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Are Trusts on the Hook for Mortgage Mess?

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We've talked a lot about the robosigning scandalwith respect to borrowers' rights and the possibility that foreclosure documents were signed improperly.

A bigger issue emerging is what those robosigners, perhaps unbeknown to them, were covering up—big flaws in mortgage securitization that could open the floodgates to investor lawsuits against trusts.

What are trusts?

In the mortgage process, after mortgage securities are "bundled" and sold to investors, they are then assigned to trusts, which manage the assets of the beneficiaries, i.e. the investors. There are only a few trusts out there, primarily Deustche Bank , Wells Fargo , Bank of New York Mellon and US Bank . They are responsible for holding on to all the documentation of these loans—the mortgage, title, note, etc. subject to mortgage pooling and servicing agreements.

The trouble is a lot of the paperwork was not properly transferred, and if not, "the 'true sale' of mortgages to the trusts that issued mortgage backed-securities would be in question," says Josh Rosner of Graham Fisher.

"The problem is the MERS system is keeping track of the deed of trust without recording the interest on the deed," says Janet Tavakoli, of Tavakoli Structured Finance. "You can't seal a deal with a handshake; we've got to have a signed document. It has to be on paper. That's what all states require."

"Probably the end game is that the litigation all ends up on the heads of the large financial institutions of this country." -Prof., Georgetown University, Adam Levitin

In other words, you can put it in an electronic database, but you can't just declare it's done.

All this means that investors in mortgage-backed securities, and about 2/3 of the nearly $11 trillion worth of U.S. mortgage were securitized and traded worldwide, could have a standing to cut their losses.

How?

They could argue that they took losses on securities that the trusts never legally had.

"I think you're going to see investors in securitization trusts suing the trustee, on the grounds that the trustee did not properly inspect all the documents it was supposed to," says Georgetown University law professor Adam Levitin. Then you could also have the trustees suing the investment banks that bundled the mortgages and sold them to the trusts on the basis that they may not have delivered what they said they were going to.

"Probably the end game is that the litigation all ends up on the heads of the large financial institutions of this country," adds Levitin.

Many have already argued that the big banks have prepared for this and have taken the appropriate cash reserves to deal with it.

But what about the trusts?

"If it wasn't correct, these investors did not have a proper asset-backed securitization," notes Tavakoli. "The trustee is at fault, but the trustees tend not to have any money."

So then you go after the securitizers, the folks who bundled these—which are of course the big banks.

Questions? Comments? RealtyCheck@cnbc.com And follow me on Twitter @Diana_Olick