"Show Me The Note" and the Latest Foreclosure Mess

Via Paul Krugman, this article provides a good summary of the latest nightmare flowing from dubious lending practices and the securitization of mortgages. Krugman ponders, "You really have to wonder how all this gets resolved."

I suspect it will have to be solved legislatively.

A year ago I was skeptical of the "show me the note" defense, not that it doesn't have some validity but that it was being used by borrowers who knew that they owed the money against servicers who, although perhaps deficient in their paperwork, would ultimately provide a court with sufficient documentation to establish their right to foreclose. What I had not anticipated was the extent of both the problem, the sheer number of notes that appear to have been lost along the way, or the willingness of the servicers to engage in outright fraud to get around the deficiencies in their documentation.

At present a servicer who lacked the ability to properly document their right to foreclose could sue everybody up the chain to establish their rights in relation to the note, but that would be costly and cumbersome, and it could end up with the entity that thought it "owned" the note having recourse against those who assigned (or, should I say, claimed to assign) the note to them as opposed to the homeowner. There could be massive, multi-party suits designed to resolve the rights of the various financial entities involved in these transactions, but again that would seem more likely to result in the shifting of financial responsibility between financial institutions and not to resolve the issue of "Where is the note?" And the litigation would likely both highlight the extent of the mess and viability of the "show me the note" defense, while otherwise rearranging the deck chairs - the big issue isn't figuring out who can foreclose, but what happens if the financial industry is unable to foreclose on hundreds of billions of dollars in real estate.

It does not appear likely at this point that the legislative patch, making it difficult for homeowners to dispute out-of-state affidavits, that is falling to President Obama's pocket veto is likely to be revived. And it does not seem likely that state legislatures will respond in a way that will make it easier for lenders to foreclose based upon dubious affidavits when they can't produce the actual note. Also, as a number of people have pointed out,

But while we have at least some recognition that this document mess might force a lancing of the festering mortgage foreclosure infection, a predictable PR pushback is taking shape. From the very beginning, the servicers have taken the position that the document problems are mere “technicalities”. While that’s a stretch even with the affidavits (false affidativs are a fraud on the court), the problem of widespread failures to convey notes to the securitization trust isn’t a “technicality”; it means what were sold as MBS are potentially just unsecured consumer paper. And it goes further than that: if no notes were conveyed at closing, the trust under New York law (and all these trusts elected NY law for the trust operation) was “unfunded” meaning it does not exist (multiple top experts on NY trust law concur on this issue).

About the only way around all of these problems is to create a federal law (thereby preempting state laws) that would allow the various entities involved to resolve the issue of note ownership between themselves, with the conclusion of the process being binding on state courts. As a matter of due process, borrowers would be entitled both to notice of a proceeding pertaining to their mortgage and of the right to participate in the proceedings. Within such a system, I expect that the financial institutions involved would for the most part cooperate such that ownership claims could be quickly resolved. But should homeowners participate, in some (perhaps many) cases the lack of documentation could effectively result in a finding that nobody has the right to foreclose. (Are you beginning to see why preventing courts from effectively reviewing out-of-state affidavits was thought to be a better solution by the banks who pushed that bill through Congress?)

Update: Via Eschaton, the mortgage industry appears to be heading toward a storm of internecine litigation:

The Association of Mortgage Investors, a trade association, has called on trustees, who oversee loan pools on behalf of investors, to demand that loans be repurchased by their originators if required documents are missing. Typically, sellers have 90 days to fix such problems or buy back the loan. The group has also asked trustees to audit and hold servicers accountable for any losses due to improper servicer practices.

"It's very hard to see how the servicers can avoid reimbursing the trusts for losses caused by taking short cuts," said David J. Grais, an attorney in New York who represents investors. Investors could press trustees to investigate servicer conduct, sue the servicers to recoup damages or replace a servicer, he said.