Major banks and related mortgage service businesses are living through a nightmare that seems endless.  No doubt leaders of these institutions want to wake up and put it all behind them, but the news just gets worse. I last wrote about the foreclosure fiasco six months ago, and it's worth taking a look at what has transpired since.

In my column from December, I wrote about the billions of dollars institutions lost on bad home mortgages and how much more was at risk when they realized they didn't have proper paperwork to prove ownership of properties on which they were trying to foreclose. I covered bank and servicer officials' assertions that loan files were reviewed for required documentation that turned out not to be true. The underlying problems included the “robo-signers,” hiring of inexperienced so-called “Burger King kids,” and outsourcing to domestic and offshore paperwork mills, where new hires seemed trained only to quickly forge signatures. And you may remember MERS, the Mortgage Electronic Registration System, set up by the banking industry to speed mortgage securitization while saving money on registration fees, but has now put ownership of the mortgages in question.

Well, a lot has happened since then, most of it bad for the banks and servicers. Let's take a look at what's been reported, as well as still more lessons to be learned.

The Legal Process Moves Along

The lawsuits are flying, with activity at the state level especially telling. The Supreme Judicial Court of Massachusetts, the state's highest court, ruled that two banks—Wells Fargo and U.S. Bancorp—didn't have appropriate documentation when they foreclosed. What did the court do? It returned the subject properties to the borrowers. In another lawsuit, New York State's chief judge said: “It's such an uneven playing field [where] banks wind up with the property and the homeowner winds up over the cliff [not serving] anyone's interest, including the banks.” As such, the judge set forth procedures to ensure all homeowners facing foreclosure have legal representation.

Not only can we expect other states to become more protective of borrowers, but no less than three federal government agencies are investigating: the Department of Justice's Executive Office for U.S. Trustees, the Federal Housing Administration, and the Federal Reserve.

A joint settlement would not end the nightmare for banks and servicers by a long shot. They still need to deal with the attorneys general and regulators, and we can expect more required changes to be forthcoming along with large financial payments for past misdeeds.

The impetus for regulatory action emanates from a number of sources, as institutions' failings and treatment of troubled homeowners generate public outrage. Certainly many borrowers also are at fault for the circumstances in which they find themselves, but injustices are prevalent. The effect in human terms is illustrated by reports of how JPMorgan Chase harassed a U.S. Marine Corps captain on active duty, including 3:00 a.m. calls threatening foreclosure. Well, it turns out the bank got it wrong in the case of the captain, along with 4,000 other military personal on active duty who were overcharged. There's something called the Service members' Civil Relief Act that allows mortgage rate reductions and outlaws foreclosures. The bank apologized for what reportedly was a failure to “adjust its records,” and now a class-action lawsuit is in the works. In a similar case, a federal judge ruled that Morgan Stanley's Saxon unit broke the law in foreclosing on and selling the home of a service man while on active duty, ordering the jury to decide on damages.

Events haven't gone well for MERS, which has run into trouble with state courts. For example, the Arkansas Supreme Court ruled that MERS “could no longer file foreclosure proceedings there, because it does not actually make or service any loans,” according to published reports. In Utah, a judge did not recognize the legal standing of MERS, ruling that the homeowner could rip up his mortgage agreement and walk away debt free. And a federal judge ruled that despite MERS' vast reach, its process did not comply with the law. Where other courts will ultimately land is unknown at the moment, but what's happened thus far does not bode well for the comfort of the banks and servicers.

Regulators Get Into the Act

My previous column noted that the Financial Fraud Enforcement Task Force, a coalition of federal agencies and United States attorneys' offices, said the foreclosure issue is its top priority. And state attorneys general have moved forward, with all 50 joining to investigate and seeking to reach an industry-wide settlement. It's been noted that under the Dodd-Frank Act the states have the authority to act against nationally chartered banks, and officials establishing the new Consumer Financial Protection Bureau have given the state attorneys general assurances that the AGs have the right to enforce the Bureau's coming regulations.

With that in progress, the Offices of Comptroller of the Currency and of Thrift Supervision, Federal Reserve Board, and Federal Deposit Insurance Corp. launched an investigation into 14 banks, among them Bank of America, Citibank, GMAC, JPMorgan Chase, and Wells Fargo, including their use of third parties. The investigation reportedly uncovered significant deficiencies in foreclosure processes, causing violation of state and local laws and regulations. The resulting report is expected to form a basis for a settlement where the financial institutions would make fundamental changes in operations and controls. The banks and other servicers would, for instance, have to:

Set up a single contact point within the organization, enabling homeowners to avoid what's often a maze of different departments;

Take steps to ensure there will be no action to foreclose while borrowers are pursuing loan modifications;

Improve training of staff handling foreclosures;

Establish more layers of management oversight over the process; and

Engage an independent consultant to review foreclosures over the past two years, and compensate homeowners who were treated improperly.

While reports say consent orders have already been signed, a ranking member of the House Committee on Oversight and Government Reform says he plans to introduce legislation that would go further, requiring lenders to evaluate homeowners for modifications before initiating foreclosure, create an appeals process for those who are denied modifications, place limits on foreclosure-related fees, and require servicers to prove they have the legal right to foreclose. And of course the state attorneys general are continuing to move forward, pushing for their stricter standards as well.

Lessons to Be Learned

A joint settlement would not end the nightmare for banks and servicers by a long shot. They still need to deal with the attorneys general and regulators, and we can expect more required changes to be forthcoming along with large financial payments for past misdeeds. Oh, if only the risks had been identified earlier and better managed, with appropriately designed business processes and basic and supervisory controls and effective compliance programs in place! This all might have been avoided.

Why, then, weren't adequate business process design and basics of internal control in place long ago, even if the volume of foreclosures wasn't anticipated? The sloppiness has caused tremendous problems for both the banks and servicers on the one hand and their customers on the other—and executives should know by now that if a large swath of consumers is harmed, then laws and regulations will surely follow. This lesson is powerfully reinforced with Dodd-Frank now on the books, and loads of regulations coming.

Another basic lesson involves treating customers with fairness and respect. Many successful companies include in their mission statements a clear and sharp focus on the customer, sometimes adopting a philosophy that “the customer is always right.” One retailer has two rules posted at its front entrance: “Rule 1: The customer is always right. Rule 2: Even if the customer is wrong, reread Rule 1.” Now maybe some of this is marketing, and of course Rule 1 isn't always accurate. But the philosophy drives this business' culture, processes, and performance, and this retailer is extraordinarily successful. Managements of firms dealing in home mortgages could learn something from this concept. 

Another lesson that shouldn't have to be reviewed is the reality that companies are held accountable for the actions of third parties to whom they outsource processing. Unfortunately, what happened with the banks demonstrates that this lesson needs to be relearned.

The Bigger Bucks

It's worth noting that although many of the reforms that servicers are accepting also are being sought by the consortium of state attorneys general, the AGs are looking for more—including reducing the mortgage principal of delinquent homeowners. This is where the big bucks are. And of course exposure is greater still when looking at demands of investors who bought the securitized obligations. Depending on where the AGs, regulators, and courts go on these matters, these costs as estimated by some analysts could rise to tens if not into the hundreds of billions of dollars. An expensive lesson in risk management and internal controls, indeed.

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