The Foreclosure Wars

(I’ve been posting less over the last month, mainly because I’ve been working on longer pieces that I’ve been sending around to more traditional publishing outlets. However, I expect that I’ll be receiving rejections soon that will free up those longer pieces for posting here. In the meantime I thought I’d post the following long article, which I finished a year ago but for which I have been unable to find a publisher. -- Stan)

           

            In January 2013, ten large mortgage servicers—including Bank of America, Citibank, JPMorgan Chase, and Wells Fargo—announced a settlement with their chief regulators, the Federal Reserve Board and the Comptroller of the Currency, pursuant to which they would pay approximately $8.5 billion in direct payments and loan foregiveness to homeowners who may have been victimized by deficient practices in mortgage loan and foreclosure processing during 2009 and 2010. This followed a $25 billion settlement in early 2012 between the four banks named above plus Ally Financial and the U.S. and 49 state governments.

            Consumer advocates and others were quick to characterize the settlement with the mortgage servicers as a “slap on the wrist.” The January 9, 2013 New York Times, for example, editorialized that “while there are no reliable analyses to identify wronged borrowers, … given the extent of foreclosure abuses and the amount of money available, the individual reimbursements will be paltry compared with the harm of losing one’s home in an abusive process.”

            But how much damage had been done to homeowners by the abusive processes?

            In 2005, about 1% of U.S. mortgages were in foreclosure, a number that had remained fairly steady for at least 15 years. By 2009, foreclosures had more than quadrupled, to 4.6%. Nearly 2.5 million American families were in the process of losing their homes, and an additional five million were delinquent on their loans.

            Most foreclosed families simply hand over the keys to the lender and move on. Some, however, hire lawyers to stop or delay the foreclosure, so the vast increase in foreclosures led to a predictable increase in foreclosure litigation. What could not have been predicted was the turn this litigation took, and the public reaction to it, most notably allegations that mortgage servicers had engaged in illegal corner-cutting practices (dubbed “robosigning” by the press), and that a central mortgage registration system holding 30 million active mortgages had no authority to initiate foreclosures.

            As the litigation increased, and headline accusation followed headline accusation, many Americans were convinced that something nefarious had indeed been going on. Unfortunately, those perceptions, combined with an understandable concern for defaulting mortgage debtors, may end up harming the group the litigation was supposed to protect: America’s homeowners. But sorting out rights and wrongs in the foreclosure wars requires a basic understanding of the rapid development of the U.S. mortgage market and the slower evolution of the governing legal rules.

Some mortgage basics

            In the United States, as in most of the developed world, homes are usually purchased with borrowed money. To protect their investment, home lenders will generally advance only a portion of the purchase price, generally no more than 90%; the homebuyer must put up the remainder as a down payment. Lenders also insist on taking a mortgage on the home.

            The details of mortgage law vary among our 50 states, but the main elements are the same: A mortgage is an agreement between the homeowner and the lender that allows the lender, if the homeowner defaults on the loan, to seize the home, sell it a foreclosure sale, and repay itself from the sale proceeds. If the lender records the mortgage in a specified public office, it will prevail over subsequent purchasers and lenders, and will not have to share any foreclosure sale proceeds with the homeowner’s other creditors. If the sale proceeds are greater than the amount owed to the lender (including foreclosure costs), the excess is usually returned to the homeowner or the homeowner’s other creditors; any deficit will, in most states, remain owing to the lender.

            Most mortgage loans require monthly payments of principal and interest, and failure to make these payments (a “delinquency”) may trigger a foreclosure. Most lenders will usually not begin foreclosure proceedings until the homeowner is at least 90 days delinquent—that is, has missed three consecutive monthly payments.

            Some states require a lender to go to court to foreclose (“judicial foreclosure”); others just require a filing in the land records office. In some states the lender can choose between judicial and non-judicial foreclosure. The lender must generally notify the homeowner of the foreclosure and give him or her the opportunity to cure the delinquency, and the foreclosure sale must be publicly announced. For a judicial foreclosure, a representative of the lender must file a sworn affidavit witnessed by a notary public. The affidavit must be based on personal knowledge as to the amount of the indebtedness, the status of the loan, and the lender’s right to foreclose.

