How foreclosures are supposed to work

This post is part of an ongoing series on foreclosures and their effect on city governments and neighborhoods. The whole series can be found here. Learn what you can do to stop foreclosures in Milwaukee here.

 

Foreclosures can be extremely expensive to city governments. The worst case scenario is the so-called “zombie foreclosure”; each zombie foreclosure can cost city governments in excess of $34,000. Their mammoth cost to the public–as well as the sheer number of zombie foreclosures in Milwaukee in the last decade following the 2008 housing collapse–means that anyone concerned about housing in Milwaukee needs to pay special attention to zombie foreclosures.

Zombie foreclosures are created when banks exploit a loophole within an already complicated system. To see where zombie foreclosures come from, we must first understand how the system is supposed to work. In this post, we’ll take a simplified example to illustrate how foreclosures are supposed to work. In the next post, we’ll take that knowledge and see how a zombie foreclosure is created.

For a simplified example, let’s follow Horatio Wells as he buys a Milwaukee home for $100,000. He does so using $20,000 of his own money as a down payment, and gets a home loan for $80,000 from State Bank. Horatio’s $80,000 mortgage from State Bank is a 30-year loan with a 5% interest rate. Using the mortgage calculator on mortgagecalculator.org, Horatio’s monthly payment is $429.46; every month for the next 30 years, he must pay State Bank $429.46.

Liens and tigers and bears…oh my!

In the United States, ownership of real estate is tracked by county governments on pieces of paper called deeds. In Milwaukee County, this is the responsibility of the Register of Deeds. The Milwaukee County Register of Deeds has a piece of paper (a deed) for every single house in Milwaukee County. Whoever’s name is on the deed is the owner of that home. Once Horatio buys his new house, the Register of Deeds writes HORATIO WELLS on the deed for Horatio’s new house.

Horatio could never have bought his home without a loan from State Bank–$100,000 is way more money than he has. And State Bank didn’t lend him $80,000 out of the goodness of their heart; they will profit off of the loan. A part of each of Horatio’s monthly mortgage payments goes to principal–that reduces the total amount he owes the bank–and another part goes to interest–that’s profit for the bank. If Horatio pays back the loan as planned, State Bank will profit $74,604.63 (you can verify this on mortgagecalculator.org). Since they loaned $80,000, they will have made 93% profits, almost doubling their money. A previous post (Your Home is not an Investment) looked at the issue of principal and interest payments.

So State Bank will make tidy profits off this loan–that is, if Horatio is able to pay it back. But State Bank has taken considerable risk in giving one person so much money. What if Horatio gets loses his job or gets very sick and is unable to continue paying his mortgage? What if he dies?

Since State Bank has so much money at risk, STATE BANK is also written* on the deed–not as an owner, but as a lienholder.

A lien (pronounced “lean”) indicates that the owner owes the lienholder money, and that the owner and lienholder have agreed to a plan for how that debt will be repaid. Horatio has a 30-year mortgage. As above, he and State Bank have agreed that he will pay $429.46 every month for 30 years. If he pays each of these monthly payments in full and on time, then after 30 years, State Bank must take a satisfaction of mortgage document to the Register of Deeds. A satisfaction of mortgage indicates that the home loan has been repaid in full; if the debt has been repaid, then the lienholder no longer has the right to a lien. The satisfaction of mortgage thus tells the Register of Deeds to remove STATE BANK as lienholder from the deed. Once this happens, the deed only reads HORATIO WELLS with no lienholders.

However, if Horatio falls behind on his monthly mortgage payments, the lien gives the State Bank the right to foreclose on the home. A foreclosure means that State Bank takes ownership of the home away from Horatio.

How foreclosures in Wisconsin are supposed to work

Let’s say that in 2005, Horatio has paid off $25,000 of his mortgage. But suddenly, he gets very sick. Remember, he borrowed $80,000; now that he has paid off $25,000, he owes the bank $80,000 – $25,000 = $55,000. However, because his medical bills are so high, he can no longer make his mortgage payments. Unfortunately, in the United States, this is a very common situation. Up to 70% of foreclosures are caused by a medical problem or unaffordable medical bills. Horatio is very sick and has not made a single payment in six months. Since Horatio has not been keeping up with his payments, State Bank–because they are listed as a lienholder on the deed for Horatio’s home–can foreclose on the home. That is, State Bank can take ownership of the home. How does this occur?

In Wisconsin, foreclosures must be approved by a court. That is, State Bank has to prove to a judge several things:

First, State Bank has to prove that they are a lienholder listed on the deed. If they are not, they cannot foreclose on the home. Second, State Bank has to prove that Horatio has missed payments. If they cannot prove that Horatio was short on mortgage payments, then they have no right to take Horatio’s home in foreclosure. Finally, Wisconsin state law requires that banks give homeowners time to make up for missed payments. Thus, the court proceeding also makes sure that Horatio was given enough time to pay back the mortgage payments that he missed.

Poor Horatio has missed 6 months of payments. The court finds that State Bank has the right to foreclose on Horatio’s home. They do so by issuing a judgment of foreclosure. The judgment of foreclosure states that State Bank has gone through the foreclosure process specified by Wisconsin state law, and that the court has verified that State Bank has the right to take Horatio’s home because (1) State Bank is a lienholder, (2) Horatio is behind on payments, and (3) Horatio was given enough time to try to catch up on payments he missed.

The last step

Most homeowners who suffer the tragedy of foreclosure believe that they have lost their home the moment the court issues a judgment of foreclosure. However, this is not the case; at this point, Horatio is still the legal owner of the home–even though the courts have issued a judgment of foreclosure. Remember, the Register of Deeds has a deed for every single home in Milwaukee County, and the name written on the deed is the owner of the home. The judgment of foreclosure does not change the deed; until the deed is changed, Horatio is still technically the owner of the home.

