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.

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