I say to my wife, my friends, my children, “don’t focus on the Dow. It’s too volatile. You’ll drive yourself crazy and not learn much of use.” But of course I peek at the Dow. Today it seared my eyeballs: down 300 points to 6763, the lowest in 12 years.

Missing Notes

Real estate mortgage foreclosure is pretty simple.  The borrower gives a promissory note to the lender to evidence the loan, the borrower fails to pay debt service when due, the lender accelerates the outstanding principal balance of the mortgage loan, obtains a court order to sell the real estate securing the loan, and auctions the property to the highest bidder.  The process rests on two plain-vanilla legal instruments, a promissory note and a mortgage.

Simple.  But take that mortgage loan, bundle it with 10,000 mortgage loans, sell the bundle to an investment bank, securitize the 10,000 debt service obligations, create A, B, and C tranches, and through financial alchemy you have new investment securities.  These securities can be an essential cog in the generation of capital for new mortgage loans or they can contribute to and exacerbate financial free-fall.  About 15 years ago I helped put together the first-of-its-kind (and, as far as I know, last of its kind) securitized pool of defaulted non-rated tax-exempt multifamily housing bonds. It was innovative, created a high tax-exempt yield for its purchaser, and worked.  Securitization can be a valuable tool.

Valuable, if the financial risks are handled properly and the mundane details don’t get lost in the shuffle.  Securitizing those 10,000 mortgage loans requires that the mortgage loan originator–a bank or mortgage company–assign the 10,000 promissory notes and related mortgage loans to whoever purchases the bundle.  Whoever securitizes the loans must place the notes and mortgages in a vault and track which set of legal instruments goes with which mortgaged property.  When Joe the Debtor defaults and the loan servicer hired to oversee the loans files for foreclosure it must present the original promissory note and mortgage to the court to prove that it owns the loan and is owed debt service payments.  No original promissory note and, usually, no right to foreclose.

It is distressing and depressing, but not surprising, to learn that keeping track of the notes and mortgages was not a Wall Street priority.  Bookkeeping is not sexy or lucrative.  Yet it is often the mundane details, the faulty O-ring, the failed anchor bolt, that brings down complicated machines.  The NY Times reported on Sunday “bankruptcy judges are finding that institutions claiming to hold the notes that back specific mortgages often cannot prove it.”  When this happen the court should hold the lender has no right to foreclose the loan.

Like everything else economic these days, no one knows how big a problem missing loan documentation might be.  The Times reports-

as messes go, this one has, ahem, potential. According to Inside Mortgage Finance, some eight million nonprime mortgages were put into securities pools in 2005 and 2006 and sold to investors. The value of these loans was $797 billion in 2005 and $815 billion in 2006.  If notes underlying even some of these mortgages were improperly assigned or lost, that will surely complicate pending legislation intended to allow bankruptcy judges to modify mortgage terms for troubled borrowers. A so-called cram-down provision in the law would let judges reduce the size of a loan, forcing whoever holds the security interest in it to take a loss. But if the holder of the note is in doubt, how can these loans be modified?

One more thing to watch.

Hiding in Plain Sight

I’m searching for the Army’s Fort Benning website to find information about graduation dates for my son’s  Officer Candidate School.  I click the link to the URL  The page fails to resolve and I receive this message: uses an invalid security certificate.  The certificate is not trusted because the issuer certificate is unknown.  (Error code: sec_error_unknown_issuer)

I receive the same message when I click the link to the U.S. Army Infantry Homepage and other Army links.  Firefox refuses to resolve to the URL.  I try the URLs in Internet Explorer and receive a message about an invalid certificate, but IE resolves to the page when I click through the warning.  I don’t find the graduation info I seek.

What’s up with these warnings?

Ahead of its Time

An article in last week’s National Law Journal titled “Law Schools Revamp Their Grading Policies” reports that Harvard Law School and Stanford Law School are switching from the traditional letter grading system to a pass/fail system.  According to the article they are switching “to create fairer evaluation systems and to better convey their students’ accomplishments to employers.”  This fall Harvard law students will receive grades of honors, pass, low pass, or fail.   Last fall Stanford adopted a similar system.  It is believed the grading system will better convey students’ accomplishments to employers, without suggesting that there is a material difference between one student with a GPA of 3.48 and another with a GPA of 3.42.  Not all law schools agree, of course–the article cites other law deans and students who support currrent letter/number grade policies.  Still, as in the old E.F. Hutton commercials (if you are old enough to remember them), When Harvard Speaks, People Listen.

I follow grading developments with interests as a teacher, an advisor to prospective law students, and a graduate (NUSL 1981) of a law school that has used pass/fail grading for over 30 years.  Northeastern University School of Law has dropped letter grades the early 1970s, replacing them with pass/fail grades supplemented by professor’s comments.  There are many reasons why the student culture at NUSL is different from other schools–larger percentage of students interested in public service law and larger percentage of women students, to name two–and the grading system plays a major role.  Students are more cooperative and less competitive when their employment success does not turn on edging out a classmate for a spot on law review by 05/100ths of GPA.  Observers ask “how can employers distinguish between students if there is no GPA?”  The answer is “quite easily.”  If my pass grade for civil procedure is accompanied with a comment that “you handled the summary judgment question adequately, spotting most of the major issues” and yours has the comment that “your analysis of the summary judgment issues was thorough, incisive, and brilliant” then an employer has a clear basis for deciding who to interview.  As for the extra work that might be involved in processing NUSL grades and comments, it may have been an issue in the 1970’s but coop and permanent employers had it figured out when I graduated in 1981.

So welcome to the future of law school education, Harvard.  If you have questions about how it works just take the Red Line across the river.