To actually take ownership of Horatio’s home, State Bank must take the judgment of foreclosure to the Register of Deeds. The judgment of foreclosures is essentially an instruction to the Register of Deeds: “Please remove HORATIO WELLS from the deed and write STATE BANK instead. Sincerely, Milwaukee County Courts.” Horatio is the owner of the home until the moment the Register of Deeds removes HORATIO WELLS from the deed and writes STATE BANK on the deed. The judgment of foreclosure does not make State Bank the owner of the home; only the Register of Deeds can change the owner. If the deed isn’t changed, the owner hasn’t changed either.

Obviously, State Bank wants to take ownership of Horatio’s home; he still owes them $55,000 but is unable to pay. Unless State Bank takes ownership of the home, they have no way to recover that $55,000. So, State Bank takes the judgment of foreclosure to the Register of Deeds. The Register of Deeds replaces HORATIO WELLS with STATE BANK on the deed. State Bank now owns the home. Horatio must move out.

State Bank hires a realtor

The foreclosure process is now complete. State Bank officially owns Horatio’s home. Poor Horatio is seriously down on his luck. First, he got very sick. Then, in order to stay alive, he incurred medical bills he could not afford to pay. This led to him losing his home in foreclosure; now, he’s homeless. If he didn’t have money for mortgage payments, he won’t have money for rent, either.

Let’s take a look at Horatio’s finances. Remember, when Horatio first bought the home, he paid $20,000 of his own money for his house. That money is gone; he will never get that money back. And, Horatio had paid off $25,000 of his mortgage. But State Bank does not have to pay Horatio back the $25,000 that he paid off; State Bank gets to keep the full $25,000. In other words, Horatio lost his health, his job, his home, and his entire savings. He is ruined. Making matters worse,with a foreclosure on his credit report, Horatio’s credit is also destroyed; he will not be able to borrow money to buy a car, and he may even have trouble applying to rent housing or apply for jobs since landlords and employers often check applicants’ credit histories.

Fortunately for Horatio, his best friend, George Walker, lives on the other side of Milwaukee. George lets Horatio move in, rent free, and helps take care of Horatio until he can heal up and get back on his feet financially. After all, what are friends for?

How has State Bank fared? Horatio owed State Bank $55,000 when he got sick and couldn’t pay them any longer. But State Bank now owns the house. Remember, the house is worth $100,000. State Bank hires a realtor, who sells the home for $100,000.

So State Bank lent Horatio $80,000. They get to keep the $25,000 that Horatio paid back. And they also get to sell the house for $100,000. When it’s all said and done, State Bank’s revenue is $125,000 even though they only loaned out $80,000(!). Actually, State Bank is in an even better situation. While Horatio was making payments, State Bank made $50,700** in interest, meaning their revenue was $175,700 on an $80,000 loan. (A previous post, Your Home is Not an Investment considered interest payments). State Bank made 120% profits. Had Horatio paid off his mortgage as planned, State Bank would have made 93% profits (see above). You did not misread that; State Bank actually makes more money if Horatio fails to pay his mortgage than if he pays it in full. And, State Bank gets a substantial payment now, rather than waiting for years to profit as Horatio slowly pays off the mortgage.

Of course, State Bank had to hire a lawyer to actually go through the foreclosure process. And State Bank also had to hire a realtor to sell the home; neither of these services are cheap. However, even after subtracting these expenses, they have made a substantial profit from the foreclosure.

Conclusion

This is how foreclosures are supposed to work. Now that we understand how foreclosures are supposed to work, we can learn how zombie foreclosures occur, as well as figure out why they have such a high cost to society.

One key point should stand out: foreclosing on a home can be extremely profitable for a bank. Remember, had Horatio paid off his mortgage as planned, the bank would have made 93% profits, stretched out over 30 years. By foreclosing, State Bank made 120% profits, and they didn’t have to wait the full 30 years to collect. In his book Chain of Title, journalist David Dayen recounts some of the outrageous lengths some banks have gone to foreclose on homeowners. Among some of the worst: a Cleveland couple lost their home in foreclosure because they were 14 cents short on a monthly mortgage payment (someone wrote the wrong amount on a paper check before mailing it in). A man lost his home when GMAC claimed the cashier’s check he sent to pay his mortgage payment bounced; this is impossible because cashier’s checks must be paid in full at the time they are issued. Bank of America employees admitted getting paid bonuses to lie to borrowers about their monthly payment amount so that they fell behind on their mortgage. Bank of America was also caught forging documents in order to foreclose on homes that had already paid off their mortgage (and thus there should have been no liens on their deed). Unfortunately–since foreclosures are often more profitable than having a loan paid back in full and on time–unscrupulous banks have an incentive to foreclose instead of trying to make adjustments (like allowing that Cleveland couple to make up the 14 cent shortfall) to keep people in their homes.

 

Image: Housing Bubble 18. Flickr / Jean-Michael Reed.

 

*I’m simplifying the process. In Wisconsin, liens are not recorded on the deed. However, the result is the same as if liens were written directly on the deed, as they are in other states.

**You can check my work using mortgagecalulator.org. Horatio’s loan was for $80,000 for 30 years at 5% interest rate. You will have to check the boxes for “Show Amoritization Tables” and “Show monthly amoritization tables.” Copy the monthly amoritization table down to the point where the balance is closest to $55,000, and paste this into a spreadsheet program. Then, add up the “Interest” column.