Saturday, November 6, 2010

Foreclosure, Fiasco and Frolic with MERS

A week blessedly silent on the 'fraudclosure' front came to an end yesterday when the decline in pending sales for existing homes was attributed by the National Association of Realtors spokesperson to the bottleneck in the foreclosure pipeline. To hit the refresh button, here is a Q and A, supplemented with some judgment calls:

1. Will MERS work? MERS is the electronic recording system used by the 'industry' in lieu of compliance with recording requirements that vary by the jurisdiction in which the secured property is located. First, for some purposes MERS was such a success that it was extended from residential to commercial properties, so in some sense MERS works. But the question that has everyone excited is:will MERS work when the rubber hits the road in a foreclosure?

The answer to that is--MERS should work some of the time for some purposes, but it almost certainly won't work all of the time, and there is an unacceptable degree of uncertainty surrounding how it will play out. When it doesn't work, it should be fairly easy to fix, assuming the backup documentation is in order.

2. What's wrong with MERS? There is an effort being made to portray the problem as simply one of paperwork lapses and antiquated local filing requirements. It actually runs deeper than that. There is a conceptual (and constitutional) limitation on judicial power--courts only decide cases and controversies in disputes brought to them by litigants. Courts do not go shopping for opportunities to flex judicial muscle (unlike, say, a police force, that should chase criminals rather than simply waiting for them). To bring a lawsuit, the prospective litigant must be a 'real party in interest.' A real party in interest is someone with a injury or other legally recognisable stake in the outcome of the controversy. In a nutshell, MERS more closely resembles a custodian or a registrar, who wouldn't be a real party in interest, than a trustee or a beneficial owner, who could be. To put it in lay terms, if you have a warranty issue with your car, the owner of the garage where you park it can't sue the car maker for you, you have to do something about it yourself.

The good news is that it's not generally that hard to figure out who should be bringing the lawsuit, again, assuming the backup documentation is in order.

3. That's the second time you've qualified an answer with that comment about backup documentation. What gives? Over the last several decades a complex and standardized process has developed in which home loans were made, mortgages originated, warehoused, deposited in trusts and used as backing for the issuance by the trusts of 'mortgage backed' securities. Then, until the loan was refinanced or otherwise paid off, a 'mortgage servicer' collected monthly payments, distributed the proceeds to the securities owners and handled any administrative or similar issues that came up (for instance, usually made sure that property insurance and taxes were paid). That was how the system was supposed to work.

It has recently come to light that in many instances chunks of this work, mostly in the middle of the chain, simply weren't done. In other words, at the front end the house closing came off without a hitch. At the back end, the MBS were issued and sold without a hitch. But, the transfers in the middle--the movement of the note and the mortgage through the conduit of bankruptcy remote vehicles--didn't happen, for whatever reason.

There are also allegations that in some jurisdictions the loan documentation was routinely destroyed. (Gretchen Morgenstern recently made this claim in a New York Times article about the situation in Florida). If true, this is mindboggling, since the legal genome is deeply imprinted with the bedrock belief that certain kinds of promises, to be legally enforceable, have to be in writing. There is something called the Statute of Frauds, dating back to the English common law, not only before the American Revolution, but before the colonization of North America. We inherited it, it runs through our legal system the same way trial by jury does. It's common sense, really. There are two kinds of promises. One, is, for example, "I'll never forget our anniversary." The other is, for example, "from even date herewith, borrower promises to pay lender $857.62 on the fifth day of each month until August 5, 2035." The latter you can sue on in court, good luck with the former.

If there are widespread documentation problems of this sort, regulators of the financial institutions responsible for those back office failures will face a challenge to their supervisory authority concerning, not the liquidity and solvency of the responsible institutions, but the adequacy and soundness of their managements, systems and controls. It may be enough to sink a couple of boats.

4. But assuming the backup documentation is there, the MERS issue can be fixed easily?
Easily may be an overstatement. Let's qualify it with three considerations: (1) economies of scale, (2) the example of bankrupt originators, and (3) the question of who owned what, when?

Economies of scale. This is a high volume process. We are talking assembly line justice, not a handcrafted approach tailored to each borrower's unique circumstances. A lawyer's rule of thumb is that it costs three times as much to fix a problem as it costs to do it right the first time. And keep in mind, it is totally appropriate for the borrower (or her lawyer) to object to any shortcut or impropriety. If the shoe was on the other foot, you can be sure the bank and its lawyer would be.

Unfortunately for the servicers and the MBS holders, I don't think these fixes are going to lend themselves to economies of scale. It will cost as much to correct the documentation on a $100,000 mortgage as on a $300,000 one. There may be more walkaways at the low end and more contested proceedings at the high end, but that is not so much an opportunity for economies of scale as a recognition of additional unpredictable cost in certain circumstances.
One area worth paying particular attention to is commercial real estate. In the bankruptcies and workouts of various failed commercial development projects, it's reasonable to expect all the MERS issues to be litigated completely and expensively. That will litigation among creditors--there won't be any homeowner victim/deadbeats in that arena. Those stakes are worth litigations. And that's an arena in which technical deficiencies in documentation (such as failure to timely perfect a security interest) tend to be penalized severely, to the benefit of the competing creditor/vultures.

Bankrupt originators. The outfits that originators mortgages weren't the most stable financial institutions. A number of them have gone belly up and are in their own bankruptcy proceedings. If, because of 'paperwork deficiencies' there are pools of assets potentially available to the creditors in those proceedings, those claims will be made. The problem has nothing to do with homeowners and mortgage servicing outfits. But you can bet it will gum up the works.

And it offers a good example of the simple fact that in this situation everyone is not going to pull together. The situation is rife with conflicting interests (and internal conflicts of interest). There is not much point to ascribing evil motives to litigants (or their lawyers) in civil proceedings, though it is certainly common.

Who owns what, when? The big issues in a foreclosure are getting the property back, of course. But there are also issues of past due amounts and servicer fees. Taking care of the MERS problem does not address the question of who is owed what, how the proceeds from the sale of the foreclosed property are distributed, what is the fate of any second lien holders, whether there will be a deficiency judgment, etc., etc. On one level, these issues are technical. But they are also disputable. It's a safe guess that they will be disputed.

5. Does resolving the procedural questions involving MERS solve the whole problem?
No, it doesn't even begin to. It's a good first step, but no, no, no . . .

1 comment:

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