Commentary: Mortgages Lost in the Cloud

The U.S. and other Western democracies have grown wealthy over the past three centuries for a simple reason: Their citizens have been able to establish clear title to land, buildings, and other property. So argues Hernando de Soto, the Peruvian economist, in his influential 2000 book The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. While people in developed nations can borrow against their property and use the money to start businesses and accumulate wealth, he wrote, squatters in countries like Peru have no such option. Property rights beget prosperity.

That's why the burgeoning foreclosure mess in the U.S. strikes at the nation's economic heart. Confusion is so rife that Bank of America (BAC), the biggest mortgage lender, suspended foreclosures in all 50 states to determine whether faulty documents were used to confiscate homes. Americans took their title-recording system for granted, abused it during the housing boom, and let it deteriorate. "Somehow in the last 10 or 15 years, everything that was good record-keeping isn't telling the truth anymore," says de Soto, reached by phone while traveling in Copenhagen. "My feeling is this: Your recession is going to last. And it's going to last, and it's going to last, because essentially the trust has broken down."

De Soto may be an alarmist, but he has correctly identified why the foreclosure mess is not a simple clerical problem. It's part of a broader breakdown in the financial world—the one that nearly caused a depression in 2008 when banks and other financial players couldn't tell whose balance sheets were stuffed with toxic subprime mortgage debt and whose weren't. Unable to trust one another, the big institutions pulled back from every asset except Treasury debt. At the height of the crisis, even stalwarts like AT&T couldn't borrow in the commercial paper market for durations of more than a day—meaning they were only 24 hours removed from default.

That crisis is past, but its causes aren't. Uncertainty still reigns. Its current manifestation is faintly ridiculous: Lenders can't say for sure who holds a mortgage—which means that sales can't go through. Buyers won't put down good money for a property if they aren't sure they'll get clear title to it, nor will lenders extend loans. Buyers of hundreds of billions of dollars' worth of mortgage-backed securities may have grounds to sue. That could "rock the market," says Joshua H. Rosner, managing director of Graham Fisher & Co., a research firm.

All this at a time when every imaginable bit of information—from your bank statement to your Facebook photos—seems to be stored in the cloud, ready for instant retrieval. Google "who owns my mortgage?" and you get a quarter of a million results in a quarter of a second. What the cloud can't tell you is what you really want to know, which is who actually does own your mortgage—that is, who has the power to throw you out on the street if you stop paying. The only way to verify that is to leave the cloud and dive into a recording system that predates the founding of the U.S.

Titles and mortgages on real property are officially recorded in county clerks' offices, a slow-moving, old-fashioned, deliberate world of ink, paper, and filing cabinets. The process has been perfected over a millennium, going back to the Domesday Book, the survey of English property completed in 1086 for William the Conqueror. This paper-based system, though admirably accurate and permanent, wasn't equipped for the era of rapid-fire refinancing and securitization. When over 8 million new and used homes are sold per year, as at the height of the boom, and most loans are packaged into securities, you need a lot of clerks.

The mortgage industry responded to the scale and speed of the modern housing market by creating an electronic overlay called Mortgage Electronic Registration Systems (MERS) in 1997. MERS, however, lacks the thoroughness and—more important—the legal standing of the old system. Some judges have rejected foreclosures based on MERS when the party claiming to hold the mortgage couldn't produce the note to prove to the court's satisfaction that it was in fact the creditor. The courts want to see paper.

State and local governments could have invested in digital record-keeping systems for real estate to preserve every legally important feature of the paper method, but with the speed and accessibility of a Google or a Facebook. Why didn't they? William Raftery, a communications and research specialist at the National Center for State Courts in Williamsburg, Va., says three things got in the way: state laws, which no one bothered to amend; court precedents dating back hundreds of years that demand paper records; and inertia. Says Raftery: "Things of this nature only happen when circumstances demand it."

The private sector couldn't afford to wait for government to catch up. Hence the MERS database, a unit of MERSCorp in Reston, Va., which was founded by Fannie Mae (FNM), Freddie Mac (FRE), and the mortgage industry. The concept was to avoid the cost and delay of recording the passing of loans from one party to another by naming Mortgage Electronic Registration Systems as the mortgagee for the lifetime of the loan, regardless of how many times it changed hands and to whom.

Some judges accepted MERS' right to foreclose on a delinquent homeowner. Others didn't. Instead of untangling the confusion early on, MERS forged ahead. It's now the mortgagee for more than 60 percent of new mortgage loans.

A promissory note—i.e., a paper I.O.U.—is the only legal proof of creditorship that courts ordinarily accept. Incredibly, though, the Florida Bankers Assn. told the state Supreme Court that when its members converted to electronic records, "the physical document was deliberately eliminated to avoid confusion." Further angering judges, MERS deputized bank executives to handle foreclosures, making it unclear who the people appearing in court really worked for. In Brooklyn, state Supreme Court Justice Arthur Schack in 2009 rejected a foreclosure in which a Bank of New York executive identified herself as a MERS vice-president. He called her "a milliner's delight, by virtue of the number of hats she wears." Ally Financial said in September that it found a "technical" deficiency at its GMAC Mortgage unit that let employees sign foreclosure documents without a notary present or with information they didn't know was true.

If the transition from paper to terabytes were unprecedented, it would be easier to give lenders a pass. But the banks behaved more straightforwardly in 2003 when they sought permission to digitize paper checks—a similar legal leap, since electronic copies had long been considered unacceptable in court. The banks lobbied Congress, which in 2003 passed the Check Clearing for the 21st Century Act. Now your monthly bank statement contains images of your checks instead of the paper, saving time and money. Because the reform was done with the blessing of Congress, there have been few problems.

MERS executives say their system will overcome legal challenges. "We find it very ironic that we're being accused of all these different wrongdoings when in fact we brought a lot of clarity to not just the industry but homeowners," says Karmela Lejarde, a MERS spokeswoman. There's some truth in what Lejarde says. This year, MERS opened its system so homeowners can find out for free online who their loan's servicer is and (usually, but not always) who owns the loan.

The problem is that the data in the MERS system isn't verifiable or legally binding. That recalls de Soto's insight into what made the U.S. work so well in the first place. "What characterized the rise of capitalism was that you actually created facts—statements that can be tested for truth. Now you've got plenty of information, but you don't have facts that can be tested for truth. Can you have a prosperous market economy without knowledge of who owns what and how they're related?" We know the answer to that one.

With John Gittelsohn

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