In the securitization boom that preceded the financial crisis, people became sloppy about the technical details of transferring residential mortgages from the originator to intermediaries and ultimately to real estate mortgage investment conduit (REMIC) entities for securitization. Bradley T. Borden and David J. Reiss described the magnitude of the mess, and its possible legal, tax, and practical consequences, in the cover article of the May/June 2013 issue of this publication.
Notes were not properly endorsed. Lenders lost them. Assignments were never recorded, or were recorded in the wrong order or with gaps. Transfers that should have been made weren’t. Notes followed one path of transfers, mortgages another. When the music stopped, enforcement became a problem because servicers couldn’t figure out the paper trail. To fill gaps, those in the back room sometimes undertook a goal-oriented creative writing program.
Because of all that sloppiness, transferees of loans sometimes flunked the basic tests to become holders in due course. Borrowers faced the theoretical risk of having to pay their loans twice. REMICs maybe failed to qualify under the tax law, exposing their investors to tax disasters.
One might add that, as a result of all this, mortgage borrowers in default have had a field day delaying or even derailing foreclosures by claiming that the plaintiff lacked standing because it couldn’t prove ownership of the note and mortgage. And when loan servicers tried to clean up the files, borrowers cried fraud and robo-signing, while remaining in default.
Next time around, Borden and Reiss argue, we should do it right. Legal technicalities and niceties do matter. When we move mortgages, we should get the notes properly endorsed, the right assignments signed, and everything recorded both promptly and correctly.
Yes, the securitization boom left behind a mess. Yes, messes are bad. But there’s more to the discussion. The post-securitization residential foreclosure mess should prompt larger questions about how we evidence, document, and transfer ownership of mortgage loans.
Does our system make any sense at all? Do the technical requirements that Borden and Reiss describe—now creating so much trouble for foreclosures—still serve any purpose in the 21st century? They certainly create tremendous paperwork, complexity, and legal issues, most of which seem entirely spurious and unnecessary.
They also create tremendous opportunities for error. As Borden and Reiss show, the mortgage origination and securitization industries seem to have fully seized all those opportunities. But do those troublesome technical requirements give anyone any protection that matters?
Yes, it’s certainly nice for a mortgage holder to be a holder in due course. But how often does holder-in-due-course status matter for today’s institutional residential mortgages? How often does the purchaser of such a loan actually benefit by taking free of defenses based on fraud or previous payment? How often has a loan purchaser been able to enforce against the borrower a previously repaid loan just because the purchaser was a holder in due course?
Today’s residential mortgages are so wrapped up with consumer protections that any holder of the loan would have trouble enforcing a mortgage loan that was truly subject to, for example, fraud in the inducement. As a practical matter, in the world of residential mortgages all defenses probably travel with the loan, so holder-in-due-course status has no real significance to a mortgage purchaser. It matters for checks and commercial transactions, but not for residential mortgages.
Borden and Reiss point out that traditional requirements for endorsement and delivery of the original promissory note also protect the borrower from the risk of having to pay the loan twice. While that risk may exist in theory, if the borrower had in fact paid the loan, that would typically provide a complete defense against foreclosure.
Any discussion that treats promissory notes as a measure to mitigate the risk of double payment relies on the fantasy that when the borrower repays the loan, he will demand that the lender prove possession of the note and the right string of endorsements.
If any residential borrower actually asked to see the note at the time of payoff, the servicer’s first response would consist of confusion and laughter. When his laughter died down, the servicer would explain that the note was lost years ago. Or perhaps the servicer might advise the borrower to speak to someone else in some other department that never answers the phone. The borrower would eventually give up.
Practically speaking, in today’s world, the main function of any original promissory note consists of getting lost.
If any mortgage borrower anywhere in the United States had ever actually needed to pay their mortgage loan a second time to keep their house, we would all have heard about it; even one instance would have prompted a tremendous outcry. But has anyone ever heard of that actually happening?