            The robosigning controversy was ignited by the discovery that in many cases, lenders’ representatives signing the affidavits had no personal knowledge of the statements being sworn to. Instead, they relied on the business processes for preparing the affidavits, which involved inserting information from the lenders’ computer records; no one personally checked the mortgage note, the mortgage, or the other paper records in the homeowners’ mortgage files. Moreover, the notaries often did not witness the signing (though in many cases they may have recognized a familiar signature), simply stamping bundles of signed affidavits as they were handed to them.

Mortgages become commodities

            The robosigning controversy had its roots in changes in the mortgage industry over the last 40 years. In the middle of the 20th century, most home mortgage lending was done by savings banks, building and loan societies, and other financial institutions that specialized in residential mortgage lending. These institutions saw mortgage loans as long-term investments, to be retained until they were paid off. Mortgage lending was a local business, and the lenders generally knew a good deal about the local housing market and frequently about the homeowner, who was often a long-term depositor.

            But mortgage loans can be tricky—and in an inflationary environment, combustible—investments. Most mortgage loans permit the homeowner to pay off the old loan at any time without any monetary penalty. When interest rates fall, homeowners often prepay their old mortgage loan and take out a new loan at a lower rate. But if interest rates rise, homeowners will hold on to their low-rate loans. In the inflationary environment of the late ‘70s and early ‘80s, as interest rates spiked upward, savings banks had to pay higher rates to attract deposits but found that their low-rate mortgage loans were paying off more slowly. A savings bank that has to pay depositors 8% while its outstanding mortgages are bringing in only 4% will be in a bind, and it wasn’t long before large numbers of savings banks failed.

            That experience, combined with other financial and regulatory changes, led to profound changes in the mortgage industry. Beginning in the 1990s, mortgage lenders, instead of holding on to their mortgage loans, frequently sold them off to investment banks, who securitized them. Securitization has come in for more than its share of opprobrium recently, but it’s a relatively benign practice: Investment banks or government-sponsored entities such as the Federal National Mortgage Association (popularly known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (popularly, Freddie Mac) create pools of residential mortgage loans. Various classes (“tranches”) of securities are then created that receive the principal and interest payments from the mortgage loan pool. For investors in these “mortgage-backed securities” the risk of homeowner default is spread over a pool that is large enough that the risks of default are statistically predictable (though when the Great Recession came, many of the prediction models proved faulty).

            Mortgage-backed securities are almost always sold to institutional investors who are regular clients of the sellers. The bankers can therefore structure the tranches to meet these customers’ particular risk and maturity preferences. Some tranches are better shielded from homeowner defaults—the AAA-rated tranches—and some are more exposed, with ratings from AA down to “junk” (industry lingo for bonds rated lower than BBB–). Among the AAA tranches, some may have faster pay-outs, others slower, some fixed interest rates, others floating.

            Because mortgage loans usually require monthly payments of principal and interest, and an escrow for real-estate taxes, the loans must be “serviced”—that is, someone must calculate the monthly payments due from the homeowner and which parts of the payment are principal and which parts interest, determine how much should be escrowed for real estate taxes and pay the taxes, check that the payments are made, send monthly statements to the homeowners, contact homeowners who miss payments, and foreclose when the loan becomes seriously delinquent.

            In the good old days, a savings bank with a portfolio of mortgage loans would service the loans itself. When savings banks began to sell off their mortgage loans, some retained the right to service the loans, others sold off the servicing rights. But servicing is a business with economies of scale, and most servicing today is done by large highly-computerized companies that service millions of loans; the five largest servicers currently have 60% of the servicing market. Servicers of securitized mortgages typically earn annual fees of 0.25% of the unpaid principal amount of fixed-rate mortgages and o.375% of adjustable-rate mortgages. The local savings bank’s main role today is to “originate” the loan—that is to evaluate a home’s value and the borrower’s creditworthiness, and to make sure the mortgage loan paperwork is in order.

