sale process.” (see paragraphs 1 and 2). Now the not-trivial problem with that is: how can you possibly evaluate the risk of buying a property out of foreclosure without asking the current owner? And if the current owner isn’t legally responsible for what they say, or more important, what they deny is a problem, they buyer cannot perform effective due diligence. This vitiates a principle that is well embodied in most areas of consumer and business law, that a seller is liable for the representations he makes about his wares.

Now specifically, the potential problem with the deal is the bank in many states will at best be giving the buyer a “quitclaim” deed (the addendum finesses this in paragraph 18, that the buyer only gets a “special/limited warranty deed. As the lawyer who took a dim view of this addendum put it, “This is like the ‘Special Olympics,’ not like ‘You are my special someone’.” That means the bank is merely transferring whatever it interest it has.

But per the AFX article above, the bank may own nothing. It may have foreclosed without having a clear enforceable right to the property (this is the basis of the burgeoning number of cases where borrowers are successfully challenging the bank/servicer’s right to foreclose, because it cannot prove it actually owns the note, which is the IOU between the borrower and the lender; if you don’t own the note, in 45 states, you have no right to enforce the lien on the property).

Now this little problem can be solved by title insurance, right? Well, guess what, some title insurers have exited the business, some others are starting to write policies with meaningful exceptions when they can’t go to the courthouse and find a clear chain of title. Oh, and Wells is trying to steer you towards their title insurer. What do you think the odds are that their title insurance policy doesn’t have exceptions?

So what is the risk? The lawyer explains:

The typical (unsophisticated) buyer thinks that because they have a lawyer at closing (no matter whose lawyer it is), a title policy, etc…….that they are all safe and sound. They struggle through one of these REO transactions for a month or two, finally get in the house, something bad goes wrong, and they find out that 1) the title policy won’t cover them and 2) the land isn’t unique (see the nasty provision in paragraph 27 on “specific performance”), so a refund is all you get – and you are out on your ear. Hopefully, with a refund – and that may be the best outcome. But if somebody comes in, and voids a foreclosure, your title policy doesn’t pay – Wells Fargo has clearly disclosed that this was a foreclosure, so you only got what they had (nothing), and you have no recourse, no insurance, and guess what, an unsecured loan for half a million bucks.

Given how many sales will be done out of REO, and the rising number of problems surfacing with making sure that mortgage securitizations took all the steps to become the real party of interest in a particular property, it is only a matter of time before we see some blowups of the sort the attorney was worried about, of a buyer shelling out hard dollars for a house, or taking a big mortgage, and winding up with nothing. And a few incidents like that getting the press they deserve will put a pall on REO sales.

Think the risk isn’t real? Then why has Wells bothered to insist that REO buyers sign a new type of addendum, when it has been selling REO for decades? This effort to shift all title risks on to the buyer is a tacit admission of problems. And look at the document itself. The buyer has to initial it in eight places as well as sign it. That’s a clear statement of Wells’ intent to shift the risk to the buyer.