The Congressional Oversight Panel created in the wake of TARP to oversee and monitor the Treasury Department has just issued a devastatingly clear report about the mortgage mess and its legal implications, which are ugly.
The report hedges and doesn't pick between the financial industry's view that the foreclosure documentation problem is limited and easily fixed and the worst-case scenario that robo-signing and the like are symptoms of fundamental problems with mortgage securitizations that could push the big banks back into bailout land -- or the financial system back over the brink.
However, the panel does recommend further stress-testing the banks, which shows that it thinks the worst-case scenario isn't so far-fetched. Moreover, a close look suggests that the financial industry's view borders on the delusional, and the worst case might even be likely.
Two Grounds for Suing Banks
The worst-case scenario has several components. First is that the big banks are forced to pay investors for all those lousy mortgage-backed securities. As the report notes:
"one investor action alone could seek to force Bank of America to repurchase and absorb partial losses on up to $47 billion in troubled loans. . .Bank of America currently has $230 billion in shareholders‟ equity, so. . .[i]t is possible that widespread challenges along these lines could pose risks to the very financial stability that the Troubled Asset Relief Program was designed to protect."
The investors could have two core grounds for suing. First and fundamentally, sloppy paperwork may mean the securities aren't backed by the mortgages after all because the trust issuing the securities doesn't own the mortgages. Secondly, the banks may have lied to the investors about the quality of the mortgages in the securities to a significant degree. In either case the investors can sue or demand that the securities be bought back.
If the mortgages weren't transferred properly during the securitization process, another set of terrible consequences results from the fact that the owners of the loans aren't the trusts that people think own the loans. As the report explains:
"Borrowers may be unable to determine whether they are sending their monthly payments to the right people. Judges may block any effort to foreclose, even in cases where borrowers have failed to make regular payments. Multiple banks may attempt to foreclose upon the same property. Borrowers who have already suffered foreclosure may seek to regain title to their homes and force any new owners to move out. Would-be buyers and sellers could find themselves in limbo, unable to know with any certainty whether they can safely buy or sell a home. If such problems were to arise on a large scale, the housing market could experience even greater disruptions than have already occurred, resulting in significant harm to major financial institutions. For example, if a Wall Street bank were to discover that, due to shoddily executed paperwork, it still owns millions of defaulted mortgages that it thought it sold off years ago, it could face billions of dollars in unexpected losses."
A related problem is that the loan servicers that are doing mortgage modifications with homeowners may not have the right to do modifications. Similarly, an entity without the right to foreclose also doesn't have the right to modify a loan.
A Broken Paper Trail
To understand how likely the worst-case scenario is, take a look at what would have to go wrong with documentation during the securitization process, and consider it in light of robo-signing and all the other paperwork problems. Although the details may differ with each set of securities, the basic issue is this: to get the notes and mortgages into the trust in a way that kept them there -- even if the mortgage originator or the sponsor went bankrupt (as many originators did) -- they had to be transferred at least twice before entering the trust.
The best way of proving those transfers would be having each one recorded on the note that the mortgage is attached to. And indeed, the contracts that governed how the mortgages got into the trust (the "pooling and servicing" agreements) generally required a chain of endorsements on the note.
How likely is it that an industry that invented an electronic database -- MERS -- specifically to avoid a paper recording of individual transfers of mortgages at land-record offices around the country stayed on top of properly endorsing the notes of each mortgage? How likely is it when you consider all of the "lost note" affidavits foreclosers are submitting to the courts? How likely when you add in the fraudulent assignments of mortgage that have defunct entities transferring the mortgage and note? Or what about notes that didn't have endorsements suddenly having them?
And if the mortgages and notes weren't given to the trust according to the pooling and servicing agreement, is there an easy fix to put the notes in now, in the same way banks claim they can fix their fraudulent foreclosure filings merely by resubmitting papers? No, because the agreements prevent the trusts from getting notes and mortgages after the fact to preserve the special tax-free status the securities are entitled to.
A Fundamental Screw-Up?
Similarly, the agreements prohibit giving the trust any loan that's in default, which many now are. So, if the banks in those freewheeling mortgage securitization days of 2005-2007 didn't do their paperwork properly, title to all those securitized mortgages could be clouded, screwing up American real estate in fundamental ways. And investors could launch crippling efforts to sue the bankers or force them to repurchase the tainted securities.
The panel's report suggests that fraud cases might be hard to win both because it could be hard for investors to prove that fraud caused their losses (as opposed to the market's crash more generally) or because making out a common-law fraud case is just plain hard.
But at least one common-law fraud case based on the rating agencies' fanciful triple-A ratings of these securities has been going forward, and I'm not sure why suing the banks should be harder. According to the panel report, sponsors of the securities may have known that many of the mortgages didn't meet the standards they were supposed to, and the sponsors demonstrated that knowledge by using the information to buy the mortgages more cheaply, without disclosing that material information to the purchasers of the securities. If true, that seems to meet common-law fraud's tough "intent" requirements.
In short, common sense suggests that robo-signing is just the most visible artifact of a mortgage banking culture that appears to have had little respect for following the letter and spirit of the law. If that disregard extended to "law" as spelled out in the key securitization agreements, we can expect to watch the worst-case scenario slowly play out. Investigations, lawsuits and wary courts will force the industry to come clean.