Even if requirements for presentation of the note could prevent the risk of double payment, they wouldn’t achieve that goal, for two reasons. First, as mentioned, many notes get lost. Second, residential lenders often require the borrower to sign multiple original notes. In other words, the requirement for a mortgage holder to show possession of the note doesn’t actually give the borrower much protection.
Outside of real estate, many loans no longer require promissory notes, nor are they burdened by the technical requirements of the recording system or of negotiable instruments. No one cares about original notes, or holder in due course. Borrowers in those transactions have not faced an epidemic of double payment claims. Purchasers of these loans, or interests in them, haven’t suffered great losses for lack of an original piece of paper or holder-in-due-course status.
Unlike mortgage assignments, corporate stock and other financial instruments are transferred electronically with little to no documentation. The transfer system itself keeps track of everything. If corporate stock transfers followed the mortgage model, every corporation would have its own detailed set of rules, requirements, fees, filings, and forms for stock transfer documentation. Every transfer of a single share of stock would require dealing with multiple pieces of paper with numerous signatures and could take weeks, with endless opportunities for problems and mistakes. Transferring 100 shares would require 100 sets of fully compliant documentation. But none of that happens, because the corporate stock transfer system is simple, functional, reliable, and largely electronic.
The 21st century is a great time to revisit the legal principles and practices that drive the complexity and paperwork that led to the mistakes described by Borden and Reiss.
We could start by eliminating promissory notes in mortgage transactions. Instead, we could document real estate loans as contractual promises in which possession of an original piece of paper has no particular significance. A promissory note is not essential to evidencing an obligation to pay, secured or not. Ownership of a loan could be presumptively determined based on an institution’s books and records, and a history of loan payments.
We might even go a few steps further and establish a central registrar to keep track of who owns mortgage loans and who has the right to foreclose. Transfers could be confirmed electronically, with no paperwork at all. A registrar’s certificate would evidence the right to foreclose.
The Mortgage Electronic Registration System (MERS) seemed like a great move in that direction. MERS contemplated that a lender would record its mortgage once, in favor of MERS, then any future mortgage assignments could take place electronically, without the paperwork, pitfalls, delays, and variations—and now legal issues—entailed by generating and filing documents with thousands of recording systems across the United States.
But the same antiquated legal notions that created so much trouble for mortgage assignments have also created trouble for MERS. County clerks anxious to protect revenue, employment, and the importance of their offices joined forces with the foreclosure defense bar to try to derail the MERS train. Judges seized the opportunity MERS gave them to help defaulting borrowers stay in their homes, and to create new law—and to achieve good consumer protection headlines—in an area that suddenly assumed great public importance. The result: a MERS mess with conflicting decisions from coast to coast, and many more months of borrower defaults with impunity.
That doesn’t mean MERS was a bad idea. Our leaders should figure out how real estate law can accommodate and support MERS and move into the 21st century. The idea of a single central registry for mortgage transfers makes sense. It would make even more sense to expand that central registry to cover all property-related transfers, replacing a system that often seems as outdated as quill pens and parchment.
Any proposal to blow up and re-create our system of land records and mortgage loan assignments will face a predictable set of objections. Jobs will be lost, though other jobs created. Tax collectors might have trouble collecting taxes. The transition process won’t go perfectly. After the transition, real estate lawyers and paralegals will have less work to do. Will the system adequately protect and preserve online data? Will it invade privacy? And, of course, it might create new opportunities for fraud.
A better system for mortgage assignments would also speed foreclosures. Would that be so bad? If a borrower can no longer afford his house and the market won’t let him sell for more than the mortgage balance, then he doesn’t really own the house anyway. The mortgage holder does, for all practical purposes. Every month the borrower has the option to keep the house by making that month’s payment. If he can’t make those payments, or chooses not to, that’s unfortunate, but he still doesn’t have any equity in the house. He should find a new place to live, just as millions of other Americans do each year.