            These changes in the mortgage industry have had several effects. For one, the risks of inflation and downturns in housing prices are now spread among myriad institutional investors instead of being concentrated in the savings and loan industry. Perhaps as important, once mortgage loans became more liquid investments, their values rose and their interest rates fell, providing a boon to homebuyers. Home sellers also benefited from the rise in home values consequent upon lower financing costs. (Not all the effects may have been so happy: It is frequently asserted—though some researchers have denied—that the separation of originators from investors encouraged riskier lending as originators no longer had to live for years with the consequences of lending to dodgy borrowers on over-priced properties.)

The documentation trail

            At a house closing, the homebuyer signs two documents with special importance for our story: a promissory note payable to the mortgage lender, and a mortgage. The lender records a copy of the mortgage and retains the original signed note and mortgage. When mortgage lending was done by local savings banks, the note and mortgage were usually kept on the bank’s premises and occasionally consulted. But in the world of computerized servicing of millions of mortgages, the note and mortgage, along with other documents (the “mortgage file”) are warehoused at a specialized document custodian, sometimes thousands of miles removed from the servicer’s operations center.

            Until recently, the promissory note and mortgage would both be in the originator’s name, and the mortgage would be recorded in that name. But as mortgage loans became tradable commodities, ownership of the note and mortgage would be transferred (“assigned” in legal jargon), usually several times, often winding up in a securitization trust that issued mortgage-backed securities. To make the series of assignments as efficient as possible, the promissory note might be endorsed by the originator “in blank”—that is, subsequent owners would not be named and the note could be enforced by whomever had valid possession. Moreover the mortgage assignments, which were usually evidenced by separate agreements, were not recorded. Lenders relied in part on the legal rule, which is part of the Uniform Commercial Code in every state, that the owner of the promissory note necessarily owns the mortgage. Many states did not even require a written assignment, let alone recordation, to validly transfer a mortgage.

            If a mortgage enters foreclosure, servicers may be reluctant to go to the bother of searching the mortgage file housed with a distant document custodian for the original mortgage, promissory note, and assignment documents. Since retrieving mortgage documents involves some cost, and since the documents may be missing, incomplete, or lacking some requisite formality, some servicers found it more convenient to file an affidavit stating that the promissory note had been lost. There are standard legal rules for handling lost notes, which to the servicers looked simpler than actually dredging up the original note.

            OK, they shouldn’t have done it. Filing false affidavits is a practice that should not be encouraged, but we can at least ask which parties were harmed by the servicers’ extra-legal shortcuts. Homeowners were, of course, harmed to the extent that observing all the legal niceties might have enabled them to avoid eviction for another month or two, but the procedural formalities were designed for other purposes: to ensure that the homeowner was indeed in default, that the amount claimed to be owed was correct, and that the proceeds of the sale of the home went to the actual holder of the mortgage loan. But with accusations flying of “fraudulent” affidavits, the press fostered the impression that large numbers of innocent homeowners were being foreclosed on—that they were not really in default, or owed less than was claimed, or that the lenders had no right to foreclose. The truth is far different, and more interesting.

How harmful was robosigning?

            At some point in the distant past, examination of a mortgage promissory note might have told a court something interesting about the identity of the note’s owner or the amount owing on the loan. Those days are long gone. Today, the best evidence of the amount owing on the note, and the identity of the loan’s owner, are the servicer’s computerized records. No computerized record can be entirely free from error, but material errors are unlikely in the case of mortgage payment records since servicers make monthly statements available to homeowners, and homeowners are likely to notify the servicer if they think something is wrong. Nor is it likely that a defaulting homeowner will be unaware that he might be foreclosed upon; foreclosures are always costly and in present conditions the proceeds of sale may not be enough to make the lender whole, so servicers make strenuous efforts to notify homeowners that they are behind, and to work out some arrangement that will be less costly to the lender than foreclosure.

