Another Way Banks Make Everyone Pay: The MERS Mortgage Mess

Much has already been written about the Mortgage Electronic Registration System -- the mortgage industry's effort to avoid paying local governments hundreds of millions of dollars in fees while facilitating trading in mortgages -- and its problematic legal foundation. I refer to the "mortgage industry" -- rather than just banks -- because Fannie Mae and Freddie Mac played important roles in the creation of MERS. However, in the context of MERS in foreclosures, "banks" is equally appropriate.

As foreclosure-related litigation challenging the MERS business model has progressed around the nation, the banks have won some and lost some, with the decisions hinging on state law. That spotty track record should outrage everyone. The mortgage industry subverted a property-ownership system that had functioned well since before the American Revolution, essentially replacing it with MERS. And whether or not MERS works as intended turns out to be based on accidents of geography.

MERS Is National, But Real Estate Law Is Local

State laws governing how homes are bought and sold vary widely because each modern law is the organic result of hundreds of years of court decisions and laws rooted in a state's history and culture. Some states have mortgages while others have "deeds of trust," some have "title theory" and some "lien theory." Some states require going through the courts to foreclose, while others don't -- and some allow both procedures, but usually use just one. Such variation shouldn't be surprising: Nothing is more local than land.

Against that complex legal backdrop, MERS makes contradictory claims about its status and powers. For example, MERS claims to be simultaneously the owner of the mortgage and the agent of the owner of the mortgage. Given the complexities, judges within each state don't always agree on MERS's ability to do what it says it can do.

As a result, MERS has proven to be the opposite of the business-friendly entity it was intended to be, because the most business-unfriendly legal environment possible is total uncertainty, and that's what MERS has produced. Banks hoping to enforce mortgages that name MERS as an interested party don't know what will happen when they try.

Like the outsourcing of foreclosures I discussed last week, the banks' embrace of MERS in an effort to save themselves millions of dollars has shifted huge costs to the rest of us. And both strategies are proving penny-wise and pound-foolish from the banks' perspective -- perverse kinds of grand lose-lose scenarios. Ultimately, the MERS mess is even worse than the foreclosure-outsourcing mess, because it affects a vastly larger number of mortgages.

MERS Model Invalid in New York

Last week, Judge Robert Grossman of the U.S. Bankruptcy Court of the Eastern District of New York decided in a case called Agard that MERS's business model fails as a matter of New York law. In short, MERS does not have the power to assign mortgages under New York law, and a bank hoping to foreclose on a MERS loan needs both the note and a valid assignment of the mortgage. Having the note alone is not enough. That's because a MERS mortgage, he found, does not follow the note:

"By MERS's own account, the Note in this case was transferred among its members, while the Mortgage remained in MERS's name. MERS admits that the very foundation of its business model as described herein requires that the Note and Mortgage travel on divergent paths. Because the Note and Mortgage did not travel together [to foreclose, a bank has to prove both were validly assigned to it.]"

As a result, banks don't have the right to foreclose on a MERS loan even if they have the note. They also have to have the mortgage. And with MERS unable to assign a mortgage, it's hard to see how a bank could get it.

To be clear, Agard is not a ruling by New York's highest court, and as such, it's not a definitive statement of New York law. But if many other judges are persuaded by Judge Grossman's reasoning, an awful lot of mortgage debt could turn out to be unsecured, just like credit card debt.

Going Far Beyond Their Legal Rights

So, under New York law, why can't MERS assign mortgages?

First, MERS claimed that mortgages naming it the "nominee" for the lender created a relationship between MERS and the lender that gave MERS the power to assign the mortgage. Judge Grossman explains that's not the case because the lender never gives MERS written authority specifically saying MERS has the power to assign the mortgage. Under New York law, nominees not only need specific authority to act, but in the case of real estate, they need that authority in writing.

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Second, MERS claims that when the mortgage separately calls it the "mortgagee of record," that label gives it the power to assign mortgages. Unfortunately for MERS, New York law doesn't include any such power, and Judge Grossman totally dismissed the argument: "MERS's position that it can be both the mortgagee and the agent of the mortgagee is absurd, at best."

