The Mortgage Mess

Guest Author: Yves Smith, has done perhaps the most complete job of following the foreclosure problem on a daily basis of any other news or blog source at Naked Capitalism.  Yves is the author of the best-selling book “Econned – How unenlightened self interest undermined democracy and corrupted capitalism”.  Yves has written this GEI exclusive to summarize her months of daily reports as the crisis has unfolded.

There has been a foreclosure on foreclosures.   The nation’s largest banks have suspended processing mortgage foreclosures because of questions about the legality of mortgage and foreclosure documentation.  As we reported Friday, Bank of America has now halted foreclosure proceedings in all 50 states.  GMAC and JP Morgan have suspended actions in 23 states.

The mortgage mess is composed of two parts:  the creation and syndication of mortgage debt and the foreclosure process when mortgages default.  These will be addressed individually.

Writing Mortgages

Only a generation ago mortgages were predominantly written by banks using local underwriting standards.  These mortgages were written, serviced and retired (when payments were completed) by the bank.  That process started changing substantially in the 1990s and change accelerated in the 2000s.  Many mortgages were originated by banks and brokers only to be sold within 60 or 90 days to aggregators who combined them into securities called MBS (mortgage backed securities) or, more specifically, RMBS (residential mortgage backed securities).

These mortgage securities were sold to various investors, including endowments, pension funds and other investment pools, creating a vastly increased amount of money available to mortgagors.  A tremendous rush ensued as all this money sought someone willing to sign a mortgage agreement and move into a house.  A credit and housing bubble was born.

Servicing Mortgages

With mortgages now embedded in complex security structures the traditional method of having the mortgagee service the mortgage during its lifetime is no longer valid.  There is no community bank mortgage servicing the mortgage it wrote and owns.  Banks and other financial entities entered into mortgage service agreements with the MBS aggregators to collect payments and funnel the money into the MBS.  All works well as long as mortgage payments remain current.  A major problem arises, as we shall see later in this article, when mortgagors default.

Automating Mortgage Registrations

In the “old days” mortgages were registered and filed with local government jurisdictions, usually cities or counties.  In August I discussed the detailed story by Ellen Brown which gave a good summary of how the widespread use of a national electronic mortgage registry called MERS (Mortgage Electronic Registration System, Inc.), designed to save mortgage securitizers the cost and bother of recording mortgages at the local courthouse, was backfiring spectacularly.  Since then the use of the word spectacularly appears to have been a spectacular understatement.

As I pointed out in August there were two wee problems with this idea:

1. Real estate is governed by state law.   A “mortgage” really consists of two elements, the note (the IOU) and the mortgage (in some states, called a deed of trust), which is the lien. In 45 of 50 states, the note is the critical instrument; the mortgage is a mere “accessory”.   You need to demonstrate that you are the owner of the note (the “real party of interest”) in order to foreclose.

2. Many of the securitizers got very sloppy with the transfer of the note to the securitization entity, a trust.   They have tried to rely on MERS to prove ownership, or worse to foreclose in the name of MERS.   A rising tide of state court decisions is nixing this approach.

A number of specific cases where standing to foreclose was denied to filings depending on MERS titles were detailed in the August article.  Cases mentioned came from across the country (California, Idaho, Kansas, Nebraska, New York and Ohio).

Let’s be clear here.  The sloppiness does not result from MERS; MERS is secondary.  If the notes had been conveyed correctly, according to the requirements of the pooling and servicing agreement, you wouldn’t have the problems we are seeing now.  Yes, foreclosing in the name of MERS doesn’t work, but that’s a symptom.  In 45 states you need to have handled the note correctly to foreclose.  You could correct the problem with the mortgage assignment (the MERS part) pretty easily if everyone had handled the notes correctly.  It would cost a lot of money and be a huge operational hassle, but it would conceptually not be hard to remedy. Not conveying the notes correctly, by contrast, is FATAL.

In short, automating mortgage registrations requires that all conveyances be handled correctly along the transfer path.  What has happened is that some (many?) of the conveyances to MERS were not handled correctly.

How Did Conveyances Go Wrong?

I recently discussed the problems with RMBS as follows:

Although many data points could be considered anecdotal, we have evidence that strongly suggests that major RMBS originators, the investment bank packagers, and the bank trustees failed to convey the notes (the borrower IOU, which is critical to having the legal standing to foreclose in 45 states) to the RMBS trusts starting in 2005, perhaps even earlier.  And comments from industry insiders suggest this problem is pervasive.

That puts a cloud over the entire US RMBS market, the biggest asset class in the world.  This paper was sold as secured; the ability to offset the cost of borrower defaults by seizing and selling his house is critical to the value of the instruments.  And if no assets were conveyed to a particular trust by closing, an even uglier possibility exists:  under New York law, which was elected by RMBS as governing law for the trust, it would be considered to be “unfunded”, which means it does not exist.

How Have Foreclosures Been Processed?

Many foreclosure proceedings have been pursued using the services of LPS (Lender Processing Services, Inc.), whose website claims they are “the nation’s leading provider of mortgage processing services, settlement services, mortgage performance analytics and default solutions.”

LPS has been hit with two suits seeking national class action status (see here and here for the court filings).  If the plaintiffs prevail, the disgorgement of fees by LPS could easily run into the billions of dollars (we have received a more precise estimate from plaintiffs’ counsel).  To give a sense of proportion, LPS’s 2009 revenues were $2.4 billion and its net income that year was $276 million.

