Some Sand in the Gears of Securitizing

Was the great securitization machine that made hundreds of billions of dollars in mortgage loans based on a legal foundation of sand?

That possibility, raised by two law school professors, has begun to scare many jittery investors, causing bank stocks to plummet, although they recovered a little Monday.

If they are correct, the best outcome for lenders would be a prolonged delay in completing foreclosures, raising costs still further and paralyzing an already depressed housing market.

The worst outcome would be a conclusion that errors by financial institutions had decoupled the payment promises made by borrowers from the mortgages they signed. In that case, the mortgages would be invalid. Homes could be sold without paying off lenders. There also could be heavy tax consequences for lenders, both in terms of federal income taxes and in payment of back fees for mortgage registrations to local governments across the country.

The arguments involve MERS, the Mortgage Electronic Registration Systems, which was created to smooth the securitization process and, in the process, to allow lenders to avoid paying registration fees to counties each time the mortgage changed hands.

Several state supreme courts have chipped away at MERS. But none has gone nearly as far as the professors, Christopher L. Peterson of the University of Utah and Adam Levitin of Georgetown, say is possible.

Nonetheless, some investors are growing worried. Bank stocks fell sharply last week, even while most shares were rising. JPMorgan Chase

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[JPM  Loading...      ()   ], which is a part owner of MERS, said it had not used the service since 2008. At least one title insurance company has gotten a bank to agree to indemnify it if the securitization process causes problems for titles. Without title insurance, the real estate market would grind to a halt.

And earlier this month a federal judge in Oregon issued an injunction blocking Bank of America

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[BAC  Loading...      ()   ] from foreclosing on a borrower’s home. United States District Court Judge Garr M. King said that under Oregon law, the borrower was likely to prevail on the argument that the use of MERS had invalidated the mortgage.

Last week the American Securitization Forum, a trade group representing companies involved in the securitization industry, said it believed the securitization process was legal, and that its lawyers were preparing a refutation of arguments to the contrary.

There is no question that MERS has been a success in terms of gaining market share. About 60 percent of mortgages in this country show up in local records as being owned by the service. In fact, none are owned by MERS. It was created to act as an agent for others, whether banks or securitization trusts, which own the actual mortgages.

Mr. Peterson, in a paper with the dry title of “Two Faces: Demystifying the Mortgage Electronic Registration System’s Land Title Theory,” argues that MERS cannot have it both ways, and that it faces problems if it is deemed to be only one of them.

If it is an agent, he wrote, “it is extremely unclear that it has the right to list itself as a mortgagee,” as it does. State real estate laws, he said, “do not have provisions authorizing financial institutions to use the name of a shell company,” in large part because “the point of these statutes is to provide a transparent, reliable record of actual — as opposed to nominal — land ownership.”

If it is a mortgagee, Mr. Peterson added, it has the right to record mortgages in its own name, as it did. But since it does not own the actual loan, doing that could be seen as violating a long line of precedents that bar separating a mortgage from the underlying note in which the borrower promises to pay. He quotes from an 1879 Supreme Court decision holding that “the assignment of the note carries the mortgage with it, while an assignment of the latter alone is a nullity.”

If an assignment of the mortgage alone is a nullity, then the mortgage can no longer be enforced. The borrower would still owe the money, but no foreclosure would be possible and the borrower could sell the home without paying off the mortgage. The lender could sue the borrower, but collecting money from distressed former homeowners might be very difficult in many cases.

It was such an argument that persuaded the judge in Oregon to block a foreclosure being pushed by Bank of America on behalf of a subprime mortgage securitization put together by Goldman Sachs

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[GS  Loading...      ()   ] in 2006. That securitization, known as GSAMP Trust 2006-HE5, is a troubled one in which investors have already suffered substantial losses. The senior security of the trust, which was rated AAA at issuance, has not suffered losses so far. But Moody’s now rates it at Caa1, a very low junk bond category.