"A Parallel Mortgage Universe"

Several years ago, I had to laugh when left-blogger Duncan Black labelled the mortgage mess "Big Shitpile", which evoked the image of lawyers and bankers running around in a panic trying to find a rug big enough to sweep it all under.

Today, the mess is still here, and it keeps threatening to destroy everything it touches. Today, MERS is in the uncomfortable spotlight.

The only way the housing mess will be solved is if people finally accept that they permanently lost their investments. It's a slow process, however. Like they say: anger, denial, bargaining, acceptance. People are still in the denial phase, and will remain so for years, and will resist that final, final reckoning to the bitter, bitter end:

Millions of U.S. mortgages have been shuttled around the global financial system - sold and resold by firms - without the documents that traditionally prove who legally owns the loans.

Now, as many of these loans have fallen into default and banks have sought to seize homes, judges around the country have increasingly ruled that lenders had no right to foreclose, because they lacked clear title.

...For big banks, "there's a possible nightmare scenario here that no foreclosure is valid," said Nancy Bush, a banking analyst from NAB Research. If millions of foreclosures past and present were invalidated because of the way the hurried securitization process muddied the chain of ownership, banks could face lawsuits from homeowners and from investors who bought stakes in the mortgage securities - an expensive and potentially crippling proposition.

...At the core of the fights over the legal standing of banks in foreclosure cases is Mortgage Electronic Registration Systems, based in Reston.

The company, known as MERS, was created more than a decade ago by the mortgage industry, including mortgage giants Fannie Mae and Freddie Mac, GMAC, and the Mortgage Bankers Association.

MERS allowed big financial firms to trade mortgages at lightning speed while largely bypassing local property laws throughout the country that required new forms and filing fees each time a loan changed hands, lawyers say.

The idea behind it was to build a centralized registry to track loans electronically as they were traded by big financial firms. Without this system, the business of creating massive securities made of thousands of mortgages would likely have never taken off. The company's role caused few objections until millions of homes began to fall into foreclosure.

...Kentucky lawyer Heather Boone McKeever has filed a state class-action suit and a federal civil racketeering class-action suit on behalf of homeowners facing foreclosure, alleging that MERS and financial firms that did business with it have tried to foreclose on homes without holding proper titles.

"They have no legal standing and no right to foreclose," McKeever said. "If you or I did this one time, we'd be in jail."

...In August, the Maine Supreme Court threw out a foreclosure case because "MERS did not have a stake in the proceedings and therefore had no standing to initiate the foreclosure action."

In May, a New York judge dismissed another case because the assignment of the loan by MERS to the bank HSBC was "defective," he said. The plaintiff's counsel seemed to be "operating in a parallel mortgage universe," the judge wrote.

Also in May, a California judge said MERS could not foreclose on a home, because it was merely a representative for Citibank and did not own the loan.

..."Assertions that somehow MERS creates a defect in the mortgage or deed of trust are not supported by the facts," a company spokeswoman said.

But that's precisely what lawyers are arguing with more frequency throughout the country. If such an argument gains traction in the wake of recent foreclosure moratoriums, the consequences for banks could be enormous.

"It's an issue of the whole process of foreclosure having been so muddied by the [securitization] process," said Bush, the banking analyst. "It is no longer a straightforward legalistic process, which is what foreclosures are supposed to be."

...Referring to the federal government's $700 billion Troubled Assets Relief Program for banks, she added, "This problem could cost the banks significantly more money, which could mean TARP II."

Felix Salmon looks at some of the consequences:

[B]ut put them all together, and it becomes clear that the mother of all legal messes has already emerged from the foreclosure crisis, and threatens not only a large chunk of the financial system but also venerable civic institutions, like the courts, which have thus far emerged from the crisis largely unscathed.

While there’s some evidence that Congress is willing to find a bank-friendly way out of this mess, I don’t think that’s going to fly, not when state AGs are already filing lawsuits against the likes of GMAC.

Argentina’s sovereign default has been called “the slowest trainwreck in history”, but this one might turn out to be slower, bigger, and much less fair. Millions of people have already lost their houses to lenders who didn’t have the proper paperwork, and it’s unlikely they will ever get any redress. For people who haven’t yet been foreclosed upon, however, it could now be a very long time before they lose their house.

The big-picture consequences here are by their nature unpredictable, as no one has a clue how this might all play out. But I can think of a few themes:

Bond investors, who have seen the value of their mortgage-backed debt rise impressively over the past 18 months, could find themselves unable to find any kind of bid at all. The paper will still be cashflowing, but those cashflows will be surrounded by enormous uncertainty, and no one’s going to want to buy them except at extremely deep discounts until the mess is cleared up.

Mortgage servicers will go from being assets to being liabilities, and banks which own mortgage servicers could find themselves on the hook for substantial losses.

The time from default to foreclosure will become indefinite, and as a result there will be a significant uptick in strategic defaults, especially in states with judicial foreclosures.

The “shadow inventory” of houses which aren’t on the market but will eventually be sold once the bank gets around to foreclosing will grow substantially from its already-enormous level.

All of this is going to be very costly and very unpleasant for all concerned; the only winners I see here are the lawyers. Add in possible securities-fraud charges against investment banks which underwrote a lot of these bonds, and the end result is a level of legal chaos I can barely imagine, in both the civil and criminal courts. And I see no easy way out at all.