            Nor is there much doubt as to the owner of the mortgage loan. The servicer has all along been forwarding monthly payments to somebody—usually a securitization trust—and it’s unlikely that anyone else has made a claim to those payments. In any case, in states that require a court proceeding for foreclosure, the judicial decree will settle the matter.

            Nonetheless, with home foreclosures more than quadrupling between 2005 and 2009, the servicers’ resources and manpower have been stretched thin. In such circumstances, one would expect the error rate to rise. An interagency review released in April 2011 by the Federal Reserve System, the Comptroller of the Currency, and the Office of Thrift Supervision noted that “some servicers failed to accurately complete or validate itemized amounts owed by [defaulting] borrowers,” and that “the percentage of errors at some servicers raise[d] significant concerns regarding those servicers’ internal controls.”

            These conclusions were based on a review of 2,800 files of foreclosed mortgages from 14 companies who in the aggregate serviced more than 2/3 of the nation’s mortgages. The files were not chosen randomly—one of the criteria for selection was that a consumer complaint had been raised—so one might expect the sample to exaggerate the extent of errors. Nonetheless, the review found that

“[B]orrowers subject to foreclosure in the reviewed files were seriously delinquent on their loans. … [S]ervicers possessed original notes and mortgages and, therefore, had sufficient documentation available to demonstrate authority to foreclose. Further, examiners found evidence that servicers generally attempted to contact distressed borrowers prior to initiating the foreclosure process to pursue loss-mitigation alternatives, including loan modifications.”

            As for errors in computing the amount owed, the errors seem to have been small—“typically less than $500”—and in more than half the cases favored the borrower. Not that the process was entirely error-free: The review noted “cases in which foreclosures should not have proceeded due to an intervening event or condition, such as the borrower (a) was covered by the Servicemembers Civil Relief Act, (b) filed for bankruptcy shortly before the foreclosure action, or (c) qualified for or was paying in accordance with a trial modification.” But these problems do not seem to have been caused or exacerbated by robosigning.

            Another persistent failure of the affidavits was notarization. A notarized document is one signed and sworn to before a notary public. Notaries are officers of the court, and false statements in the notarized document thus carry possible penalties for perjury. But lawyers routinely have documents notarized without having the signer present. It’s one of the smaller sins of legal practice, to which few pay much heed—worthy of a “tut-tut” but not much more.

            What has emerged is a situation that is difficult for the legal mind to grasp, though perfectly obvious to non-lawyers: Who owes what to whom on a mortgage loan is determined primarily by the servicer’s records, since the servicer’s monthly statements are available to both the mortgage owner and the homeowner. In the absence of anyone questioning those monthly statements, they can be regarded as dispositive. Just as you accept your monthly bank or securities account statement without the need for those silly passbooks or stock certificates, so you can accept the monthly mortgage statement without having to refer to the warehoused promissory note. And if you did review the promissory note, what could it tell you? It likely to be endorsed in blank rather than to the current owner of the mortgage loan, and it will almost certainly not reveal how much of the loan has actually been paid. A person signing an affidavit prepared by a computer is more likely to get the main points right than someone who muddies the waters by insisting on reviewing the documents. Not for the last time in the foreclosure wars, the legal rules from a bygone paper-based era have lingered long past the point of usefulness.

            In sum, the situation seems to be as follows: In attempting to foreclose mortgage loans, servicers have signed affidavits based on computerized mortgage records that are likely to be more accurate than the paper records. This has involved making false statements as to their examination of the paper mortgage file. But the false statements have not been material, the errors have been small—probably smaller than would have been the case with manual procedures—and have favored the borrowers at least as often as the lenders.

            Of course, the files examined in the Interagency Review may not have been an adequate sample of the problem, and the examination was subject to other limitations. Accordingly, the agencies required each of the 14 servicers to have an independent review conducted of its 2009–2010 foreclosure actions “to determine any financial injury to borrowers caused by errors, misrepresentations, or other deficiencies identified in the review….” Unfortunately for our purposes, that larger review was never conducted.

