Where the foreclosure crisis might be heading

Banks will abandon foreclosures, mortgage backed security holders will need to make a deal with homeowners through a universal loan modification

Mortgage DebtThe foreclosure situation is entering a crisis. Largely, this is a disaster of the bank industry’s own making. The core of the problem is the nature of a “mortgage backed security”. Many are raising the fatal legal issues of ownership and representation. The result of all of this is foreclosure as a strategy may be dumped by lenders. In addition, oddly enough, we will end up back where we started with the rationality of loan modifications after having travelled a long painful circle.

The first issue in this financial tragedy is the issue of ownership.

Do Banks own the mortgages?

In many cases, banks and mortgage companies are claiming to own the mortgages of foreclosed properties, though the mortgages were sold long ago in pools with other mortgages to create mortgage-backed securities. Judges at foreclosure hearings are discovering that the banks often do not have any paperwork proving mortgage ownership, in some cases lenders were caught in outright lies providing falsified documents.

Does MERS own the mortgages?

In some cases, banks not having any paperwork have filed for foreclosure in the name of MERS (Mortgage Electronic Registration Systems).

MERS is a private electronic recording firm set up by the banks and Fannie Mae to track the complex tangled history of mortgage transfers. This institution supposedly streamlines the system of records; it records ownership transfers of notes in a cheaper way than going to a county recorder and paying a fee. MERS has claimed to save lenders and mortgage holders a billion dollars in its existence since 2004.

However, MERS does not own the mortgages; these notes are the property of investors. MERS is merely a middleman in the process — recording transfers, though at times it claims to represent the current and true owners when for example in foreclosure cases a bank like Chase will have MERS file the foreclosure action.

Can MERS identify who currently owns the mortgage securities?

When asked directly MERS refuses to disclose who owns a mortgage. It states that “investor guidelines” do not allow disclosure or MERS will simply not respond to the legitimate query.

One might conclude that MERS is engaged in a strategy of protection for the true note holders attempting to free them of needless court trouble and speed up the legal process. On the other hand, there is the possibility, that the MERS does NOT know who owns your mortgage!

The reasons being that the bonds sold based on mortgage pools are not denominated in the specific names of the borrower, and there are so many transfers of bond ownership that tracking would be very difficult and complex.

Banks, government institutions, and Wall Street firms pooled or combined hundreds and thousands of mortgages into huge sums of debt. Fannie Mae, Freddie Mac, Ginnie Mae and Wall Street firms like the now defunct Goldman Sachs set up the amalgamations of loans to issue bonds; they “securitized” the mortgages.

These mortgage pools become bonds of many sizes — $1000 to $10000 to $25000. The “Mortgage-backed securities” are sold to big investors and small investors. These bonds are repackaged according to risk, then sold, and resold around the planet.

It is important to understand that the entity who created the mortgage bond pool is not the same as the institution, business, or individual who actually bought the bond and owns its payments of principal and interest.

If MERS or a lender tells a Judge or defense lawyer that Fannie Mae or some other pool creator is the owner of the mortgage, this is not actually true. The owner of the mortgage is the one or ones who own the bonds, the pool maker created the bonds, securitized the mortgages, and sold its interest in them to someone else. When MERS evades, a legitimate inference is that MERS actually does not know who owns your mortgage because the list of owners might be in the thousands. Why?

Your mortgage is put into a pool; it is comingled with thousands of other mortgages. There is no bond based upon an individual mortgage. For example, a $200,000 mortgage creates twenty $10,000 mortgage bonds; the whole fund may contain $100 million in mortgages with 10,000 bonds.

Individual mortgage names disappear in this pooling process, we have one nameless collection called the “something trust” etc. In this situation, everyone who buys a bond from a securitizer is a partial owner of your personal mortgage and thousands of other mortgages.

Investors don’t want bonds based upon specific mortgages, what if they default on their loan. It is better to play the odds on the aggregate than to chance getting a bond denominated in some specific name of someone who decides not to make his payments.

Can MERS represent the bondholder?

So when a homeowner in foreclosure court asks a legitimate question, “Who owns my mortgage note?” this is not irrational or naive — because a basic principle of legal procedure is that a defendant has to know who his or her accusers are, more, in contract law ownership is everything, so please show us who the owners are.

The problem is then that MERS might have to produce all of the current bondholders because this is the total and accurate answer. Providing the securiftizer, the entity that created the bonds and sold them is not the same thing. This is not the current owner. If otherwise, homeowners would be sued by Fannie Mae or the debt heirs to the defunct Goldman Sachs. Identifying a bank that turned your mortgage into a bond is also not acceptable.

MERS may not have complete and accurate records to satisfy a Judge or any reasonable person. This is why courts have discovered so much mortgage fraud in the last few years. The lenders through MERS have not been able to find the true owners of the mortgages. The mortgage companies have resorted to bluffs, falsification and browbeating Judges.

What might Judges do?

An irate Judge who suspects fraud can demand the names of all of the current bondholders as difficult as that task might be. If the Judge does not get the names within a certain timeframe, the case could be dismissed.

If the mortgage company produces a list of bondholders, another problem arises. The resources and labor power to check a huge list of bondholders, and everyone who bought into the mortgage backed security pool is enormous.

What can the court do? The case might simply stall as the court and defense lawyers take their time confirming names, contacting each company, institution or individual. This could literally take months or years to obtain a full up to date list just for one foreclosure case.

