The foreclosure fraud mess continues. Bank of America, one of the top four lenders in the country, has expanded their freeze on foreclosure operations to all 50 states, beyond the 23 states which require a judicial sign-off.

I imagine they’ll be only the first, given their role as a market leader. We’re going to have a de facto moratorium on foreclosures, if not one put in by the government.

Why would BofA be concerned about foreclosure process in non-judicial states? This really comes back to title ownership. The Washington Post story on MERS today was really, really important to understand the fraud at the heart of this.

Mortgage Electronic Registration Systems, headquartered in a nondescript office building in Reston Town Center, has flourished quietly over the past decade, saving financial firms hundreds of millions of dollars by helping them avoid the time and expense of filing mortgage documents and paying fees each time a loan changes hands.

Its motto: “Process loans, not paperwork.”

But lawyers throughout the country increasingly are challenging that approach, questioning whether the company has the legal right to foreclose on homes, on the grounds that it doesn’t actually own mortgages. And the argument is gaining traction with some judges [...]

The company is an integral part of the system that emerged during the global housing boom, when mortgages were created and sold, sliced and diced, packaged and repackaged so quickly that financial firms had neither the time nor the patience to file paperwork in local courthouses as the loans were traded. By using MERS, lenders were able to reassign loans quickly and cheaply. But often the chain of ownership was not accompanied by an official paper trail.

The MERS registry tracks more than 65 million mortgages throughout the country and continues to facilitate rapid-fire transfers that keep the market for mortgage-backed securities humming.

But if courts increasingly begin to nullify the MERS model – different judges have issued differing rulings – this could call into question the legitimacy of millions of mortgages, wreak havoc on the real estate market, spur costly litigation against Wall Street banks and ultimately harm the broader financial system.

Basically every big lender in the country used MERS to trade mortgages. MERS facilitated this “financial innovation.” But they basically didn’t secure the kinds of records required by law. As a result, lenders looking to foreclose cannot actually come up with the paperwork showing a legal title on many homes. In fact, some lawyers are challenging MERS’ claim to reassign loans, calling into question a process that has been used since 1997.

That’s a huge mess. And as Brad Miller explains, the liabilities for the banks are enormous:

Brad Miller: There is massive potential liability for the securitizers, which are mostly the biggest banks. The contract was that if mortgages didn’t meet certain requirements, then the securitizer would buy them back. The mortgage servicers and trustees have exclusive control over the paperwork. Both the investors, the people who own the mortgage-backed securities, and the homeowners, really depend on them. There’s been lots of litigation where investors try to get securitizers to buy back the bad mortgages because they were flawed, but that litigation has been stymied by procedural objections. If the private investors can break through that defense and require the mortgages that don’t meet the requirements to be bought back, the liabilities for the biggest banks will be enormous.

EK: So this is, in other words, a problem for bank balance sheets. These banks bought the mortgages from individuals, packaged them into securities, and then sold them to investors. But because the mortgage contracts weren’t valid, the investor can potentially force the banks to take the mortgages back, thus blowing a new hole in their balance sheets?

BM: Right. They’ll have to buy them one mortgage at a time. Someone said there might be a second round of bank insolvencies because of this and there might need to be more TARP. There is no chance that Congress would pass more TARP.

This is why the banks are stopping the foreclosure processes. They need to understand the liabilities here.

Is this bad for the economy? First of all, that’s irrelevant to the rule of law. The banks created this mess, after all. And it was going to have to unwind sooner or later. But it really doesn’t have to cripple the economy (a lack of stimulus is doing that on its own, actually). The lenders can assess the risks, and make the conclusion that the best-case scenario for them is to modify loans on a massive scale. The effect on consumer spending and consumer confidence would be enormous. It’s only “bad” if you view the economy as what’s best for Bank of America. Beyond that, as Miller darkly notes, “At the least, we now have resolution authority that we can take out for a spin.”

UPDATE: Harry Reid pounces:

“I thank Bank of America for doing the right thing by suspending actions on foreclosures while this investigation runs its course. It is only fair to Nevada home owners to suspend foreclosures until a thorough review of foreclosure processes is completed and home owners can be assured that their documents are being analyzed properly, ”said Reid. “This is good news in what has been a bad time for many Nevada families who are going through foreclosure or at risk of losing their home. I urge other major mortgage servicers to consider expanding the area where they have halted foreclosures to all 50 states as well.”