Putting robosigning behind us

            The robosigning crisis now seems to be largely over. As part of the $25 billion global mortgage settlement, the federal and state governments agreed not to pursue robosigning claims against the five bank defendants. The banks also agreed to new servicing procedures that should—at an unknown cost—make robosigning less likely going forward. Several states, most notably California, are moving forward with “homeowners’ bill of rights” legislation that will mandate these procedures for all large servicers.

            It is impossible to say just how much of the $25 billion settlement was owing to robosigning claims, or to estimate the future costs of the new procedures, but it seems likely that the robosigning firestorm gave the government considerable leverage. Even if robosigning contributed only $500 million to the settlement—less than 2% of the total—that’s still a lot to pay for procedural flaws that arguably injured no one.

            The global settlement does not affect the rights of individual homeowners to raise robosigning claims. But homeowners have generally not been successful in invalidating foreclosures or liens on the basis of robosigning allegations. For homeowners, robosigning allegations “have more bark than bite,” as one lawyer put it.

MERS wars

            Robosigning may have garnered most of the headlines, but another war, fought in dozens of separate litigations, may prove more consequential. In state after state, homeowners have alleged that the entity holding their mortgages, Mortgage Electronic Registration Systems, Inc. (MERS), did not have the legal authority to foreclose. MERS is the record holder on 30 million active mortgages, and a decision in favor of the homeowners could throw the entire foreclosure system into chaos.

            MERS was set up in 1995 as a membership organization owned by major players in the mortgage origination, securitization and servicing industries, including Fannie Mae, Freddie Mac, Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo. Its 3,000 members include almost all mortgage lenders as well as many companies that trade or service mortgage loans.

            MERS was designed to solve a particular problem: As mortgage loans became tradable commodities, the paperwork routines that had worked when mortgages stayed in one place began to seem onerous. The journey from mortgage originator to securitization trust might involve a half dozen stops, and keeping track of and documenting the transfers, and possibly having to record at least some of the assignments, was expensive, time-consuming, and error-prone.

            MERS changed all that. Mortgage agreements now usually authorize the mortgage lender to record the original mortgage in MERS’s name as nominee for the original mortgage lender and for all subsequent owners of the mortgage loan who are MERS members. Thus, when a mortgage lender that is a MERS member assigns the mortgage loan to another MERS member, such as an investment bank, MERS remains the named party on the recorded mortgage, but now as the nominee of the investment bank rather than the original lender. Since MERS remains the nominee of the owner of the mortgage loan, the assignment of the mortgage need not be recorded. When the investment bank further assigns the mortgage loan to a MERS-member securitization trust, MERS automatically becomes the nominee of the securitization trust, thus avoiding still another mortgage filing. MERS keeps an electronic database of the real owner and the servicer of each mortgage loan for which MERS acts as nominee (although the accuracy of the database depends on noteholders and servicers keeping MERS informed of transfers).

            When a mortgage loan defaults, the mortgage usually permits MERS to bring a foreclosure action in its own name—that is, MERS can initiate judicial foreclosure proceedings and conduct the foreclosure sale. MERS has few employees, but has appointed thousands of non-employees—almost always employees of the real owners or servicers of the mortgage loans—as MERS officers to act for MERS on foreclosures and other matters.

            Most state foreclosure statutes were written and most precedents decided well before mortgages became tradable commodities, and there is now some legal confusion about how to categorize MERS’s role in foreclosure actions. Legal theory distinguishes between “legal title” and “beneficial ownership.” The classic case is the trust, where the trustee has legal title to but no economic interest in the trust assets. The trustee acts for a beneficiary who is the beneficial owner of—that is, has the real economic interest in—the trust. There is no doubt that a trustee can bring a legal action in its own name as trustee, and the same reasoning might seem to apply to MERS, except that MERS is neither a trust nor a trustee. Sometimes MERS seems to function as a nominee or agent (other familiar legal categories), and sometimes as the legal owner. It’s all very confusing to the legal theorist.

