The Mortgage Machine Backfires

The Mortgage Machine Backfires

By Gretchen Morgenson | 26 September 2009

With the mortgage bust approaching Year Three, it is increasingly up to the nation's courts to examine the dubious practices that 'guided' the mania. A ruling that the Kansas Supreme Court issued last month has done precisely that. It has significant implications for both the mortgage industry and troubled borrowers.

The opinion spotlights a crucial but obscure cog in the nation's lending machinery: a privately owned loan tracking service known as the Mortgage Electronic Registration System (aka, MERS). This registry, created in 1997 to improve 'profits and efficiency' among lenders, 'eliminates' the need to record changes in property ownership in local land records[!?!] Dotting i's and crossing t's can be a costly bore, of course. And eliminating the need to record mortgage assignments locally helped keep the lending machine humming at hyperspeed during the boom.

But the MERS system also led to confusion. When MERS was involved, borrowers who hoped to work out their loans couldn't identify who they should turn to. And now, however, this 'clever' setup (for those 'clever' mortgage asset packagers) is coming under fire. Legal experts say the fact that the most recent assault comes out of Kansas, a state not known for radical jurists, makes the ruling even more meaningful.

Here's some background: For centuries, when a property changed hands, the transaction was submitted to county clerks who recorded it and filed it away. These records ensured that the history of a property's ownership was complete [[and 'freely' (notwithstanding minor administrative fees) and readily available to all: normxxx]] and that the priority of multiple liens placed on the property— a mortgage and a home equity loan, for example— was accurate. During the mortgage lending spree, however, home loans changed hands constantly [[and rapidly: normxxx]]. Those that ended up packaged inside of mortgage pools, for instance, were often involved in a dizzying series of transactions.

To avoid the costs and complexity of tracking all these exchanges, Fannie Mae, Freddie Mac and the mortgage industry set up MERS to record loan assignments electronically. This company didn't own the mortgages it registered, but it was listed in public records either as a nominee for the actual owner of the note or as the original mortgage holder. Cost savings to members who joined the registry were meaningful. In 2007, the organization calculated that it had saved the industry $1 billion during the previous decade. Some 60 million loans are registered in the name of MERS.

As long as real estate prices rose, this system ran smoothly. When that trajectory stopped, however, foreclosures brought against delinquent borrowers began flooding the nation's courts. MERS filed many of them.

"MERS is basically an electronic phone book for mortgages," said Kevin Byers, an expert on mortgage securities and a principal at Parkside Associates, a consulting firm in Atlanta. "To call this electronic registry a creditor in foreclosure and bankruptcy actions is legal pretzel logic, nothing more than an artifice constructed to save time, money and paperwork". As cases filed by MERS grew, lawyers representing troubled borrowers began questioning how an electronic registry with no ownership claims had the right to evict people.

April Charney, a consumer lawyer at Jacksonville Area Legal Aid in Florida, was among the first to argue that MERS, which didn't own the note or the mortgage, could not move against a borrower. Initially, judges rejected those arguments and allowed MERS foreclosures to proceed. Recently, however, MERS has begun losing some cases, and the Kansas ruling is a pivotal loss, experts say. While the matter before the Kansas Supreme Court didn't involve an action that MERS took against a borrower, the registry's legal standing is still central to the ruling.

The case involved a borrower named Boyd A. Kesler, who had taken out two mortgages from two different lenders on a property in Ford County, Kan. The first mortgage, for $50,000, was underwritten in 2004 by Landmark National Bank; the second, for $93,100, was issued by the Millennia Mortgage Corporation in 2005, but registered in MERS's name. It seems to have been transferred to Sovereign Bank, but Ford County records show no such assignment.

In April 2006, Mr. Kesler filed for bankruptcy. That July, Landmark National Bank foreclosed. It did not notify either MERS or Sovereign of the proceedings, and in October, the court overseeing the matter ordered the property sold. It fetched $87,000 and Landmark received what it was owed. Mr. Kesler kept the rest; Sovereign received nothing.

Days later, Sovereign asked the court to rescind the sale, arguing that it had an interest in the property and should have received some of the proceeds. It told the court that it hadn't been alerted to the deal because its nominee, MERS, wasn't named in the proceedings. The court was unsympathetic. In January 2007, it found that Sovereign's failure to register its interest with the county clerk barred it from asserting rights to the mortgage after the judgment had been entered.

The court also said that even though MERS was named as mortgagee on the second loan, it didn't have an interest in the underlying property. By letting the sale stand and by rejecting Sovereign's argument, the lower court, in essence, rejected MERS's business model. Although the Kansas court's ruling applies only to cases in its jurisdiction, foreclosure experts said it could encourage judges elsewhere to question MERS's standing in their cases.

"It's as if there is this massive edifice of pretense with respect to how mortgage loans have been recorded all across the country and that edifice is creaking and groaning," said Christopher L. Peterson, a law professor at the University of Utah. "If courts are willing to say MERS doesn't have any ownership interest in mortgage loans, that may eventually call into question the priority of liens recorded in MERS's name, and there are millions and millions of them". In other words, banks holding second mortgages could find themselves in the same pair of unlucky shoes that Sovereign found itself wearing in Kansas.

Asked about the ruling, Karmela Lejarde, a spokeswoman for MERS, contested the court's reasoning. "We believe the Kansas Supreme Court used an erroneous standard of review; this is not the end of the judicial process," she said. "The mortgages on which MERS is the mortgagee will remain binding contracts."

But Patrick A. Randolph, a law professor at the University of Missouri, Kansas City, who describes himself as "a friend of MERS", described the recent decision as unsettling. "This opinion is hostile to the notion of MERS as nominee and could lead to problems for it in foreclosing," he said. "The entire structure of MERS as a recorded nominee could collapse in Kansas, and that could lead to a patch-up job where they would have to run around and re-record the mortgages."

If so, MERS would be hoisted on its own petard. And it would be a rare case of poetic justice in this long-running mortgage mess. [[Well, maybe not so poetic, as the eventual 'stuckees' for those mortgages will actually be the buyers of most of those ABSs— pension funds, retirement funds, insurance companies, municipalities, private individuals— even foreign cities.: normxxx]]