The Foreclosure Mess

This commentary, forwarded by David Kotok, is a very worthwhile read — but it has a significant legal flaw in it that requires me to preface it with the following: Courts have long had the authority to apply principles of equity, as opposed to common or statutory law, to cases brought before it.

Included in this means is preventing outcomes that unjustly enrich wrongdoers, or other similar bad outcomes. With the foreclosure fraud cases, we have two actors that are not blameless here: The homeowner, who is in default, and the banks/securitizers, that failed to do the document creation and title management correctly.

Judges in civil cases do not want to see an absurd outcome. Rewarding either the homeowner (free house!) or the lenders (No penalty for massive screw ups!) would offend those principles of equity and fairness.

What might be a “just” outcome in these cases?  An example of a possible fix in a full blown litigation might be for the court to order the mortgage modified to the current equity value of the home, so that it a) punishes the lenders who failed to do their proper legal work on the documents, but b) does not give a home to a defaulted homeowner for free. The odds would be that the homeowner still gets foreclosed on, but does not owe additional monies to the bank. Since these are very often uncollectible judgments anyway, the court’s judgment can mete out justice fairly, not give anyone an undeserved windfall, yet move the cases forward. That is but one “just” solution, and I am confident that most courts have the sophistication to fashion an appropriate remedy.

Courts of “equity” (meaning “just, fairness”) can apply these principles to avoid ridiculous outcomes. Whether they choose to do so or not will be determined by them.

-BR

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The Foreclosure Mess
October 15, 2010
David Kotok
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[BR: Update: The original post was written by Gonzalo Lira].

Dear Readers, this text came to me in an email from sources that are in the financial services business and with whom I have a personal relationship.  The original text was laced with expletives and I would not use it in the form I received it.  Therefore the text below has had some substantial editing in order to remove that language.  The intentions of the writer are undisturbed.  The writer shall remain anonymous.  This text echoes some of the news items we have seen and heard today; however, it can serve as a plain language description of the present foreclosure-suspension mess. There is a lot here.  It takes about ten minutes to read it.

-David Kotok

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Homeowners can only be foreclosed and evicted from their homes by the person or institution who actually has the loan paper—only the note-holder has legal standing to ask a court to foreclose and evict. Not the mortgage, the note, which is the actual IOU that people sign, promising to pay back the mortgage loan.

Before mortgage-backed securities, most mortgage loans were issued by the local savings & loan. So the note usually didn’t go anywhere: it stayed in the offices of the S&L down the street.

But once mortgage loan securitization happened, things got sloppy—they got sloppy by the very nature of mortgage-backed securities.

The whole purpose of MBSs was for different investors to have their different risk appetites satiated with different bonds. Some bond customers wanted super-safe bonds with low returns, some others wanted riskier bonds with correspondingly higher rates of return.
Therefore, as everyone knows, the loans were “bundled” into REMIC’s (Real-Estate Mortgage Investment Conduits, a special vehicle designed to hold the loans for tax purposes), and then “sliced & diced”—split up and put into tranches, according to their likelihood of default, their interest rates, and other characteristics.

This slicing and dicing created “senior tranches,” where the loans would likely be paid in full, if the past history of mortgage loan statistics was to be believed. And it also created “junior tranches,” where the loans might well default, again according to past history and statistics. (A whole range of tranches was created, of course, but for the purposes of this discussion we can ignore all those countless other variations.)

These various tranches were sold to different investors, according to their risk appetite. That’s why some of the MBS bonds were rated as safe as Treasury bonds, and others were rated by the ratings agencies as risky as junk bonds.

But here’s the key issue: When an MBS was first created, all the mortgages were pristine—none had defaulted yet, because they were all brand-new loans. Statistically, some would default and some others would be paid back in full—but which ones specifically would default? No one knew, of course. If I toss a coin 1,000 times, statistically, 500 tosses the coin will land heads—but what will the result be of, say, the 723rd toss? No one knows.
Same with mortgages.

