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, 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 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 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.
Would you like to be a vice president?
The problems with MERS began to come to light when “vice presidents” of the firm began to submit affidavits in foreclosures, saying the original note had been lost. In some cases those notes were signed by people who signed thousands of such affidavits, and have now admitted they did not actually review the files, as the affidavits said they had.
Nor were those people really employees of MERS. It turns out that MERS allows financial institutions that are its members to name anyone a vice president or assistant secretary of MERS. It seems a little unlikely that someone who had never been hired or paid by a company could be a vice president.
“Ironically, MERS Inc. — a company that pretends to own 60 percent of the nation’s residential mortgages — does not have any of its own employees but still purports to have ‘thousands’ of assistant secretaries and vice presidents,” Mr. Peterson wrote. “This corporate structure leads to inconsistent positions, conflicts of interest and confusion.”
In a case in Arkansas, the owner of a second mortgage foreclosed on a home without notifying MERS, which was listed as owning the first mortgage. When MERS sued to overturn the foreclosure, the state supreme court ruled that MERS had no case. It had lost nothing, the court concluded, because it was not the actual beneficiary of the first mortgage.
The MERS Web site asserts that “MERS has been designed to operate within the existing legal framework of all 50 states,” adding, “Any loan registered on the MERS System is inoculated against future assignments because MERS remains the nominal mortgagee no matter how many times servicing is traded.” The company uses the slogan, “Process Loans, Not Paperwork.”
A spokeswoman for MERS, Karmela Lejarde, said Monday that Mr. Peterson was wrong about several things. “Every single court challenge to the standing of MERS in the foreclosure process has been upheld, either in the initial court proceeding or upon appeal, when proper evidence is presented before the court,” she said in an e-mail.
Asked about the Arkansas Supreme Court decision, she said “that particular case was not about foreclosures,” although it did involve an effort by MERS to overturn a foreclosure. She added that the decision was “in direct contravention to longstanding Arkansas law.”
It is possible that the courts in most if not all states will conclude that the details of how MERS functioned, even if not completely in accord with state law, should not prevent foreclosures.
But even if that happens, Mr. Levitin, the Georgetown professor, argues that there might be tax consequences that would further harm investors in mortgage securitizations. That is because the securitizations operate under a special provision of tax law that exempts them from taxation. But that status is predicated on the transfer of mortgages to the securitization when it was created. If that is not the case, that could cause a major tax problem.
In addition, Mr. Peterson argues that local governments might prevail if they sue, claiming that the basic operating structure of MERS involved the filing of false documents. In that case, they might be entitled to collect several mortgage recording fees per mortgage — money that presumably would also come out of the securitization trust.
All of these problems might have been avoided had Wall Street sought legislation in the states to assure that such issues would not be raised. It is not clear why that did not happen. Perhaps the lawyers saw no problem, or perhaps they feared that efforts to change the law would be blocked by county officials wanting to preserve a source of revenue from recording mortgage transactions. In any case, no laws were amended.
Now, Mr. Peterson wrote, the courts may be confronted with a difficult conundrum. “Had the parties to these transactions followed the simple policy of specifying in the documents who owns what, a vast amount of confusing litigation and commercial uncertainty could have been avoided. These anchorless liens now flail in the wind of our commercial tempest,” he wrote.
“Courts that come to understand this situation will be in a bitter predicament,” he wrote. A ruling against the securitizations would “throw the mortgage market into further turmoil.”
But ruling the other way, against the complaining borrowers, would have its own perils, he argued, in part because MERS has made it difficult and in some cases impossible to learn from public records just who owns a mortgage, despite a long tradition that such information must be publicly recorded.
“If the courts write opinions allowing MERS to act as a ubiquitous national proxy mortgagee, they will write into the American common law fundamental legal mischief that will plague generations to come,” he wrote.
If some courts do rule against MERS, the legal battle could be a long one. Real estate law is largely a matter of state law, leaving the 50 state supreme courts as the final arbiters.