I've had this question thrown at me by a couple of readers, in the light of earlier articles I've written about the current economic and financial situation. It's a very important subject, so I thought I'd take a bit of time to discuss it.
First of all, let's outline the nature and scope of the problem (something the mainstream media haven't done terribly well). Gonzalo Lira summed it up very well (if rather profanely) for Zero Hedge. Here's part of his article. It's a lengthy excerpt, but vitally important. Bold print is my emphasis.
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 MBS’s 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 therefore 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 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 were created, of course, but for 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 specifically? I dunno.
Same with mortgages.
So in fact, it wasn’t that the riskier loans were in junior tranches and the safer mortgage loans were in the senior tranches: Rather, all the loans were in all the tranches, 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 take the loss last.
But who was the owner of the junior tranche bond and the senior tranche bond? 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 MBS 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 the operating table 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 note: The true owner of the mortgage notes should have been the REMIC’s.
But the REMIC’s didn’t own the note either, because of a fluke of the ratings agencies: The REMIC’s had to be “bankruptcy remote”, in order to get the precious ratings needed to peddle Mortgage Backed Securities to insitutional investors.
So somewhere between the REMIC’s and the 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 wouldn’t 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’s 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 important. So the botched paperwork became a non-trivial 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, hell, whaddaya know—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 a delinquent mortgage. These foreclosure mills might have even forged the loan note itself—
—wait, why am I hedging? The foreclosure mills actually, deliberately and categorically faked and falsified 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 bystander getting caught up in this 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 enough people were getting screwed that the banks or the government or someone with 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 title.
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 gettin’ innerestin’: 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, with all the 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’d be no registry of who had voted for it, and therefore no accountability, the corrupt pricks.)
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 un-Constitutional in short order. (The jug-eared milquetoast didn’t even have the gumption to 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 screwed—again. By the same ****ing thing as the last time—the ****ing Mortgage Backed Securities!
The reason the banks are ****ed 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 because the homeowner failed 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 this all means—but I’ll tell you: If enough mortgage-paying homeowners realize that they may be able to get out of their mortgage loan and keep their house, scott-free? ****, that’s basically a license to halt payments right the **** now. That’s basically a license to tell the banks to **** off.
What are the banks gonna do—try to foreclose and then evict you? Show me the paper, mother****er, will be all you need to say.
This is a major, major crisis. This makes Lehman’s bankruptcy look like a spring rain, compared to this hurricane. And if this isn’t handled right—and handled right quick, in the next couple of weeks on 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?
If this isn’t handled right, then this will be the second leg down, in the American Death Spiral.
There's more at the link. Highly recommended reading (as is the entire Zero Hedge web site - those people know whereof they speak).
Mr. Lira's not joking about the scale of the problem. Janet Tavakoli has bluntly called this "the biggest fraud in the history of the capital markets". Megan McArdle points out:
The worst case scenario is not that all mortgages are cancelled and banks start going bust; it's more like what Adam Levitin outlined for the Wall Street Journal:
"In the worst case, the issues become a "systemic problem" that grinds the mortgage market to a halt and title insurers refuse to insure mortgages involving existing homes. In other words, housing Armageddon. "It would be devastating for the resale market if this robo-signer issue spiraled out of control," Mr. Watson says."
Folks hoping that now the banks finally get what's coming to them should be mindful of the fact that if we decide there's no clear title on houses with existing mortgages, that probably means you can't sell your home, either.
(Bold print is, once more, my emphasis.) Ms. McArdle goes on to point out, in another article:
... overall, the implications seem much more disturbing for people who aren't in foreclosure.
Take the investors in these mortgage bonds. Most of these securities have clauses that allow investors to force the banks to take back loans in the case of fraud. When did the fraud start? You can expect to see that extensively legislated--and I doubt that many of the originators have the capital to withstand a mass wave of such loan repatriations, especially since you can expect that they'll only be forced to take the bad ones. This is going to be an expensive mess for the courts to sort out, could lead to another wave of bank failures, and doesn't have any obvious legislative fix.
Or how about people who are in trouble, but not in foreclosure? I heard someone on the radio saying that this all could have been avoided if banks had modified loans with generous principal reductions, like they ought to have. I find this remark puzzling. If a loan servicer doesn't have sufficiently clear authority to foreclose, then presumably they also don't have any authority to modify the loan. In fact, shouldn't banks be stopping their modifications, too, until clear lines of ownership are established?
