Why the Foreclosure Mess Settlement Proposal Can't Fix the Damage

Ever since this fall, when the mortgage industry's robo-signing scandal first broke, people have been aware that banks have been illegally foreclosing on homes.

Now there's a huge fight over what to do about that, mostly focused on a 27-page proposal that was supposed to represent the consensus of the 50 state attorneys general, but apparently doesn't. On top of that effort came a report of a "shock and awe" modification push from the federal government, but as Yves Smith at Naked Capitalism details, it's neither good policy nor practical.

One feature of both the attorneys general's proposal and the "shock and awe" maneuver is speed.

The attorneys general are in such a hurry to find a solution that they haven't even investigated the banks: They're just relying on consumer complaints to define the problem. Similarly, the shock-and-awe plan involves an impossible six month deadline. As Treasury Secretary Timothy Geitner explained to Congress: "All parties have a stake in bringing this to resolution as quickly as possible" and "It's very important that we try to bring this to bed as quickly as we can."

At least part of this desire for a fast fix is rooted in the belief that an agreement will help the housing market recover, which in turn will help straighten out the overall economy. That's true to some extent: If millions of mortgages were successfully modified and unnecessary and servicer-driven foreclosures were halted, as the settlement proposes, that would be good for the economy and the real estate market.

The Enormous Clouded Title Problem

But the settlement doesn't go nearly far enough to save the housing market. In fact, it can't go far enough, because it can't address one of the most confounding problems the banks have created: the millions of properties nationwide that now have "clouded" titles.

To put it plainly: Because of these bad titles, property owners can't prove they own the properties they think they bought, and banks can't prove the had the right to sell them.

Even though it's impossible to know how many properties are affected, I have confidence in saying millions nationally for the following reasons:

• More than 1 million foreclosures have been completed since 2005; nearly 200,000 were completed in the third quarter of 2010 alone.

• Foreclosures involving securitized mortgages seem to be flawed as a rule, not the exception.

• Even when foreclosures may have been otherwise valid, the practices of foreclosure attorneys have clouded titles.

• The problems are ongoing. More flawed foreclosures are completed every day.

• The clouded title problem extends well beyond foreclosures. Both MERS, the electronic database that holds more than half the mortgages nationally, and possible securitization failures could have damaged the titles of the properties even though the borrowers are current on their mortgages.

The Solid Effects of Clouded Titles

You can't sell real estate when you can't establish that you own it -- banks won't loan money for purchasers to buy the property. That's because the bank wants to be sure that if it forecloses, it will get good title to the property. (Yes, this issue practically oozes irony.) That's why banks won't approve a mortgage for a property if a title insurance company won't insure its title. And title insurance companies won't do that if they know the title is clouded.

A few months ago, the Massachusetts Supreme Judicial Court issued its Ibanez decision, which made it clear that the banks' foreclosure practices -- and indeed, the standard securitization deal -- violated longstanding basic Massachusetts real estate law, and thus, many completed Massachusetts foreclosures were invalid. The foreclosing banks, which had either since sold the properties or still "owned" them, had no right to foreclose, and therefore had never owned those properties. So who owns them now? Well, the fact that it's a question is the very definition of "clouded title."

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Since it has been a couple of months since the Ibanez decision, I called a couple of large title insurance companies in the Boston area to see how title insurance for improperly foreclosed properties is being handled. To bypass talking points and smooth-talking spokespeople, I called insurance sales agents, representing myself as someone contemplating purchasing a Massachusetts foreclosure. Because I didn't say I was a member of the media, I'm not going to name the companies. But the conversations confirmed my thesis.

One agent called improperly foreclosed homes in Massachusetts "uninsurable." Another explained that the problem underscored in the Ibanez case has been around for years, and that any title company would need to look at foreclosures dating at least until the late 1970s, when securitization became more common, to make sure no improper foreclosure had happened in all those years. And some properties, she noted, had been foreclosed on multiple times.

That agent did note that the problem was worst for properties improperly foreclosed on in recent years that were still bank-owned. Those properties were truly uninsurable. That's because the bank couldn't make a claim on the title insurance policy it had purchased when making the original loan, since it was the entity that clouded the title. Indeed, honoring that policy would be like letting a arsonist collect on fire insurance. Thus much of the current bank-owned inventory in Massachusetts is largely uninsurable and thus unsellable.

No settlement with the servicers is going to solve that problem. And it's a national problem, not a Massachusetts one.