So in fact, it wasn’t that the riskier loans were in junior tranches and the safer ones were in senior tranches: rather, all the loans were in the REMIC, and if and when a mortgage in a given bundle of mortgages defaulted, the junior tranche holders would take the losses first, and the senior tranche holder last.

But who were the owners of the junior-tranche bond and the senior-tranche bonds? Two different people. Therefore, the mortgage note was not actually signed over to the bond holder. In fact, it couldn’t be signed over. Because, again, since no one knew which mortgage would default first, it was impossible to assign a specific mortgage to a specific bond.

Therefore, how to make sure the safe mortgage loan stayed with the safe MBS tranche, and the risky and/or defaulting mortgage went to the riskier tranche?

Enter stage right the famed MERS—the Mortgage Electronic Registration System.
MERS was the repository of these digitized mortgage notes that the banks originated from the actual mortgage loans signed by homebuyers. MERS was jointly owned by Fannie Mae and Freddie Mac (yes, those two again —I know, I know: like the chlamydia and the gonorrhea of the financial world—you cure ‘em, but they just keep coming back).

The purpose of MERS was to help in the securitization process. Basically, MERS directed defaulting mortgages to the appropriate tranches of mortgage bonds. MERS was essentially where the digitized mortgage notes were sliced and diced and rearranged so as to create the mortgage-backed securities. Think of MERS as Dr. Frankenstein’s operating table, where the beast got put together.

However, legally—and this is the important part—MERS didn’t hold any mortgage notes: the true owner of the mortgage notes should have been the REMICs.

But the REMICs didn’t own the notes either, because of a fluke of the ratings agencies: the REMICs had to be “bankruptcy remote,” in order to get the precious ratings needed to peddle mortgage-backed Securities to institutional investors.

So somewhere between the REMICs and MERS, the chain of title was broken.
Now, what does “broken chain of title” mean? Simple: when a homebuyer signs a mortgage, the key document is the note. As I said before, it’s the actual IOU. In order for the mortgage note to be sold or transferred to someone else (and therefore turned into a mortgage-backed security), this document has to be physically endorsed to the next person. All of these signatures on the note are called the “chain of title.”

You can endorse the note as many times as you please—but you have to have a clear chain of title right on the actual note: I sold the note to Moe, who sold it to Larry, who sold it to Curly, and all our notarized signatures are actually, physically, on the note, one after the other.

If for whatever reason any of these signatures is skipped, then the chain of title is said to be broken. Therefore, legally, the mortgage note is no longer valid. That is, the person who took out the mortgage loan to pay for the house no longer owes the loan, because he no longer knows whom to pay.

To repeat: if the chain of title of the note is broken, then the borrower no longer owes any money on the loan.

Read that last sentence again, please. Don’t worry, I’ll wait.

You read it again? Good: Now you see the can of worms that’s opening up.

The broken chain of title might not have been an issue if there hadn’t been an unusual number of foreclosures. Before the housing bubble collapse, the people who defaulted on their mortgages wouldn’t have bothered to check to see that the paperwork was in order.

But as everyone knows, following the housing collapse of 2007-’10-and-counting, there has been a boatload of foreclosures—and foreclosures on a lot of people who weren’t sloppy bums who skipped out on their mortgage payments, but smart and cautious people who got squeezed by circumstances.

These people started contesting their foreclosures and evictions, and so started looking into the chain-of-title issue, and that’s when the paperwork became important. So the chain of title became crucial and the botched paperwork became a nontrivial issue.

Now, the banks had hired “foreclosure mills”—law firms that specialized in foreclosures—in order to handle the massive volume of foreclosures and evictions that occurred because of the housing crisis. The foreclosure mills, as one would expect, were the first to spot the broken chain of titles.

