State attorneys general are demanding this sum, but the numbers and legal realities suggest that they are being unreasonable
At this point, we can be fairly confident that banks cut corners and sometimes even broke laws when processing foreclosures over the past couple of years. As a result, they should face whatever fines or penalties -- or even criminal charges -- that should result through the laws in place. Banks should also face civil lawsuits from any borrowers on which they wrongly foreclosed. How much money could those civil lawsuits cost them? According to the state attorneys general, the five big banks could be on the hook for $17 billion. Is this a realistic estimate?
Earlier this week, the Wall Street Journal reported that this $17 billion sum is the one that's being presented to the five biggest banks in settlement talks. The banks, however, think that number is much too high. They are reportedly offering $5 billion. Obviously, there's a big difference between $5 billion and $17 billion. Which number more realistically describes what banks might owe borrowers in civil court?
In order to determine this, you have to figure out the different reasons why banks might have inflicted injury on the potential litigants. There are two scenarios that likely describe most situations where banks botched the process.
The Common Scenario: In many cases, banks cut corners, but ultimately foreclosed on homes where borrowers were severely delinquent and were legitimately facing foreclosure. In most of these cases, the timeline was still longer than the law called for, as the huge flood of foreclosures overwhelmed banks and resulted in a slow process, even with banks skipping steps.
The Uncommon Scenario: In what's likely a very, very small handful of cases, some loan files got mixed up and banks foreclosed on some borrowers' home despite the fact that they were current on their payments. Considering how few accounts we have seen in the media of this sort of thing, the number of people wrongly foreclosed on must be quite low.
In each scenario, what do banks owe the borrowers? In the common scenario, banks probably owe these borrowers little to no damages whatsoever. According to Kenneth E. Scott, a law professor at Stanford who specializes in regulatory and securities law, if borrowers have defaulted on their loan, then banks will likely owe them nothing. Even if there was some damage inflicted on these borrowers, it would merely be subtracted from the debt they still owe the bank. For example, if a person's foreclosed home was auctioned off for $50,000 less than their mortgage balance and a judge awards the person $10,000 in a suit, then the result would merely be the litigant owing the bank $40,000 instead.
In the uncommon scenario, however, some damages could more easily result. Then, any costs or harm resulting from the foreclosure process could result in a monetary award. According to Scott, these damages would likely use the equity that the borrower had in their home at the time of foreclosure as a starting point. In a market where so many homes are underwater, however, it's hard to see how even these damages could be very high.
So in almost all cases (the "common scenario"), the damages that banks owe would be negligible. In a small handful ("the uncommon scenario"), they could be larger, but certainly no where near as large as the size of the mortgage.
Now let's look at the numbers and do some estimating. From 2006 through 2010, roughly 9 million foreclosures have occurred in the U.S., according to RealtyTrac. Now let's make some assumptions that vastly favor the state attorneys general. First, we'll assume all 9 million were through the five big banks. Next, let's say 100,000 borrowers were wrongly foreclosed on, which is roughly 1%. This is a very, very generous estimate, as the number of people whose home was seized by the bank despite being current on their loan is more likely in the hundreds or low thousands. Under these assumptions, $17 billion would amount to an average award of $170,000 per person. That's approximately the average home sale price in the U.S.
In other words, even if you imagine that an astronomical number of people were wrongly foreclosed on, the damages would have to also be impossibly high to come up with $17 billion in damages. This analysis makes even bank's $5 billion offer to the state attorneys general look generous.
So how much should banks worry they could owe? In settlement this becomes more complicated. The possibility of a class action lawsuit could increase the damages. But Kenneth Scott explains that filing class action could be difficult in this situation. Different states have different laws and regulations governing mortgages. Different borrowers' situations also can differ greatly. Reconciling all that into one big lawsuit wouldn't be easy.
Of course, settlement also has the advantage of avoiding hundreds or thousands of individual lawsuits, so sometimes litigants try to bake in the legal cost savings of their opponent into their award as well. To be sure, banks would incur many millions of dollars in legal fees if all of these lawsuits are brought individually.
So what number is reasonable? Scott finds it "extremely doubtful" that banks could face close to $17 billion in damages from potential civil lawsuits. And from the analysis above, it does seem likely that something closer to their $5 billion offer would be more reasonable, if not generous. Of course, this doesn't include whatever penalties or fines they should face due to their misdeeds. But that's an entirely separate issue, unrelated to this aspect of the settlement negotiations between the big banks and the states.
Image Credit: Larry Downing / Reuters