While falling behind in his mortgage payments, Ken Winchester developed serious health problems. But before undergoing surgery, he wanted to make sure his wife and their disabled daughter would be able to keep their Richmond Heights home. So he signed for what he thought was a second mortgage.
The financial-services company even promised to pay his subprime mortgage while he was recuperating. It also told him the deal would be a way to fix his damaged credit and he could later refinance for better terms.
But Winchester eventually discovered that the second mortgage document he signed was actually an agreement that transferred ownership of his home to the financial services company, which also failed to pay his mortgage during his recovery.
“All I wanted to do was to make sure that my wife and daughter were taken care of in the event that I didn’t come out of surgery alive,” says Winchester. “Now, we are in an even worse financial situation and [we] are in danger of being removed from the house in which we have lived for the past 25 years.”
Stories like Ken Winchester’s line the streets of many Cleveland and Cuyahoga County neighborhoods, where thousands of families lost their homes because they couldn’t repay their high-interest subprime mortgages.
Last year, an average of 20 Cleveland homeowners faced the devastation of foreclosure every day. The number of foreclosures in Cleveland skyrocketed from 182 in 2003 to 7,583 in 2007.
Who is to blame?
So who is to blame for the city’s foreclosure crisis, frequently spotlighted in the national media? Cleveland leaders are pointing to some of the world’s largest financial institutions such as Bank of America, Citigroup, Deutsche Bank, Goldman Sachs, HSBC Holdings, Credit Suisse, JPMorgan Chase, Merrill Lynch, Morgan Stanley, Washington Mutual and Wells Fargo.
In January, the city of Cleveland filed a public nuisance lawsuit naming 21 financial-services companies, charging they sold billions of dollars in Wall Street securities that continuously pushed subprime mortgages with adjustable interest rates on homeowners with weak credit and low incomes.
Consequently, when their mortgage interest rates ballooned, thousands of people lost their homes because they couldn’t afford the monthly payments.
The abandoned homes, the city claims, are vulnerable to looting, vandalism, arson and other illegal activity. Cleveland also is losing tax revenue that supports city schools and other public services.
A study by the Center for Responsible Lending reported that in 2005 and 2006 Cuyahoga County homes and their tax valuations collectively declined by more than $462 million because of foreclosures. The city argues all of these factors were triggered by the subprime surge, costing Cleveland hundreds of millions of dollars. Cleveland’s goal is to recover those costs from the 21 banks named in the lawsuit.
Joshua R. Cohen of Cohen, Rosenthal & Kramer LLP, a Cleveland-based law firm representing the city, is seeking a damage figure in the hundreds of millions of dollars. “We don’t have an exact figure, because we haven’t hired our experts yet,” he says. “But we know there are established ways to calculate the damages a city suffers on the basis of foreclosures.”
At least one of the banks named in the lawsuit, JPMorgan Chase, has filed a formal answer to the city’s lawsuit in U.S. District Court in Cleveland. JPMorgan Chase denies all of Cleveland’s allegations and has asked the court to dismiss the case, contending the city’s claim is preempted by federal banking laws and regulations.
Although the public nuisance lawsuit was initially filed in Cuyahoga County Common Pleas Court, it was moved to federal court. City lawyers are now attempting to get the lawsuit back into state court.
Cuyahoga County Treasurer Jim Rokakis was one of the first public officials to alert federal authorities to the county’s foreclosure problem more than eight years ago. He was alarmed when foreclosures in Cuyahoga County doubled from 3,500 in 1995 to more than 7,000 in 2000.
“Just like drugs are the scourge of our communities that have destroyed our neighborhoods, so has easy credit and these easy mortgages,” says Rokakis. “In our society, we put drug users in jail, but we put a higher premium in jailing drug pushers, and we put the highest premium on jailing the drug lord, who supplies the drugs.
“In this foreclosure problem, the pushers were the mortgage banks and the mortgage brokers, and the drug lord was Wall Street,” he argues. “They bear the ultimate responsibility because they put the apparatus together that enabled people to get this easy credit.”
No easy win
Cleveland’s public nuisance lawsuit will not be easy to win, say legal experts and other observers. In fact, they contend the city’s most important claim will be very difficult to prove.
The city claims the banks could have foreseen that their financing of subprime loans would create Cleveland’s foreclosure crisis, resulting in a major public nuisance.
Public nuisance law is generally defined as anything that interferes with or violates the common public right to health, safety and welfare or interests. Blocking a public road, polluting the air and water, or running a crack house would be examples of a public nuisance.
The banks bear some responsibility for the city’s foreclosure crisis, says Kathleen C. Engel, professor at Cleveland-Marshall College of Law at Cleveland State University. Yet she doubts whether a court will recognize the city’s claim of public nuisance.
“The public nuisance law around lending is not very well developed,” observes Engel, “and the courts don’t like a lot of uncertainty.”
