NEW YORK -- Karl Case, the co-creator of a widely watched housing market index, was upbeat three weeks ago. Mulling the economy while at a meeting at a resort near the Berkshires, Case thought the makings of a recovery were finally falling into place.
"I'm a 60-40 optimist," he said at the time.
Today, Case's mood is far more subdued. In scarcely two weeks, he and other housing analysts have watched as the once-staid world of back-office bank procedures has spawned a scandal that threatens to further unhinge the housing market.
Allegations of possible mortgage fraud against financial giants GMAC, JPMorgan Chase and Bank of America read like a corporate thriller: forged documents, faked Social Security numbers, phantom titles, disappearing paper trails, "robo-signers" and mortgages sliced and diced so many times that nobody really knows who owns them.
On Friday, PNC and mortgage servicer Litton Loan Servicing joined those three financial institutions in suspending some foreclosures while they review how documents were handled. Bank of America, which had already announced a halt for 23 states, expanded the suspension to cover the whole nation. If other banks follow suit, it raises the specter of a national foreclosure moratorium.
In all, the banks will have to review the paperwork for hundreds of thousands of mortgages. On top of that, class action lawyers and state attorneys general have filed lawsuits and called for foreclosure moratoriums.
In the near term, the freezes could actually benefit both homeowners and the housing market. Homeowners would have time to live rent-free and chip away at their debt. Prices might stabilize because so many homes are penned up.
But the long-term implications are grave. Only a month ago, housing watcher Mark Zandi, chief economist at Moody's Analytics, predicted that a housing recovery would be under way by the third quarter of next year. Now he believes the foreclosure scandal could prolong the housing depression for at least another few years.
The alleged document fraud could open up the entire chain of foreclosure proceedings to legal challenge. Some foreclosures could be overturned, others deemed outright fraudulent.
Before a housing recovery can occur, all those foreclosed properties have to be re-scrutinized by the banks and then sold. With any foreclosure-related deal open to legal challenge, that inventory could be taken off the market while the legal challenges make their way through the courts.
That's not to mention the questions being raised about missing paper trails on mortgages owned by people who have never missed a payment. What started as simple paperwork bungling in a Pennsylvania office park now threatens to bring to a standstill the nation's entire foreclosure machinery.
The development is especially troubling given how large the foreclosure market is. Before the scandal erupted, forecasters at John Burns Real Estate Consulting predicted that 41 percent of residential sales this year would be on distressed properties. Typically, distressed properties account for 7 percent.
Since housing is the engine that in the past seven recessions has pulled the economy out of recession, any further damage couldn't come at a worse time.
"As far as I'm concerned, anything that slows the foreclosure process is a bad thing," Case said this week.
The debacle injects yet more uncertainty into a frail recovery that is still trying to find its strength.
"This is definitely one of the last things anyone needed to have to deal with," says Diane Pendley, managing director of Fitch Ratings.
The news that GMAC, recently renamed Ally Financial, and JPMorgan Chase and Bank of America were stopping foreclosure proceedings in 23 states was merely the beginning. Federal lawmakers are calling for a federal investigation, saying the excuses from the industry are not credible, and on Wednesday the Ohio attorney general filed a fraud suit against GMAC, calling it "the tip of an iceberg of industry-wide abuse." GMAC denies the allegations.
In at least six states, attorneys general are calling for foreclosure moratoriums and launching their own investigations.
What's more, lawyers who have already filed class action lawsuits in Maine and Kentucky are now signing up entire neighborhoods as new clients. They're hiring private eyes to track down former industry employees and holding marathon conference calls to strategize on how to get every speck of dirt on the banks that they can.
The low-level bank employees in question were supposed to have reviewed mortgage documents in detail. Instead, they say they never so much as glanced at the papers. Nor did they even know where the papers were.
"They were just so haphazard and so gloriously incompetent to save a few pennies here and there," says Barry Ritholtz, director of equity research at Fusion IQ. "But a few pennies times millions of documents is a billion dollars."
The banks insist that most of the people involved in the foreclosure deals were legitimately behind on their payments. But even so, if the procedures that put them into foreclosure are deemed fraudulent, it will nullify the deals and require that the entire process start all over again.
The financial institutions insist that, in most if not all cases, there was no fraud, the borrowed missed their payments and the foreclosures are justified. Delays may occur, they say, but the outcomes will be the same. Moreover, they insist they are strengthening their procedures. They are chalking up much of the controversy to possible shoddy paperwork.
But the pronouncements have done little to assuage those connected to the mortgage industry, and the uncertainty is spreading fast.
On Sept. 23, Standard and Poor's warned of a possible downgrade on GMAC. The next day, Moody's Investors Service also placed GMAC on a watch. On Sept. 29, Fitch Ratings said it was reviewing the mortgage servicers' practices.
Perhaps most worrisome was the news on Oct. 1 that title insurer Old Republic National -- which provides protection to the homebuyer and mortgage provider in case any unpaid taxes, questionable ownership or other problems turn up -- had ordered its agents to cease offering policies on foreclosed properties owned by GMAC or JPMorgan Chase. On Oct. 7, another title insurer, Stewart Title, issued an internal memo making it incredibly difficult -- if not impossible -- for an agent to write a policy for any foreclosure property connected to any of the now-tainted banks.
"Right now everyone in the industry is trying to understand the scope and breadth of the problem, and is looking to lenders to get their paperwork in order so that sales can resume," says Kurt Pfotenhauer, chief executive of the trade group American Land Title Association.
Meanwhile, real estate agents who specialize in selling bank-owned properties say the market is locking up. Dorothy Buse, a Coldwell Banker agent in the Orlando, Fla., area, said that out of the 200 foreclosures she has listed for sale, 40 are now in the foreclosure freeze. Of the 40, 12 that were already under contract are now on hold. It's now unlikely that anyone would want to make an offer on any of the other 160 homes.
"There's nothing within my power -- or my staff's power -- that we can do, except try to reassure them that we're working on this," Buse says.
In addition, legal challenges are mounting. On Sept. 24, a district court judge in Maine threw out a ruling in favor of GMAC to foreclose on a house owned by an unemployed mother of two. Now that case will go to a bench trial in Portland.
The court also sanctioned GMAC about its paperwork process, noting that "this case is not the first time that GMAC's high-volume and careless approach to affidavit signing has been exposed."
Michael Holmes is one of the thousands of mortgage holders whose house was put into foreclosure by the now infamous "robo-signer," the GMAC employee who signed 10,000 foreclosure affidavits a month. On Oct. 1, GMAC informed Holmes that the foreclosure on his Belfast, Maine, home had been put on hold. The bank didn't say for how long.
The temporary halt has done little to subdue Holmes' stress. He spent the past year and a half fighting to get a loan modification from GMAC, a process he says yielded a file the size of a Manhattan phone book and virtually no response from the bank. He also claims he received no written notice of a foreclosure.
Now Holmes, a former hospitality executive at such Boston hotels as the Ritz-Carlton and the Copley Plaza, says he wants to fight to keep the Victorian he grew up in. But from one day to the next, he doesn't know what will happen.
"The one safe place you have is your home," Holmes says. "It's your comfort zone, and to have that in limbo, it feels like the wolves are on my porch."
Alan Zibel contributed from Washington and David Pitt contributed from Des Moines.