            Moreover, in states that require a judicial proceeding for foreclosure, it is often argued that only the real “party in interest”—that is, the beneficial owner—can bring a suit (although this is never the case for trustees). Thus, it is claimed, only the owner of the mortgage note, and not MERS, can initiate a foreclosure. As a result of these conceptual difficulties, homeowners and their lawyers have attempted to argue that MERS does not have legal authority (“standing” in legal jargon) to bring a foreclosure action. MERS has managed to fend off most of these attacks. However, a few courts have been sympathetic to the view that MERS lacks standing, and at least one New York State court declared that MERS did not have the power as a nominee to either foreclose or to assign a mortgage back to the note owner. Since the court also held that the note owner could not foreclose unless the mortgage was assigned back to it, this holding would have raised an insuperable barrier to any foreclosure, at least for those mortgages MERS held in New York State. Happily, the decision was overturned on technical grounds, but its reasoning could still reappear in an appropriate case. (The case illustrates the benefits for some homeowners of litigation: The foreclosure action was commenced in March 2008, with litigation continuing—and the homeowner presumably remaining in the house without paying principal or interest on the mortgage loan—for four years.) As a result of the onslaught of litigation, MERS now discourages members from initiating foreclosures in MERS’s name, preferring to assign the mortgage back to its beneficial owner, who will then foreclose in its own name.

            Another frequent allegation in MERS litigation is that MERS has subverted the mortgage recording system. One purpose of the system, it is claimed, is to provide homeowners with a record of the real owners of their mortgage. Such a claim seems far-fetched. For one thing, there is no requirement that a mortgage be recorded; parents and other relatives frequently take unrecorded mortgages on their relations’ houses. More important, the purpose of recording mortgages is not to provide a record for homeowners but to protect lenders. If a house with an unrecorded mortgage is sold to an unsuspecting buyer, who records the sale, the lender will lose its mortgage. (The original homeowner will still owe the lender on the note, but the debt will now be unsecured and the lender’s chances of collecting diminished.) Similarly, if a subsequent lender records a mortgage without knowing of the earlier unrecorded mortgage, any foreclosure proceeds will go first to the recording lender. Finally, if the homeowner files for bankruptcy, an unrecorded mortgage will be without legal effect.

            It may be desirable that the homeowner know whom to talk to about the mortgage, but that person is the servicer, not a mortgage owner that is unlikely to have any useful information. (Various federal laws now require homeowners to be notified of the identity of their servicer, including a toll-free telephone number, and, since 2009, any assignee of their mortgage loan.)

            In February 2012, New York State sued MERS and three of its shareholders—Bank of America, JPMorgan Chase, and Wells Fargo—for fraudulent and deceptive acts or practices. (Similar suits had been initiated in Delaware and Massachusetts.) Much of New York’s complaint was based on practices, such as robosigning, that were discussed in the Interagency Review, rephrased in a more hysterical manner. But the complaint also alleged that many of the 13,000 foreclosure actions initiated in MERS’s name in New York were invalid because MERS lacked standing. The suit demanded that MERS be enjoined from continuing such activities, and that the defendants disgorge all profits and fees collected and pay all damages caused by such acts and practices (although the defendant banks settled the robosigning claims for an aggregate $25 million). While it is by no means clear that there were any profits collected or damages caused by these actions, the injunction would at the very least make using MERS in New York a more expensive process.

            Of course, for non-lawyers it doesn’t seem all that important whether the real (beneficial) owner of the mortgage loan brings a foreclosure action in its own name or in the name of a nominee such as MERS. The important practical questions are: Does the homeowner owe the money?, and Will the foreclosure proceeds be paid to the appropriate person? The answer to both questions is almost always “Yes.” But the advent of MERS has raised those cloudy legal questions one would expect when a real-world system outpaces its legal conceptualization.

