This magic moment, so different and so new,
Was like any other, until I met you.
And then it happened, it took me by surprise…
I knew that you felt it too, I could see by the look in your eyes…
This Magic Moment – Lou Reed
Wise investing is difficult. Constant spin and deception in the mainstream media only make it harder. A sudden event that changes everything is, in parlance, a magic moment. Previously, I discussed how one bank, HSBC, took a $10b write off in 2007. This was our initial warning, the “magic moment,” that predicted a major financial crisis. See Watershed Event in the Financial Crisis. In that case, the smoke-and-mirror financial atmosphere at the time prevented most of us from seeing what was happening.
To make things more frustrating, an old saying on Wall Street goes: “no one rings a bell at the top.” That means, no one is ever going to alert us to the market’s magic moments. We have to be smart enough to peer through the smoke, push aside the mirrors, and see clearly what may be right in front of us. And we can never count on the same set of circumstances to happen twice. The lack of that bell leads us to an epiphany: things are never going to be the same again.
We are again approaching a magic moment – “Foreclosuregate”. JP Morgan, Ally and Bank of America are imposing moratoriums on foreclosures and 40 state attorneys general are on the verge of announcing a joint investigation into the practices of the mortgage servicing industry. 40 States Expected to Investigate Foreclosures. Two major title companies, Old Republic and Stewart, have ordered their agents to stop writing title policies on foreclosed homes. Stewart Title Clamps Down on Foreclosure Sales. The Wall Street Journal and the New York Times have tried to downplay the issue; they so far dismiss the problem as one of technical defects and paperwork errors. Why does this remind us of Ben Bernanke”s 2007 assertions that the subprime crisis was “well contained?” Fed’s Bernanke: Subprime Mortgage Problems Contained
Elements of “Foreclosuregate”
First, a disclaimer: although I am an attorney, I worked on only two real estate closings in 35 years of law practice. I did learn, however, that real estate transactions are document intensive, detailed and precise. Disclosures must be crystal clear. All legal formalities must be observed, such as notarizations, fees, stamps, seals, etc. Documents must be promptly and correctly recorded to protect the buyer and the mortgage holder. Any shortcuts could harm one’s client, law license and malpractice premium.
Apparently, in the frenzy of mortgage backed securities, banks and lenders took many such shortcuts. It is beyond the scope of this blog to detail every bit of malfeasance and poor legal practice during the Roaring 2000’s in the housing market. But here are some of the pitiful truths fueling the developing crisis:
- Poor underwriting standards – Individuals who clearly did not qualify received loans. Stories are legion of low wage workers taking out loans of several hundred thousand dollars. Interest only and teaser rate loans were used to generate fees for the mortgage broker. The broker was hoping that the borrower would return in a couple of years, refinance the home based on an inflating house price and generate more fees.
- Poor Documentation – Mortgages consist of the mortgage itself and an accompanying promissory note. These documents are usually promptly filed at the county level to perfect a lien on the property. It appears that this step may have been handled incorrectly or bypassed (See MERS).
- MERS (Mortgage Electronic Registration System) – MERS is a bank creation to enable financial firms to securitize (create mortgage backed bonds – MBOs) quickly and to avoid county filing procedures and attendant filing fees. Let’s take a quick look at how and why the banks did this:
In the mid-1990s mortgage bankers decided they did not want to pay recording fees for assigning mortgages anymore. This decision was driven by securitization—a process of pooling many mortgages into a trust and selling income from the trust to investors on Wall Street. Securitization, also sometimes called structured finance, usually required several successive mortgage assignments to different companies. To avoid paying county recording fees, mortgage bankers formed a plan to create one shell company that would pretend to own all the mortgages in the country—that way, the mortgage bankers would never have to record assignments since the same company would always “own” all the mortgages.
They incorporated the shell company in Delaware and called it Mortgage Electronic Registration Systems, Inc.
Even though not a single state legislature or appellate court had authorized this change in the real property recording, investors interested in subprime and exotic mortgage backed securities were still willing to buy mortgages recorded through this new proxy system. The MERS Edifice Quavers
- Poor Foreclosure Processes – To foreclose on a property, one needs proof of ownership of the note, supporting affidavits and notarizations. An affidavit requires personal knowledge of the bank official seeking to foreclose, who then swears that he has reviewed all documents and that they are true. MERS has thousands of assistant secretaries, who are not employees of the firm, but employees of the bank, seeking to foreclose on their behalf. Some courts have ruled that MERS has no legal standing to foreclose. Moreover, many of these assistant secretaries sign thousands of these foreclosure documents each month, and have no personal knowledge of the documents or file. These individuals have been called “robo signers” and are arguably acting in violation of court rules. In addition, it appears that original documents do not exist and have been recreated, raising the issue of forged documents.
- Poor Securitization Processes - Real Estate Mortgage Investment Conduits (REMIC) are investment vehicles designed to hold commercial and residential mortgages in trust and issue mortgage backed securities representing an undivided interest in the mortgages. Under IRS regulations and NY Trust law, the mortgages must be contributed on the startup day. A problem arises if MERS claims to have title to the mortgage:
… all rights to a mortgage loan must be deposited into the trust for it to achieve tax exempt status under federal REMIC law—which does not contemplate the use of a proxy mortgagee. Yet, despite claiming sole ownership of mortgages sold to investors, in documents regularly recorded with county officials these same institutions maintain that MERS is the sole owner of the mortgage. The chain of financial institutions linking originators to securitization depositors collectively want to have their lien and sell it too. The MERS Edifice Quavers
These are just some of the myriad problems arising from the mortgage mess.
Implications
This is not a problem that is going to be resolved quickly. Banks are vulnerable on a number of fronts:
- At best, the banks will have a delayed right of foreclosure thereby reducing the value of the mortgage note.
- Banks could be charged with fraud or required to take back the mortgages from MBS purchasers who were misled as to the value of mortgages and the shoddy securitization practices now imperiling their investment.
- The banks could owe tax penalties for failing to have the mortgages and notes conveyed to the REMICs on startup date.
- Plaintiffs’ lawyers have already brought a number of class actions against the banks seeking damages and a stay of foreclosures.
- State attorneys general will be seeking recording fees, foreclosure stays and other penalties for these practices.
- Title companies will be forced to pay out policies and seek redress from the banks. .
- Courts may impose sanctions against the banks and their attorneys and may delay or dismiss foreclosure proceedings.
Mistakenly, the press has focused only on the issue of residential foreclosures. There are two more issues to be concerned about: securitized commercial mortgages and MERS procedures were used in that part of the market as well. Second, failure to follow procedures may affect homeowners not in foreclosure. When an owner has paid off his mortgage and the mortgage and note has been resold and assigned numerous times, how does he know he has a legally binding accord and satisfaction of his mortgage? The chain of title may have been compromised on a national level. In fact recently a website encouraging homeowners to demand proof that one’s servicer is holding one’s mortgage note has gone online , Where’s the Note?
The market continues to rally much as it did after the HSBC subprime confession and write down in 2007. Another financial aphorism goes: economic facts don’t matter, until they matter. See It Doesn’t Matter Until It Matters. Disturbing facts are just entering the public consciousness. In this volatile, thinly traded market dominated by computer traders, I would rather exit two months early and sell my bank stocks, rather than be five minutes late and thousands of dollars poorer.
Disclaimer: The Prophet does not have a position in any banks, title insurance companies or other financial institutions and this is not a recommendation to buy or sell any security. Consult your own financial advisor.
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