Have a REO & Short Sale Business? Might Want to Track This…

From the dusty files of the excruciating minutiae of bankruptcy court proceedings (courtesy of the NY Times) comes this story:

But while banks may have booted a few robo-signers and tightened up some lax procedures, one question at the heart of the foreclosure mess refuses to go away: whether institutions trying to take back a property can prove they even have the right to foreclose at all.

Some in the industry believe that questions about this issue — known as “legal standing” — are trivial. They say it’s just a gambit by borrowers’ lawyers to throw sand in the foreclosure machine. Nine times out of 10, bankers say, the right institutions are foreclosing on the right borrowers.

Maybe so. But the United States Trustee Program, the unit of the Justice Department charged with overseeing the integrity of the nation’s bankruptcy courts, is taking a different view. The unit is stepping up its scrutiny of the veracity of banks’ claims against borrowers, and its approach is evident in two cases in federal bankruptcy court in Atlanta.

This, to put it mildly, could be a thermonuclear land mine. There’s no reason to panic yet, since no court has ruled on the standing issue, but the action by the U.S. Trustee hints at the possibility that this issue will become larger and larger, and likely require significant litigation to resolve. And looming in the background? MERS… which is not tech-speak for merde, but the entrance of the DOJ (the parent department of the U.S. Trustee) could result in a major merde-storm.

Legal Standing, For Laymen

What the hell is “legal standing” anyhow, such that this could be an issue, when the industry as a whole thinks this is a non-issue, no problemo, whachutalkinabout Willis? You could read this or this, and know that it’s a fascinating area of procedural law. But really, what legal standing means is that someone has the right to bring a lawsuit at all. It’s the legal equivalent of a Court saying, “So… what’s it to ya?”

Say some scam artist rips off my neighbor for $50,000. I’m outraged! I sue the scammer in court, and the court goes, “Okay, so this scammer fella ripped someone off. Was it you?” I say, “No, not me, but my neighbor.” The judge goes, “Yeah, okay, so what’s it to you?” and throws my case out of court. Because I lack standing. I’m not the injured party; my neighbor is. Unless my neighbor makes me his agent (not real estate agent, but legal agent) or sells me his claim or something (which may or may not be valid), I’m just a busybody pokin’ my nose in where it don’t belong.

There are some legal rules for when a party has or doesn’t have standing (yeah, what else would you expect from a bunch of lawyers?) but for our purposes, legal standing is an issue because if one of the parties to a foreclosure action lacks standing, the whole thing gets thrown out.

Why Standing Might Be An Issue

This latest news about the U.S. Trustee taking a position comes at the heels of some real action centered around MERS, the Mortgage Electronic Registration System. Read this for a good overview. Boil it down and what you have is that banks were buying and selling mortgages quite a bit on the secondary market, whether as whole loans or placed into a RMBS pool or whatever. At the heart of the whole deal, however, is a promissory note by some borrower, who makes a promise to some bank, that he will repay $XXX over some period of time. That’s the core document: a legal contract between Borrower and Lender (plus, the actual mortgage note).

The Lender might sell the note, the right to receive payment from Borrower, to someone else. In property law, all such transfers are supposed to be recorded at the county office, a time-consuming, lengthy, arcane practice from the bowels of the 16th century. MERS created a database where banks could register a mortgage and then buy and sell them without having to go through the paperwork that would otherwise be necessary. It appears that the bank would assign the mortgage to MERS, who then goes and files the paperwork, but then internally, within its system, banks would buy and sell the mortgage to each other, and have MERS track who owns what electronically, with MERS as the lienholder of record as far as the county office is concerned. It’s actually a brilliant little system to get around 18th century process in the 21st century.

Trouble is, MERS might lack legal standing to bring a foreclosure action. At least, that’s what the attorneys for the homeowners who are getting foreclosed are claiming.

Given that so many mortgages were packaged into securitization pools (RMBS), sliced and diced, with different investors taking a different piece of a few hundred thousand pooled mortgages… it really isn’t clear who actually owns the mortgage, and has the right to enforce its terms by foreclosure (or have its duly authorized agent/servicer do it).

Why This Is A Thermonuclear Device

The best overview of why legal standing might be a major issue comes from our friends across the Pacific, in Australia. From the Business Spectator:

Banks may not have, or may never have had, the mortgage notes. This may mean banks will have to stop foreclosures for months as they track down these notes.

A much more worrying problem for the banks is if US courts decide that this failure to properly transfer the physical mortgage notes associated with their home loan means that the “chain of title” has been broken. This would mean that the person who took out the loan to buy the house no longer owes the loan, and the bank has no right to foreclose.