MERS also argues that because the debtor signed the mortgage, and the mortgage says MERS has these powers, MERS must have them. Judge Grossman dismissed that position, too, noting the debtor has no power to create a relationship between the lender and MERS.

Third, MERS claims that its membership agreement means that all MERS members have made MERS their agent with the power to assign mortgages on behalf of its members. But Judge Grossman notes that as currently written, the membership agreement doesn't, under New York law, create an agency relationship between it and its members. Fundamentally, that's because the membership agreement never explicitly says MERS is the agent for its members nor does it "grant any clear authority to MERS to take any action with respect to the mortgages held by MERS members."

Next, Judge Grossman discusses the MERS assignment that the loan servicer attempting to foreclose gave the court. The document says that the original lender, First Franklin, assigned the mortgage to U.S. Bank, which is the trustee for a mortgage securitization trust.

But that's not really what happened. U.S. Bank, following MERS protocol, assigned the mortgage to itself. Judge Grossman notes the document is "stunningly inconsistent with what the parties define as the facts of this case." He doesn't critique it further, however, since he'd already ruled MERS couldn't do an assignment anyway.

Will Other Judges Follow Grossman's Lead?

So what does Judge Grossman's opinion mean? Well, for cases that come before him, banks that want to foreclose MERS loans will have to produce both the note and a valid assignment of mortgage. Presumably that means an assignment from MERS and a document authorizing MERS to do that assignment -- presumably from the original lender. Or MERS would need to produce the note and an assignment from the last mortgage-holder, again, presumably the original lender. Either way, getting a validly assigned mortgage is going to be tricky. And what if the original lender is no longer in existence, as many are not?

These requirements will be imposed by any other judge persuaded by Judge Grossman's reasoning.

Despite all the criticism of courts as bastions of activism, the judiciary is an inherently conservative institution because each decision must take into account those that preceded it. Precedent's role favors incremental change while simultaneously buttressing the overall framework of existing law. And precedent leads to paragraphs like this one from Judge Grossman:

"The Court recognizes that an adverse ruling regarding MERS's authority to assign mortgages or act on behalf of its member/lenders could have a significant impact on MERS and upon the lenders which do business with MERS throughout the United States. However, the Court must resolve the instant matter by applying the laws as they exist today. It is up to the legislative branch, if it chooses, to amend the current statutes to confer upon MERS the requisite authority to assign mortgages under its current business practices. MERS and its partners made the decision to create and operate under a business model that was designed in large part to avoid the requirements of the traditional mortgage recording process. This Court does not accept the argument that because MERS may be involved with 50% of all residential mortgages in the country, that is reason enough for this Court to turn a blind eye to the fact that this process does not comply with the law."

Judge Grossman's tone, and his conclusion that a basic mortgage industry business practice is illegal under New York law, is reminiscent of the Massachusetts Supreme Judicial Court decision in the Ibanez case, which noted that a key practice in the typical securitization deal violated a century of Massachusetts law.

Note to homeowners hoping their MERS mortgage is a path to a free home: At most, Judge Grossman's opinion means your debt is unsecured. That is, you still owe the money, but the bank can't foreclose on you to make you pay. And it's important to remember that as persuasive as it is, Judge Grossman's decision is just one bankruptcy judge's opinion, not an edict from the top of the legal pyramid.

Another "Cost-Saving" Lose-Lose From the Banks

How did we get to this place where MERS hurts everyone, even the banks that otherwise benefit from it? Just think of the legal fees MERS members are paying as they try, sometimes unsuccessfully, to defend its basic business model. I'll bet they didn't plan on that.

What were the lawyers thinking when they blessed MERS's structure? Did they really analyze the MERS business model in light of 50 states' real property and agency laws? It's hard to believe they did, given the number of cases MERS has lost. It's also hard to believe they didn't, given the nature of the undertaking.

But that's all water under the bridge now. At present, the MERS model, like the outsourcing of foreclosures, is just another example of how the mortgage industry has tried to save itself big bucks without paying due attention to the law. And for a long time to come, all of us will be paying for it.