Already, it's apparently impossible to sell a foreclosure--and people who have bought foreclosed homes are starting to sweat, wondering if they're going to get embroiled in a lawsuit. But what about short sales? Again, if a company doesn't have the authority to foreclose, it doesn't have the authority to authorize you to sell it for less than the value of the mortgage. Things seem cleaner with ordinary sales, but what if some other company comes out of the woodwork to claim that the note wasn't properly registered, and you paid the wrong guy? Does the lien go back on the house? Who owes the money?
This is why people are worried that the title-insurance system will break down.
. . .
All this uncertainty is ultimately going to be terrible for both the housing market, and the broader economy.
There's more at the link.
There's another aspect to this crisis that I haven't seen mentioned in any of the mainstream media. Title insurance companies have insured millions upon millions of titles of properties that are currently in the process of repossession, or have already been repossessed and resold to new buyers. What happens if it can be proved that a significant proportion of these repossessions and/or resales have been based upon flawed documentation? The title insurers will then have to pay out to the holders of the insurance policies - and I'm not sure there's enough reserves among title insurers to pay out that number of claims, on so massive a scale. If title insurers go bankrupt - which is not at all impossible - then the entire property market is affected. Many transactions simply won't go through. The US housing market could collapse.
So what will this crisis cost us - the US economy as a whole - in real figures? According to Bloomberg:
Delays tied to the probes may cost U.S. lenders $2 billion for every month, said Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia, who put the cost of extending foreclosures at $1,000 monthly for each property in the pipeline.
“There are 2.3 million loans that are out there in foreclosure,” said John Courson, chief executive officer for the Mortgage Bankers Association. “The administration has in fact made the right decision by not pressing for an overall moratorium. They see the debilitating effects that could have from the standpoint of the entire economy.”
. . .
Foreclosure filings totaled 930,437 in the third quarter, a 4 percent rise from the previous three months, according to RealtyTrac Inc. Filings in the states most affected by court reviews of foreclosure documents accounted for 40 percent of the total in the third quarter.
Again, there's more at the link.
Do the math for yourselves, folks. 2.3 million mortgages in the foreclosure process, at a monthly cost of $1,000 to extend each foreclosure, amounts to $2.3 billion each month that's going down the drain. The banks are having to pay that money just to keep the accounts active and maintain the judicial process. Are you wondering why the banks aren't making funds more easily available to would-be borrowers, be they private individuals or small businesses? That's one of the chief reasons why. They're collectively spending billions each month by pouring it down a legal cesspit. It's not available to be used productively, to boost the economy - it's paying for the colossal administrative incompetence (and, let's be honest, the undeniable legal and financial fraud) perpetrated by the banks and the mortgage finance industry.
If we accept Bloomberg's figure of 2.3 million mortgages in the foreclosure process (a figure that's actually increasing), and a cost per mortgage of about $1,000 per month to keep them active, that's well over $25 billion per year being wasted. It's being poured down the drain, with no hope of any return on that 'investment'. Over and above that figure, consider the lawsuits that may be (make that will be) filed by investors who bought securitized mortgage investments, only to find that the legal requirements for the transfer of those mortgages weren't fulfilled or observed; or the lawsuits that'll be filed by those who've had their homes seized in the foreclosure process by banks who didn't have the legally correct and binding documentation they needed to do so; or the lawsuits to come from those who've bought foreclosed properties, only to have them repossessed by their original owners, if (when) they can prove that the foreclosure process was illegal due to improper or incomplete documentation. Taking all those elements into account, we could be talking about an impact to the US economy measured in the hundreds of billions of dollars every year, for the foreseeable future.
That's why the mortgage mess is important. It goes way beyond housing. It threatens to suck the entire US banking system down the drain - and our economy with it. Many securitized US mortgages were bought by investors (and other banks) all over the world. Our problem is causing real financial pain in many other countries, and is bound to affect the overall credit standing of the US as a whole. I'm sure there'll be legislation put in place (in a hurry) to try to stop the problem before it gets too great . . . but whether or not such measures will be too little, too late, is unknown. Your guess is as good as mine.
Keep your powder dry, friends.
EDITED TO ADD: Am I a prophet, or what? Two days after writing this article, along comes the first lawsuit against the banks from purchasers of securitized mortgages . . . involving a mere $47 billion!