So I had a pretty incredible conversation last night with Christopher Peterson, the law professor and Associate Dean for Academic Affairs at the University of Utah, who wrote two illuminating Law Review articles about MERS, the shell entity that created an electronic database for the trading of mortgages. I’m going to do my best to summarize the findings of the interview, but I want to stress two things that I learned – 1) this is very heady stuff, tied up in contract law and all sorts of associated legal issues, 2) absolutely nobody in this country knows with any certainty how this is going to play out.
With that as a base, here’s the gist of the conversation.
It’s important to know from the beginning that MERS is a wholly owned subsidiary of big financial institutions. The mortgage bankers wanted to avoid recording fees and reduce their overall expenditures. So they basically devised a method that would free them from those fees, ran an accounting study showing the savings, and just created MERS. There was no public debate or legislative statute to overturn what had been the customary practice for generations. The money backing MERS came from investors, according to Peterson, including some of the biggest banks and mortgage brokers in the country like Bank of America, Citi, and Countrywide, as well as Fannie Mae. You can see all their shareholders right here. It’s just a creation of the banks.
There are actually two MERS companies at this point. There’s MERSCORP, which owns some physical assets, including an office location in Reston, Virginia, and has about 60 employees, including a group of lawyers. There’s also MERS Inc., which has zero employees. This shell company is the one listed as the “mortgagee” on about 60 million American homes, or 60% of the total mortgage market.
Peterson described MERS to me as “a big Excel spreadsheet,” where financial institutions can input mortgage trades and information. “I don’t even like the word tracked,” he said. “They don’t assign records or anything.” The servicers use it to make a loan or a trade, and MERS stays as the mortgagee throughout the duration of the loan. This avoids recording the mortgage change each time with the county recorders office, altering the tradition for hundreds of years of recording the mortgage. This particularly becomes important if there’s a dispute on the property, which is what we’re dealing with now.
The other advantage of using MERS is that they will bring the foreclosure action instead of the mortgage servicer. This has tactical advantages; companies don’t have to take the PR hit of foreclosing on borrowers. In addition, Peterson said that some judges might not ask to produce the promissory note if MERS does the foreclosure action as the mortgagee. While MERS stipulates that the servicers must convey the promissory notes to MERS, it appears they didn’t do that in all or even most cases, and the underlying paperwork could be lost.
Because MERS has no personnel to bring foreclosures, they basically outsource the operations back to the servicers and foreclosure mills, just as the assignment of the mortgage was outsourced to them. Employees of the servicers simply pretend to be Vice Presidents or assistant secretaries or certifying officers of MERS Inc. Therefore, a company with no actual employees has thousands of Vice Presidents and certifying officers.
“I don’t think it’s legal, but whether it’s legal or not remains to be seen,” said Peterson. “The appellate courts haven’t dealt with it yet. MERS is a new system and they often settle cases, making it difficult to litigate through state courts (which have the jurisdiction). Plus, the defendants are usually borrowers almost always in foreclosure, and many don’t hire attorneys or can’t afford good ones.”
State Supreme Courts in three states – Kansas, Arkansas and Maine – have come out and said that MERS is not a mortgagee and has no standing to foreclose. Last September, in Kansas’ ruling, they compared MERS to the parable of the blind man in India touching an elephant, Peterson said. “How he describes the elephant depends on what part he’s touching at any time.” Sometimes MERS, if being sued over violating some consumer protection statute, describes themselves as merely an agent or a nominee, without a meaningful economic right to foreclose. But if they bring foreclosure actions, they call themselves the mortgagee. It’s extremely novel, and though depositions are just starting to capture this, it’s not clear what all the consequences are.
“If you sign a promissory note on the back with your name, like endorsing a check, even a thief can cash it,” Peterson explained. “So if MERS came into possession of promissory notes for mortgages, they would have standing based on holding it. They relied upon this in court. But this hasn’t worked out so well, because the financial institutions can’t find the promissory notes!”
Which brings us to the important question of where this all goes. If you have 60% of the mortgage market where nobody has standing to foreclose, these “MERS-infected assets,” as Peterson calls them, what happens to these millions of homes?
As I said, nobody really knows. “In the short-term it’ll be much more difficult for foreclosures, especially in judicial states,” Peterson said. “The potential fallout can get much worse if several different legal problems that the mortgage finance industry is facing starts to shake out in ways unfavorable to them in different states.”
MERS has been ruled not a mortgagee in three states; if applied nationally, then on 60 million mortgages in the United States, perhaps nobody can really foreclose. Importantly, that doesn’t mean the debt goes away; more likely it means that the loans become unsecured debt, like credit cards, instead of mortgages. The home essentially transfers to the borrower, in a sense. “This causes breakthtaking problems for the investors (in mortgage-backed securities). Good news for those facing foreclosure,” Peterson said.
Lenders or investors could sue on the debt, and those judgments “could be turned into judgment liens,” said Peterson. But that would be subject to a homestead exemption, which could protect the home, depending on the state, from creditors. “That’s why OJ moved to Florida,” where the homestead exemption is very large.
Another possibility is that the courts could impose an equitable mortgage on the borrower on behalf of the investors. “This is a rare and unusual remedy, given normally when there’s a technical defect” in the mortgage, according to Peterson. But that’s basically where we’re at.
In that case, the judge would have a lot of discretion to set the terms of the equitable mortgage. The judge could look at an option-ARM mortgage with an exploding interest rate and say “I can reform it in the interest of justice.” Essentially, a regular court, not a bankruptcy court, could resolve the problems with title and standing to foreclose by implementing something that looks a lot like cramdown. This would depend on the individual judge, of course, and the equitable mortgage might have a different legal status, particularly in bankruptcy. But in the main, “it might not be that different than the proposal we saw in Congress… to allow the modification of home mortgages,” Peterson said.
In addition to what borrowers might expect as relief, the investors suing to have the servicers repurchase the securities “seems like a huge problem,” Peterson said. The investors have a strong case, he added, because the agreements made on the purchase of mortgage-backed securities stipulate that the depositor promises to convey over the promissory notes and transfer them into the possession of the trustee. “In many cases they didn’t do that,” and if the investors put in their money based on the representations from those pooling and servicing agreements, they have a right to expect their money back, plus interest. “Say you go to your car dealership and the dealer says you’ll get a Ferrari, but you get a beat-up Hyundai. How can the courts not allow you to get your money back?” he said.
Informed that the Federal Home Loan Bank of Chicago on Friday sued several of the nation’s biggest banks for just this reason, Peterson responded, “It’s happening. Oh my gosh!”
“That has the potential to have a massive effect on the economy and the future resolution of this national crisis.”