Where to Lay the Blame

When it comes to the clouded title problem, one group is wholly innocent: the borrowers -- "deadbeat" or not. The title issues are the equivalent of unforced errors in tennis: the banks have done this to themselves.

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And one party is generally guilty, in the sense that none of the problems could have developed this far if it had been doing its job, and that's the government.

By government I mean: regulators, particularly at the federal level; law enforcers at both the federal and state level; state legislatures and Congress to the extent they passed laws making the situation worse or failed to pass to pass laws that would have helped; and finally, Fannie Mae and Freddie Mac for their role in setting up MERS.

Even in that context, the largest share of the blame still must go to banks and their lawyers: But for them, the clouded title mess wouldn't exist. Here's how all of them created the crisis.

How Ownership Gets Confused

First, banks across the nation have used fraudulent documents to "prove" they have the right to foreclose. This is the classic robo-signing situation, and it, at least, would be solved if the attorneys general's settlement proposal was adopted.

While the issue is clearest in judicial foreclosure states -- where the documents are getting more scrutiny -- the problem exists everywhere. In nonjudicial foreclosure states, the problem frequently surfaces first in federal bankruptcy courts when banks ask for permission to foreclose on debtors in bankruptcy. The problem also shows up in those states' courts as homeowners try to fight the foreclosures.

For this title clouding problem, blame the mortgage servicers, who incidentally are also the big banks.

Second, as both the Ibanez and Kemp case from New Jersey illustrate, banks' standard securitization procedures may have failed to properly assign the promised mortgages to the securitization trusts, which means those securities aren't really mortgage-backed after all. It also means that the ownership of those mortgages (and in some states, title to the properties) remains with different banks that were part of the securitization processes -- banks that may or may not still exist today.

The clouded titles that result from busted securitizations are a particular problem in those states where the lender who holds the mortgage holds legal title to the property until the mortgage is paid off. In those states, all the borrower has is the right to use and enjoy the property until the mortgage is paid off and she gets legal title. Importantly, busted securitizations cloud the titles of current and defaulted mortgages in those states equally.

For this problem, blame the securitizers, who include the big banks, Wall Street, and their big law firm attorneys.

Forgeries and the Illegal Practice of Law

Third, foreclosure attorneys have processed their filings in illegal ways. For example, in Pennsylvania, the attorneys have done foreclosures with papers no lawyer reviewed, bearing signatures forged with the firms' named partners' permission. Those foreclosures, which were done via the illegal practice of law, appear to be void -- and there are many. Or consider that several Maryland firms have also had underlings forge lawyers' names on foreclosure documents, including on more than 1,000 deeds. Or consider the practices of the now defunct David Stern foreclosure mill in Florida.

Remembering that the Lender Processing Services business model emphasizes speed over substance and LPS deploys lawyers for something like half the mortgages in default, it's impossible that these problematic practices of foreclosure attorneys are limited to Pennsylvania, Maryland and Florida.

For this problem, blame both the foreclosing banks and their foreclosure lawyers. Blame the banks, because it was their relentless cost cutting that got us the current foreclosure business model. Blame the lawyers, because they knew what they were doing was illegal and let their greed get the better of them.

The Mess That Is MERS

Fourth, and perhaps most problematic, is the MERS debacle.

MERS mortgages have questionable validity. Whether or not the MERS model is legal seems now to depend on which judge is making the decision. Cases in different states, and even within the same state, are coming out differently. Where the MERS model is illegal, foreclosures done by MERS or by the people it assigns the mortgage to have clouded titles. Even where the MERS model is legal, the system's incredibly sloppy record keeping could leave multiple banks believing they have the right to foreclose on a given property.

For the MERS problem, blame the following, in no particular order: Fannie Mae and Freddy Mac, who were instrumental in creating it; Covington and Burling, the law firm that blessed it; Moody's, for blessing it as well; and the big banks who ran with the flawed system and made it what it is today.

Fixing the Problem

Because real estate law is state-based, fixing the clouded title problem will take legislation in all 50 states. But before legislators get busy drafting bills, a much more detailed investigation of the problem in each state needs to be done. How many properties are involved? How many different types of title problems? How many different players helped cause the problem, and how can they be made to pay for fixing it? What should be done about the innocent buyers of illegally foreclosed property? What should be done about the borrowers who were evicted by the wrong bank?

It's a horrible mess. And it's one that the rush to cut a deal with the banks is blowing right past.