Well, what do you know, it turns out that these foreclosure mills might have faked and falsified documentation, so as to fraudulently repair the chain-of-title issue, thereby “proving” that the banks had judicial standing to foreclose on delinquent mortgages. These foreclosure mills might have even forged the loan note itself—

Wait, why am I hedging? The foreclosure mills did actually, deliberately, and categorically fake and falsify documents, in order to expedite these foreclosures and evictions. Yves Smith at Naked Capitalism, who has been all over this story, put up a price list for this “service” from a company called DocX—yes, a price list for forged documents. Talk about your one-stop shopping!

So in other words, a massive fraud was carried out, with the inevitable innocent bystanders getting caught up in the fraud: the guy who got foreclosed and evicted from his home in Florida, even though he didn’t actually have a mortgage, and in fact owned his house free –and clear. The family that was foreclosed and evicted, even though they had a perfect mortgage payment record. Et cetera, depressing et cetera.

Now, the reason this all came to light is not because too many people were getting screwed by the banks or the government or someone with some power saw what was going on and decided to put a stop to it—that would have been nice, to see a shining knight in armor, riding on a white horse.

But that’s not how America works nowadays.

No, alarm bells started going off when the title insurance companies started to refuse to insure the titles.

In every sale, a title insurance company insures that the title is free –and clear —that the prospective buyer is in fact buying a properly vetted house, with its title issues all in order. Title insurance companies stopped providing their service because—of course—they didn’t want to expose themselves to the risk that the chain –of title had been broken, and that the bank had illegally foreclosed on the previous owner.

That’s when things started getting interesting: that’s when the attorneys general of various states started snooping around and making noises (elections are coming up, after all).

The fact that Ally Financial (formerly GMAC), JP Morgan Chase, and now Bank of America have suspended foreclosures signals that this is a serious problem—obviously. Banks that size, with that much exposure to foreclosed properties, don’t suspend foreclosures just because they’re good corporate citizens who want to do the right thing, and who have all their paperwork in strict order—they’re halting their foreclosures for a reason.

The move by the United States Congress last week, to sneak by the Interstate Recognition of Notarizations Act? That was all the banking lobby. They wanted to shove down that law, so that their foreclosure mills’ forged and fraudulent documents would not be scrutinized by out-of-state judges. (The spineless cowards in the Senate carried out their master’s will by a voice vote—so that there would be no registry of who had voted for it, and therefore no accountability.)
And President Obama’s pocket veto of the measure? He had to veto it—if he’d signed it, there would have been political hell to pay, plus it would have been challenged almost immediately, and likely overturned as unconstitutional in short order. (But he didn’t have the gumption to come right out and veto it—he pocket vetoed it.)

As soon as the White House announced the pocket veto—the very next day!—Bank of America halted all foreclosures, nationwide.

Why do you think that happened? Because the banks are in trouble—again. Over the same thing as last time—the damned mortgage-backed securities!

The reason the banks are in the tank again is, if they’ve been foreclosing on people they didn’t have the legal right to foreclose on, then those people have the right to get their houses back. And the people who bought those foreclosed houses from the bank might not actually own the houses they paid for.

And it won’t matter if a particular case—or even most cases—were on the up –and up: It won’t matter if most of the foreclosures and evictions were truly due to the homeowner failing to pay his mortgage. The fraud committed by the foreclosure mills casts enough doubt that, now, all foreclosures come into question. Not only that, all mortgages come into question.

People still haven’t figured out what all this means. But I’ll tell you: if enough mortgage-paying homeowners realize that they may be able to get out of their mortgage loans and keep their houses, scott-free? That’s basically a license to halt payments right now, thank you. That’s basically a license to tell the banks to take a hike.

What are the banks going to do—try to foreclose and then evict you? Show me the paper, Mr. Banker, will be all you need to say.

This is a major, major crisis. The Lehman bankruptcy could be a spring rain compared to this hurricane. And if this isn’t handled right—and handled right quick, in the next couple of weeks at the outside—this crisis could also spell the end of the mortgage business altogether. Of banking altogether. Hell, of civil society. What do you think happens in a country when the citizens realize they don’t need to pay their debts?

–David R. Kotok, Chairman and Chief Investment Officer