Foreclosure-Gate Is Quickly Spinning Out of Control

"Foreclosure-Gate" is quickly spinning out of control. While the 14 million borrowers now delinquent or in foreclosure are entitled to foreclosure processes free of fraud, so too the 42 million borrowers current on their loans and first-time homebuyers deserve a functioning mortgage market free of runaway costs; the taxpayers, now responsible - between Fannie Mae, Freddie Mac and Federal Housing Administration mortgage insurance - for $6.5 of the $10.7 trillion mortgage market, are entitled to see their subsidies of Fannie and Freddie, now standing at $148 billion, come to an end; folks who make their livings from existing home sales sorely need to remain employed; lenders are entitled to their collateral where borrowers have defaulted; and all Americans need the housing crisis to come to an end sooner rather than later. What's sorely needed but lacking here is an appreciation of the real risks to defaulted borrowers and a balancing of legitimate competing interests.

The average borrower in foreclosure paid his last payment a year and half ago, and JP Morgan Chase reports that one in three homes on which it's seeking foreclosure are vacant. 18.9 million homes now stand vacant.

One in four existing home sales now come from distressed inventory, so a nationwide freeze stopping foreclosures even of "zombie borrowers" - those who have abandoned their homes and moved on - is an overreaction that will derail and extend for years a housing recovery already proceeding at an agonizingly slow pace due to a persistent 17 percent effective unemployment rate.

Likening the "robosigners" defense that they did as they were told to that asserted by Nazi war criminals at the Nuremberg trials as Ohio Attorney General Richard Cordray immediately did, adds to the hysteria but does nothing to solve the problem. Foreclosing lenders, overwhelmed by millions of foreclosures, must staff up, and guard against law firm foreclosure mill abuses. Accounting records of payments and charges must be carefully reviewed and authenticated. Affidavits must be signed in the notary's presence.

That's why both Houses of Congress passed HR 3808: the Interstate Recognitions of Notarizations Act. It says that if a state court receives a document notarized by a notary licensed in another state because the document was signed in that other state, the court must accept it.

Apparently, President Obama wants to make sure the banks have to move their officers all over the country to sign affidavits. On October 7, he used his "pocket veto" to kill HR 3808.

A more esoteric problem centers on the issue of legal standing - whether the foreclosing lender is the proper party to foreclose.

Most residential mortgage backed securities were issued by tax pass-through entities known as Real Estate Mortgage Investment Conduits. Each REMIC typically holds thousands of mortgages, and the securitization bar utilized a trustee to hold the pooled mortgages on their behalf.

Pooling and servicing agreements were entered into among the REMIC as depositor of the pooled loans, a REMIC trustee, frequently a money-center bank that agreed to own the loans, the originating lender as seller of the pooled loans, and a servicer (often the originating lender) that would collect and remit interest and principal payments (or institute foreclosure actions following defaults).

RMBS, typically issued by the REMICS as multiclass bonds or certificates, bore the risk of defaults in inverse order of seniority with junior bond classes suffering losses first - so the pooled mortgages were not allocated to specific RMBS classes at the outset.

Given these complexities, the major mortgage lenders - the Bank of America, Wells Fargo, Citigroup, GMAC, Washington Mutual and major title insurers - along with Fannie Mae and Freddie Mac - formed an electronic mortgage registration cooperative called Mortgage Electronic Registration System Inc.

MERS maintained a secure database containing digitized images of the mortgage notes and mortgages. Approximately 60 percent of all US home mortgages are registered with MERS. When MERS member banks originated mortgage loans, the mortgage note (the IOU) would list the bank as payee but the mortgage itself (the collateral) typically would be issued in the name of MERS as nominee for the bank.

As borrowers became seriously delinquent in the 23 states where foreclosure proceedings must take place in court, MERS acted as plaintiff.

Our jurisprudence views a mortgage as an incident to the debt it secures, having no legal life independent of that debt. And since MERS typically wasn't listed as payee on the mortgage note, a separation of the IOU and its collateral resulted. Some borrowers have claimed that MERS lacks standing to foreclose - that the note holder must become a plaintiff.

While mortgage assignments are a matter of public record, mortgage notes are transferred typically by delivery of possession or by endorsement, often in blank. Because the purpose of MERS was to simplify by digitizing mortgage record-keeping in order to facilitate the securitization process, "blue-ink" (hard copy) note endorsements were often not signed - at least not on a "real-time" basis - and often in blank. In some cases, apparently no one knows where the original mortgage notes are.

The legal notion of standing ensures that our courts only hear real controversies, and that defendants are not exposed to a sort of civil double jeopardy. Suppose a defaulted homeowner's house were sold at foreclosure for $300,000. If the mortgage note is for $400,000, and the borrower lives in a "recourse" state, he still has a liability to the lender though it's limited to the deficiency - $100,000. The worry is that some previous owner of the note sues the borrower after the foreclosure sale saying - I am still the real owner of the note and got none of the $300,000, so as far as I am concerned you still owe me $400,000.

While I know of no case where that has happened, that's the only risk (as far as standing goes) borrowers are entitled to protection against. The standing problem can be fixed by the states enacting legislation that says:

· As long as the plaintiff is the record owner of the mortgage, the case should be allowed to proceed. If the note cannot be located, the plaintiff should be required to submit a lost note affidavit (a common practice) and certify under penalties of perjury its ownership of the note.

· Any party claiming to own the note who doesn't come forward before the auction (it's publicly advertised), should be barred from seeking further recourse against borrower (but preserve his fraud claim against the foreclosing lender).

· As a further borrower protection, where the chain of title to the note cannot be established to the court's satisfaction, the foreclosing lender should be barred from seeking a deficiency judgment against the borrower.

The foreclosure fiasco isn't so much institutionalized fraud as it is the product of (1) an unintended collision between the electronic world of Wall Street and the paper world occupied by our courts and (2) the sheer volume of foreclosure cases. If a fix is what we're after - and not taking a page from Saul Alinsky's Rules for Radicals in order to achieve a massive redistribution of wealth (that is, another failed effort at modifications, this time with massive principal writedowns) - Foreclosure-Gate can be resolved through thoughtful changes to state laws, increased lender vigilance and clamping down on foreclosure mill abuses. But for incumbents whose goal is not to let this latest crisis go to waste, keeping it going seems to be the order of the day.