In the world of real estate, foreclosure has long been the ultimate sanction--a kind of capital punishment for the borrower gone bad. But some foreclosures are now facing legal challenges that threaten to delay or even derail the proceedings. That could spell more trouble for both lenders and investors in the giant market for mortgage-backed securities.
The notion that large numbers of homes across the country might one day have to be seized as security for mortgage loans seemed preposterous during the go-go days of the recent housing-market boom. As Wall Street collected millions of mortgages into giant securitization pools, one of the key legal procedures for transferring ownership of the loans appears to have been often ignored. At a minimum this lapse could impose extra costs on the mortgage industry when it can ill afford it. At the maximum it could open mortgage investors to an obscure legal attack by homeowners that in some cases could block foreclosure.
The problem stems from a shortcut that many players in the fast-moving securitization business have used in recent years. Normally, when a loan is sold, a simple document is prepared showing that the debt and any collateral attached to it has been transferred to the purchaser. That piece of paper is called an assignment. But in buying up thousands of mortgages at a time, Wall Street commonly skips this step, which requires separate paperwork for each loan. Instead, the industry customarily relies on a lengthy contract, known as a pooling-and-servicing agreement (PSA) to spell out arrangements for all of the loans in a pool. But, as some recent court rulings indicate, a PSA may not be good enough when it comes time to foreclose.
The problem drew attention in an Oct. 31 decision by Cleveland federal judge Christopher A. Boyko, who tossed out 14 foreclosure cases filed by Deutsche Bank National Trust on behalf of mortgage investors. Under a PSA, mortgages purchased from homeowners are transferred to a specially created trust, which then sells bonds to pension funds, mutual funds, and insurance companies. But without any formal assignment of the mortgages to the trust, Boyko said Deutsche Bank couldn't show it had the ownership required to initiate foreclosure. Four other Ohio judges have since dismissed dozens of foreclosure cases brought by other trustees on similar grounds. A Deutsche Bank spokesman says the bank simply served as a trustee of the trust and had no ownership interest in the properties.
In the wake of the Boyko ruling, which came as a surprise to Wall Street, mortgage-industry representatives said it would be easy for players such as Deutsche Bank (DB) to fix the technical problems and resume foreclosing on homes. That may be true, but these added steps will introduce costly delays and additional fees to the foreclosure process. Lawyers will have to draft assignment documents, paralegals will have to get them signed and recorded, and filing fees will have to be paid. "These deals operate on very, very thin margins," notes Joseph R. Mason, a finance professor at Drexel University in Philadelphia. Even an extra dollar a loan, he says, is "a huge cost."
There also could be a more troubling consequence for investors, says Kathleen C. Engel, a professor at Cleveland-Marshall College of Law. Players in the secondary market for mortgages rely on an obscure but critical legal theory--known as the "holder in due course" doctrine--to insulate themselves from problems with the underlying loans.
Under the doctrine, a homeowner who believes that a lender deceived him about the terms of a loan can't press such claims against the purchaser of a mortgage, such as a mortgage-backed securities trust. The holder-in-due-course doctrine protects pension funds and the like from having to worry about any misbehavior by home lenders--and thereby greases the wheels for the whole mortgage-securities market. But it's a different story if, as appears to be common practice, the trust waits to complete paperwork transferring a loan until after it goes into default. In that case, the holder-in-due-course protection evaporates, and anybody who tries to foreclose could face defenses from the borrower that he or she was lied to when seeking a loan.
For investors in mortgage securities, this nightmare scenario has not played out yet. But suddenly it seems a lot more plausible than it did just a few months ago. Foreclosure is turning out to be trickier than many on Wall Street anticipated. Observes David D. Dowd Jr., a federal judge in Akron who joined colleagues in trying to streamline the process for handling foreclosures when the housing bust hit: "I think they liked the procedure we set up--until we started asking nasty questions about whether they actually own the note."