This would mean that the flow of the foreclosure pipeline would come to a halt. Banks could file new cases but they won’t be heard for years. Courts, you can be sure, will not be thrilled doing MERS’s and the bank’s work for them, so you can predict that the verification process will go on at a leisurely pace ad infinitum.

The next difficulty arises when the names are eventually confirmed. A Judge might rule that MERS cannot represent these parties and that the original lenders cannot either. The legion of bondholders would have to form their own entity to represent their interests and show their faces directly to the defendants.

These issues arise out of the very structure of a mortgage backed security, its collective nature, and its mobile ownership. In addition, when you have an institution that does not track every detail of transfers then chaos will ensue.

The likely result is the paralysis in the US of the foreclosure process. Cases will simply pile up with no legal locomotion or resolution.

More foreclosures are coming

The banks and mortgage holders are facing daunting prospects. ARM (Adjustable Rate Mortgages) are scheduled for more rounds of interest rate resets in 2011 and 2012. Economists predict that we will have another round or rounds of foreclosures coming as more homeowners fall behind on payments.

Banks and mortgage holders are in a twilight zone of bad news. Foreclosures are causing an enormous loss of mortgage payments, houses are selling far below original loan value, and the foreclosure process is now paralyzed. In a year or two, even more mortgage payments will be missed, but at that point, it might be impossible to foreclose on a house because of all the ownership and representation issues discussed above.

Pressure on the banks

A strategy of filing for foreclosure when things go bad might be disastrous because the foreclosure option might be dead or at least in a long-term coma.

Lenders will have to consider short sales to cut losses, where the owner voluntarily sells the home for whatever the market will fetch just to get out from under the debt. In this case, the bank will have to accept the shortfall because the house will not be worth anything near its initial loan amount. A deed in lieu might also become a more common action.

However, even these strategies might be fruitless and non-accretive.

Banks might get out of the foreclosure business

Many banks at some point might give up on foreclosure actions.

One important reason is that they have already sold the mortgages. They are not the ones missing payments; the bondholders are losing out. Banks actually are making profits again strangely enough. One reason is of course the huge sum of bailout money given them in 2008. The second reason is that they passed on the mortgage debt to someone else.

However, foreclosures pose a danger for the lenders. The costs of court, lawyers, lost time and energy, lost focus, expensive bad strategies may be too high. Further, lenders are liable for damages and compensation for the eviction of homeowners through their frauds of ownership and representation.

Banks can start refusing to foreclose. Even though they have legal obligations to mortgage holders, they cannot pursue the foreclosure strategy without going bankrupt themselves. To do this, they would need another shot of cash from the federal government and this is not likely a second time.

In the first gift of the people’s funds, the banks were supposed to liberally arrange loan modifications for homeowners; but they refused to do this. Now, they are being hammered by the shortsighted consequences of their actions, which have led to massive foreclosure activity. The problem is that they simply assumed that they could take the houses unaware of the massive dysfunction caused by the nature of a mortgage backed security, and a tracking system that was only designed for “fair weather” conditions and not the perfect storm of today.

The lenders have only themselves to blame. They gave out loans without a sound basis. They invented the mortgage-backed security and securitized most of their loans. They took the cash they received from the sale of the bonds to lend out more money on an unsound basis, and then created another round of bonds and on and on. This process drove up house pricing and initiated a boom in construction. A bubble emerged and then popped. The banks and mortgage lenders lost billions of dollars. Now they are the victims of another invention of theirs: MERS.

Universal loan modification is the solution

At some point, the BONDHOLDERS will have to make a pivotal decision — continue with the foreclosure process, which brings no payments or choose to make a deal for some minimal cash flow. The choice will be between some revenue and no revenue at all in a market that is spiraling downward.

Strangely enough, the obvious and real solution to the crisis is the original idea to solve the mortgage problem in the US: Loan Modification! Banks will run from foreclosures soon, the bondholders will be left holding the bag. They will have no choice but to accept a deal.

The federal government has the power to push for a “universal loan modification” solution based upon what homeowners can actually pay. A doable plan for a 30-year mortgage is the only answer. Gouging homeowners will not work and tricking them into plans that increase payments in 5 years beyond their capacity will not work either. The sad reality is that the bondholders will have to accept a reduced income in this world of reduced expectations.

A universal loan modification plan can be done relatively quickly. People can simply submit financial information with documentation, a simple formula can be created to determine what they actually can pay, and that is what they WILL pay.

The government does not have to “guarantee” any mortgages other than what it has already done with Ginnie Mae for example. The motivation for a bondholder to accept this deal is simply survival, not a handout from the taxpayers.

In this scenario, the bondholders will get something at least. Homeowners will no longer be evicted. Foreclosures will cease. House prices will stop careening downward. Maybe then, in this situation the housing market will come back.

Another market solution

The logic has generally been that the foreclosure process would correct and rebalance the housing market. As this article shows foreclosure will not work because there are more issues than a simple “free market” response; there is legality and there is morality.

This means there must be another solution. The suffering owners of the mortgages will have to make a deal with the suffering homeowners, and then overall there will be a little less suffering. In addition, this too is a market solution where entities in the market make a voluntary contract. It may come as a surprise to MBAs and CEOs but consumers are also players in a market, they have power, they are not lambs for slaughter. The market goes beyond boardrooms; it compasses all of society.

This market solution is more rational and equitable than banks throwing people out of their houses when the financial institutions created the crisis in the first place.

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