The banks are expected to argue that they had legal relationships with the homeowners, not the city, says Kathy Hessler, a consumer lawyer and law professor at Case Western Reserve University. She also represents Ken Winchester, the Richmond Heights man who lost his home. She says because there was no contractual relationship between the banks and the city, Cleveland has no standing to bring the public nuisance lawsuit against the banks.
But the city could argue, Hessler says, that it is a third-party beneficiary and that the banks hold some responsibility when they knew the impact of their behavior would affect the city.
“I’m not disputing this is a layup case, because it’s not,” says Cohen. “But it’s not an impossible proposition. There is no question that the city has been deeply, deeply damaged by what happened through no fault of its own.”
Hessler points to the banks abandoning their own underwriting standards and offering no-document loans as clear examples that they understood the impact of their behavior. “The banks were making so much money, they just figured whoever ended up with the loan would carry the risk,” Hessler says.
Foreseeing Cleveland’s crisis
The lawsuit comes down to whether the banks could foresee that their actions would violate the public right of health, safety and interests of Cleveland’s neighborhoods, Cohen says.
“We have no doubt they could have foreseen it,” he says, “but they probably did foresee it.”
However, Engel says, in this type of litigation, the city is going to need a lot of evidence of complicity by the investment banks to overcome the banks’ motions to get this case tossed out of court.
In its lawsuit, the city describes how the banks underwrote billions of dollars in securities backed by the subprime loans marketed in Cleveland and across the nation. The securities were sold on Wall Street to investors.
Because there was a huge demand for these investments, which also produced lucrative fees for the banks, the city alleges Wall Street wanted to keep this gravy train fueled to the point that it “subverted the normal operations and inevitably led to the abandonment of meaningful underwriting standards.”
To keep pace with Wall Street’s burgeoning demand, banks targeted borrowers with poor credit unlikely to meet their obligations, the city’s lawsuit alleges. So lenders devised new mortgage products, such as hybrid adjustable-rate mortgages, low- and no-documentation loans and interest-only loans.
Just a year after these new mortgage products flooded Cleveland neighborhoods in 2003, the city saw foreclosures more than double to nearly 400, and then to 1,926 in 2005. By 2006, foreclosures skyrocketed to 7,369.
Cohen charges that banks certainly would have pored over the value and risks associated with these subprime mortgage-backed securities.
“There is no possibility that there wasn’t an evaluation of what would be the default rates,” Cohen contends. “Did they see what would happen to Cleveland on these defaults? The answer in my mind is yes. They knew what the situation was in Cleveland and there was only one way this could have turned out and that was the way it turned out, and they didn’t care.”
What’s more, Cohen argues, the banks knew about the city’s lower-income families with below-average credit who were living in homes not appreciating, as were homes in other parts of the nation.
In addition, the city’s loss of good-paying jobs and other deteriorating economic conditions created a perfect storm that was unique to Cleveland. Nevertheless, Cohen adds, the banks kept pushing their subprime mortgages on consumers who were the most vulnerable to default on their home loans.
Most subprime loans repaid
Some observers say it will be very difficult for the city to prove that the banks should have foreseen that the subprime mortgage products would have created Cleveland’s foreclosure crisis.
“The banks knew that these loans were risky, but that is not the same thing as saying they knew these loans were going to go bad,” says William G. Hamm, a California-based economics consultant and a former chief operating officer for a $50 billion bank. “They made these loans expecting that a very high percentage of them would be repaid, which would offset the losses on the loans that went bad.”
In fact, 87 percent of subprime home loans did not end up in default as of 2005, according to a mortgage industry study released by the Brookings Institution, an independent Washington, D.C.-based public policy group. But, the 13 percent delinquency rate among subprime mortgage homeowners is much higher than the 2 percent delinquency rate among prime mortgage holders.
In addition, the Brookings report notes that subprime delinquency rates may “rise somewhat” this year because monthly payments on many subprime mortgages will be reset to higher payments when interest-only periods end or adjustable interest rates increase.
A positive outcome?
If anything, Hessler says the lawsuit might produce indirect benefits for the city.
“If the city’s goal is to bring these banks to the table to talk, then this lawsuit may be an effective tool,” says Hessler. “If the city can get the banks to the table and agree to a foreclosure rescue program, then I think this lawsuit will create a positive outcome regardless of the merits of the legal claim.”
But don’t count on the banks to settle, because other cities hit hard by the subprime mortgage mess may follow Cleveland’s lead. Cohen doesn’t expect the city’s case to open the lawsuit floodgates, because very few cities experienced the exact same set of circumstances that devastated Northeast Ohio’s neighborhoods.
Still, it may be years before the suit is settled. In the meantime, Cleveland will continue to struggle with its foreclosure crisis— and deal with a lot more stories like Ken Winchester’s sad tale.