There are fears that the whole US housing sector could be thrown into disarray if the title insurance companies start refusing to provide insurance. In every sale, a title insurance company provides insurance that the title is free and clear. And there are fears that title insurance companies are beginning to shy away from providing insurance because they don’t want to expose themselves to the risk that the chain of title had been broken, and that the bank had illegally foreclosed on the previous owner. (Emphasis added)

Oh boy. Just imagine the impact of some 64 million mortgages (and 60% of all new mortgages) being declared void because the chain of title has been broken. Does the word KABOOM enter the mind? That’s probably the collapse of the global financial systems right there.

You may have heard about various banks, like Bank of America, JP Morgan Chase, etc. suspending foreclosures in some 23 states. Here’s how the WSJ reported it:

At the root of all three announcements are “robo-signers,” middle managers who sign affidavits that allow banks to repossess homes that are in default, without properly reviewing the loan documents. One GMAC employee, Jeffrey Stephan, admitted in depositions that he authorized up to 10,000 foreclosures a month without seeing the files associated with them. At Chase, Beth Ann Cottrell, a robo-signer in Ohio, told a lawyer in a sworn deposition that she signed off on about 18,000 foreclosure affidavits and other documents a month without reviewing all the files.

That’s a problem, sure. But I don’t know that BofA and other major banks would simply suspend foreclosures due to robo-signers and other procedural problems, and then suspend only in the 23 states where foreclosures are handled through the courts. The real problem, and the one that BofA is rather eager not to bring before a court, is the legal standing issue.

Enter the U.S. Trustee

That’s all background. What’s new as of today is the intervention by the United States Trustee for bankruptcy into the issue of legal standing. The NY Times reports on one Trustee, Donald Walton in Georgia, who filed two motions recently in bankruptcy court opposing a bank’s motion to lift the automatic stay so that it can foreclose on the debtor’s house. Because this came in bankruptcy court, with homeowners who were declaring personal bankruptcy, rather than through the normal courts where foreclosures and real estate matters might be brought, it may be that the standing issue sort of snuck through.

Here’s the key part of Walton’s motions:

5. The Motion for Relief fails to state sufficient facts from which this Court can grant the requested relief. Particularly, the Motion for Relief fails to state any facts from which the Court can conclude that the entity seeking relief, Wells Fargo, is entitled to enforce the note and security deed, as alleged in a conclusory manner in the Motion for Relief. Wells Fargo attached no exhibits to the Motion for Relief.

6. If Wells Fargo seeks to enforce the note and deed to secured debt as a servicer/agent of the holder of the note and security deed, Wells Fargo has failed to allege sufficient facts from which the Court can conclude that it is in fact the authorized agent of such holder and entitled to recover attorneys’ fees for its actions.

In plain language, the U.S. Trustee is saying, “These guys are claiming to be either the mortgage owner, or the agent/servicer of the owner, but they haven’t produced any evidence that they are.” They lack legal standing.

If the Court rules that the banks lack legal standing, then forget the lifting of the automatic stay in bankruptcy — the entire foreclosure itself is likely kaput as well.

Now, the way the motion is worded, it may simply be enough for the bank to state “sufficient facts” — whether that is a signed affidavit, or maybe the MERS information would suffice, or a letter from the CEO, or a note from the doctor. And from the papers, it doesn’t look as if MERS was implicated in these two instances.

Chances are, however, that the debtor’s attorney (and future defendant’s attorney in a foreclosure suit) would demand to see the actual mortgage paperwork and prove chain of title. And chances are that at least one of the two cases in Atlanta did involve MERS.

<play Twilight Zone theme music here>

Implications

At this time, I’m unclear as to the full implications. I rather doubt the doomsday scenario of 64 million mortgages suddenly being found to be null and void, unless four of the seven Supreme Court Justices owe a lot of money on their mortgages. What’s more likely is a lot of work for contract workers to pore through boxes and boxes of paperwork to find the actual loan documentation to double check who owns what, and can be proven.

One clear impact, I think, is that the REO business might be in for some interesting times. You sell a REO property to a buyer; then it turns out that the bank that foreclosed didn’t have the right to foreclose on the previous owner due to lack of standing. Uh oh. What happens now?

Similarly, with short sales, if the standing issue really comes to the forefront, does the bank that is approving the short sale even have the legal right to approve it? If it does not, is the short sale valid?

I expect transactions will still get done, but take longer (as if they’re not long enough already) and be far more difficult to close going forward, since no bank anywhere wants to even raise the spectre of legal standing until there is some sort of a backup plan, or they know what sort of liability they are facing.

So, if you do significant REO/short sale business, I’d track this issue if I were you. The title insurance guys and the mortgage guys might be more on top of the issue, so go corner them and ask them what’s up. It’d be a good idea, I think.

Thoughts? Anything to add from my friends in the title/mortgage side?

-rsh