A familiar problem

            We have all been here before, and recently. The creation of MERS was inspired partly by earlier developments in the securities industry. In the early 1960s almost all stock or bond trades required the physical transfer of a paper certificate, which involved turning in the old certificate to the issuer or its transfer agent, who would then issue a new certificate to the new owner. It was a system devised for a quieter era; back then, an active day on the New York Stock Exchange might involve the transfer of five million shares. But then the volume of trading expanded rapidly, and before the end of the decade 10 million-share days were common. Brokerage back offices were overwhelmed by the paper crunch, resulting in the failure of many old and established firms.

            Within a relatively short time, the industry devised a solution: A depository was set up—The Depository Trust Company (DTC)—to hold the stock certificates in its name (actually, in the name of DTC’s nominee, Cede & Co.). All the major brokerage houses and banks were “participants” in DTC, and DTC kept records of which of its participants was the beneficial owner of the share certificates held in DTC’s vault. The participants, in turn, kept records of which of its customers (some of whom were themselves financial institutions) were the beneficial owners of the shares the brokerage house held through DTC, and so on down the chain until at the end one found the true beneficial owners of the securities—those persons who were not holding for someone else. When a beneficial owner bought or sold shares, his securities firm would indicate the change by appropriately marking its records (a “book entry”), and corresponding book entries would be made at the firms further up the chain and finally at DTC; no paper certificates would change hands.

            This strategy of “immobilizing” the certificates at the depository and doing all the transfers by book entry has worked remarkably well. The New York Stock Exchange now routinely handles one billion share days without fuss or panic. Most investors hold their shares through their brokers; they receive a brokerage statement that shows their stock holdings without realizing that these holdings are evidenced only by a chain of computer records, culminating in an actual single stock certificate issued to DTC (an entity they have never heard of) that represents all of the shares held by the depository.

            While the system has solved the most pressing practical problems of securities transfer, it was for some time a legal orphan. Transfers of investment securities are governed in every state by the Uniform Commercial Code, and for roughly a quarter-century that statute provided only minimal guidance as to the status of a financial institution holding shares for its customers through a depository: Was the broker an agent, a trustee, or a bailee? What duties were owed by the depository or the broker to persons further down the chain? None of the familiar legal categories seemed to quite fit the situation, yet the choice of category could carry important legal and financial consequences.

            It was only in 1994 that a new version of the Uniform Commercial Code became available—quickly adopted by all 50 states—that, for our time and situation, resolved the legal categorization problem. The solution consisted largely in realizing that the relation of the various parties in the chain of security ownership did not fit into any of the standard legal categories. Instead, a new category was invented—the “security entitlement”—and rules propounded for the new way of doing business.

            The mortgage recording system with MERS at its heart was partly inspired by the success of the depository system for immobilizing security certificates, and seems to be suffering the same sort of legal uncertainties that afflicted that system before the 1994 modifications to the Uniform Commercial Code. Unfortunately, there is no analogue to the Uniform Commercial Code for mortgage and foreclosure statutes, so it may be some time before we have a legal structure that is responsive to the new realities of the mortgage markets. In the meantime the consequences of overly-technical judicial decisions could be serious.

The stakes

            Almost all the reactions to the mortgage crisis involve changes in procedures that will initially be costly to industry participants. While the one-time costs are likely to be borne by those participants, the ongoing increased monitoring and documentation burdens will inevitably be passed on to the industry’s customers—homebuyers and home sellers. Moreover, the crisis has revealed some unexpected legal risks in mortgage lending, as courts have not only bent over backward but have contorted pretzel-fashion to come up with rationales to benefit families in foreclosure. For an extreme example, in 2011 Massachusetts’s highest court decided that a bank did not have standing to bring an action to settle title to a foreclosed property because the mortgage was not recorded in its name, even though the bank held the promissory note. The generally recognized common law principle is that “the mortgage follows the note”—that is, the holder of the note has the benefit of the mortgage even if the mortgage has not been formally assigned to it. But the Massachusetts court, relying on judicial decisions from the nineteenth century, denied that the mortgage followed the note, without even considering that Massachusetts’s version of the Uniform Commercial Code, as it became effective in 2001, reaffirmed the mortgage-follows-the-note principle and clearly trumped the ancient decisions cited by the court. (The court’s failure to consider the statute may not have been deliberate: Perhaps because the issue had not been raised in the lower courts, none of the nine legal briefs submitted to the court by the parties and several friends of the court, including the Attorney General, mentioned the statute. But the following year the court repeated the mistake, again without any litigant citing the statute.)