Foreclosures are part of any mortgage finance system, one possible outcome when someone borrows money and grants security. If we can’t stomach residential foreclosures, maybe the federal government should just buy everyone a house.
Commercial real estate is, of course, a different story. It is less fungible than houses. The roles of borrower and lender are more complex, nuanced, and interrelated. The identity of the borrower matters. And commercial foreclosures do not seem to have experienced the same problems as residential foreclosures.
Aside from speeding up residential foreclosures, any attempt to fix loan transfers will also raise well-founded concerns that trying to change anything will just make it worse. But if we take a gradual and careful approach—perhaps moving state by state—to bringing our real estate documentation and security systems into the 21st century, then over time it should be possible to overcome these and other objections. The United States did something like that, though not as dramatic, when Revised Article 9 became effective in 2001. Nothing too disastrous happened.
Some would argue that today’s system protects mortgage borrowers by making it hard for mortgage lenders to spuriously enforce a mortgage loan that they don’t own or perhaps that isn’t even in default. Today’s system may do that. Aggressively applied by the courts, it puts mortgage lenders to the test and forces them to prove they own the loan they want to foreclose. When paperwork deficiencies prevent the lender from proving standing, the lender gets thrown out of court.
In these cases, however, the borrower is still in default. And, realistically, lenders don’t often try to foreclose on loans they don’t own or that aren’t in default. When the court throws lenders out of court because of issues of standing, the defaulting borrower gets to keep her house, at least until the right paperwork gets lined up and submitted. In that time, as long as four years for a residential foreclosure proceeding in New York, the borrower typically doesn’t pay debt service, insurance, or real estate taxes. Once in a while the defaulting borrower gets really lucky: the paperwork is so bad that no one actually has the right to foreclose.
All of this produces extraordinarily long, complex residential mortgage foreclosures, destabilizing neighborhoods and preventing property values from recovering. When it isn’t clear who owns a property and no one has an incentive to maintain it, and nothing about the foreclosure gets resolved quickly, the mortgage collateral inevitably festers and deteriorates. Today’s clumsy system for documenting mortgage loan transfers puts properties into legal limbo for years as a result of paperwork requirements that might be quaint and funny if they didn’t create so much trouble.
Let’s assume, though, that a genuine risk exists that a mortgage lender might in fact try to foreclose a loan it doesn’t own against a borrower who isn’t in default. To address that risk, one could say that if a mortgage borrower ever lost his house under any such circumstances, he should be entitled to recover treble (or more) damages, plus attorney’s fees, from the originator of his mortgage or whoever wrongfully took his house. The borrower would have the same right if she were forced to pay the same loan twice. Some state laws may already give borrowers rights like these; there, no change in law would be necessary at all.
With suitable safeguards, a streamlined system to track mortgage assignments would give borrowers ample protection.
In a separate discussion, Borden and Reiss also argue that technical glitches in transfers of mortgages may have caused many REMICs to fail the various technical tests established under the Internal Revenue Code. The solution to that problem, if it really is one, would be much easier to adopt than other measures suggested earlier in this article.
Solving the REMIC problem would require nothing more than a technical amendment to the Internal Revenue Code, which is, after all, entirely capable of being amended. The Code should say that as long as a REMIC directly or indirectly holds the risks and benefits of a mortgage loan, and cleans up any technical imperfections in its ownership within a reasonable time after learning of them, that should be just as good as if the REMIC actually owned the loan.
The apparent lack of publicized REMIC disqualifications to date may tell us that the IRS applies the REMIC requirements with the practicality and flexibility suggested in the previous paragraph. If that’s true, then perhaps nothing need be done.
The problems Borden and Reiss describe do definitely cry out for action—but not necessarily the action they suggest. Instead of exalting the technicalities of the current system, we should get rid of them. We should massively simplify loan transfers and revise the law as necessary to do that.
Joshua Stein PLLC
New York, New York