            Perceptions of increased legal risk in foreclosure may make lenders less eager to lend on traditional terms, with substantial consequences for anyone who owns a home. Most people buy the most expensive home they can afford, based on the down payment and the expected monthly payment. Imagine a three-bedroom cottage in a quiet suburban community that Mr. & Mrs. Seller are offering for $250,000. Lender banks are willing to make a $225,000 (that is, 90% of the sale price) mortgage loan on the cottage to Mr. & Mrs. Buyer. The Buyers love the house and can just scrape together the $25,000 down payment and can just afford the monthly loan payments. House sold!

            While a 20% down payment is occasionally cited as a standard for prudent lending, and while residential mortgage securitization trusts often required primary mortgage insurance for mortgage loans above 80% of the value of the house, for many years before 2007 most borrowers did not have to post such a large down payment, 10% being frequently acceptable. But now suppose that perceived legal difficulties with foreclosing on residential real estate cause lender banks to reassess the risks of mortgage lending. They decide to raise the down payment requirement for Mr. & Mrs. Seller’s house to 20%—that is, they will now only finance 80% of the purchase price. Now the minimum down payment on the house will be $50,000. No sale—unless Mr. & Mrs. Seller lower their price.

            By how much must the price come down? The $25,000 maximum down payment that is all the Buyers can make is 20% of only a $125,000 purchase price.

            Of course, in the real world Mr. & Mrs. Seller will look for other buyers for their house. A rise in the required down payment will dampen demand, but it’s reasonable to assume that the price of the Sellers’ house will fall by less than would be necessary to close the sale to Mr. & Mrs. Buyer. Let’s suppose that another buyer can be found who can afford a $45,000 down payment. Then the increased down payment requirement will result in a reduction of the purchase price to $225,000, or 10% less than the sale price before the increase in the required down payment. (Sale price reductions could also be expected if the bank decided to charge additional interest to compensate for increased foreclosure risk.)

            In 2010 the value of residential fixed assets held by U.S. households was over $15 trillion. A 10% drop in the value of those assets would thus represent a decline of over $1.5 trillion in value. Of course, the 10% drop is purely my back of the envelope guesstimate, and increased foreclosure risk may not be the largest factor driving an increase in required down payments, but it does give some idea of the amounts at stake.

            The last few years have witnessed a real estate bubble that raised the sales price of most homes by substantial amounts. We are now undergoing the painful process of lowering those prices to more traditional amounts. But the provision of 90% financing was not a cause of that bubble, and a retreat to 80% financing is likely to force home prices well below pre-bubble levels.

            We often slip into thinking of houses (and many other things) as having an intrinsic value. The truth is that the value of anything is what a willing buyer will pay a willing seller, and that willingness is heavily influenced not only by beliefs about future price trends but also by financial and institutional arrangements. If we change the institutional arrangements for mortgage lending—for example, by convincing lenders that they may not be able to foreclose on mortgages—we can lower the value of the nation’s homes.

            For most Americans, their home is their most valuable asset. Commonly, as children move away and homeowners no longer need the extra room, they move to smaller quarters, selling their homes to provide retirement income. Or they may refinance their home to provide cash for starting a business, paying medical bills, or sending a child to college. Any rise in down-payment percentages or mortgage interest rates will lower sales prices, decreasing retirement nest eggs and diminishing the ability to raise cash for other needs. The ultimate dark legacy of the foreclosure wars may be that in their desire to help borrowers facing foreclosure, the foreclosure warriors may end up being responsible for a material decline in the value of most Americans’ largest single asset.