As evidence about problems with the foreclosure process has surfaced at more and more servicers, one of the common themes has been that a substantial portion of the foreclosure process was outsourced to various processing companies.  Foreclosure defense attorneys have cited LPS as one of the largest as well as more problematic firms in the outsourced foreclosure business. In addition, by 2008, LPS had purchased a company called DocX, the company responsible for the “document production” price sheet cited here earlier.

But the rub in this line of business is that the servicers are technically not the clients.  LPS acts a sort of general contractor, farming out various tasks to both internal staff as well as outside firms.  But LPS’s business pitch to the servicing industry was that it would come in and use a technology platform and provide (if desired) a turnkey solution, FOR NO ADDITIONAL COST than what the servicers were already paying on foreclosures.

How could that be?  All of LPS’s revenues in Default Solutions come from the lawyers in the national network of foreclosure mills that LPS has developed over time.  Note that these cases may be filed in state court or federal bankruptcy court, depending on the situation of the borrower. In a routine foreclosure, all legal actions will be filed in state court. If the borrower has filed for a Chapter 13 bankruptcy, the Federal bankruptcy court has jurisdiction. In theory, the bankruptcy filing stops the actions of all creditors until the borrower has worked out a payment plan with the court.  But in these cases, LPS and its network firms are seeking to break the bankruptcy court time out and grab the borrower’s house (the legal procedure is “motion for relief of stay”).

Drive-By Foreclosures

To illustrate the degree of control LPS exercises over its network:  we have been told by an LPS insider that the software that LPS uses to coordinate with all law firms in its network, LPS Desktop, incorporates a scoring system called 3/3/30.  When LPS sends a referral on a foreclosure, the referee is expected to respond in three minutes.  When it accepts the referral, it is auto debited (ACH or credit card).  In three days, it is expected to have filed the first motion required in pursuing the case, and it is expected to have resolved the case in 30 days.  Firms are graded according to their ability to meet these time parameters in a green/yellow/red system.  Firms that get a red grade are given a certain amount of time to improve their results or they are kicked out of the network.

The cases describe the many fees between LPS and the network law firms.  The terms of standard agreements provide for the payment of $150 at the time of referral (the first 3 in the 3/3/30 standard above).  Network firms allegedly pay other fees as various milestones are reached, and these are couched as fees for technology, administrative review, document execution, and other legitimate-sounding services.  We’ve also been told separately by LPS insiders that LPS and network law firms split the fee for the motion for relief of stay in bankruptcy court, as well as the fee on a small filing called a proof of claim.

What, pray tell, is wrong with this business model?  The two suits attack LPS’s very foundations.  One case was filed late last week in Federal bankruptcy court in Mississippi and the other in state court in Kentucky.  Both make similar allegations, but the Federal case is broader in some respects (it includes a company called Prommis Solutions a firm backed by Great Hill Partners, that, like LPS, provides services to foreclosure mills, including one named in this case as defendant along with LPS).

Outside the Law and Fabricated Documents

The Kentucky case includes on the RMBS trust issue discussed in the next section of this article.  First, it contends that the mortgage assignment attempted by the local law firm to allow the trust to foreclose was a void under New York law, which governs the trust. Hence the foreclosure was invalid.  Second, it claims that the defendants (the local law firm and LPS) fabricated documents.  Third, the plaintiffs claim that the defendants (LPS and the local law firm) conspired together to practice systemic fraud upon the court and engage fee sharing arrangements, which is tantamount to the unauthorized practice of law.  (It is illegal for a law firm to split fees with a non-lawyer or to pay a non-lawyer for a referral; it’s considered to be the unauthorized practice of law.)  And this leads to some very serious conclusions.  Per the Kentucky case:

This attempt by the Trust to take real property is most analogous to stealing since this Trust cannot provide any legal evidence of ownership of the promissory note in accordance with the requirements of New York law which governs and controls the actions of the Trust and the Trustee acting on behalf of the trust.

Stealing, Collusion and Illegal Kickbacks

But the real meat in these cases are the class action claims, and they are real doozies. Both allege undisclosed contractual arrangements for impermissible legal fee splittings, which are camouflaged as various types of fees we described earlier.  The suits describe the considerable lengths that LPS has gone to keep these illegal kickbacks secret, including requiring that all attorneys who join the network keep the arrangement confidential, as well as using dubious “trade secret” claims to forestall their disclosure in discovery.

As bad as this fact pattern is, it has even more serious implications for the bankruptcy court filing in Mississippi.  In a bankruptcy case, any attorney pleading before the court must disclose every disbursement pursuant to a case, no matter how minor.  Yet the payment of fees to LPS have never been disclosed to a single bankruptcy judge in the US, since LPS requires they be kept confidential.  LPS and its network lawyers are thus engaged in a massive, ongoing fraud on all bankruptcy courts in the US.

Illegal Practice of Law

The Prommis Solutions/Great Hill charges are included only in the Mississippi case. Prommis is broadly in the same business as LPS’s Default Services unit (”leading provider of technology-enabled processing services for the default resolution sector of the residential mortgage industry”).  And Prommis and its investor Great HIll, like LPS, are not a law firms, which means their participation in foreclosure-related legal fees constitutes illegal fee sharing.  Prommis filed a registration statement (it planned to go public) this past June.  Consider this section from its “Risk Factors” discussion (boldface theirs):

Regulation of the legal profession may constrain the operations of our business, and could impair our ability to provide services to our customers and adversely affect our revenue and results of operations.

Each state has adopted laws, regulations and codes of ethics that grant attorneys licensed by the state the exclusive right to practice law.  The practice of law other than by a licensed attorney is referred to as the unauthorized practice of law.  What constitutes or defines the boundaries of the “practice of law,” however, is not necessarily clearly established, varies from state to state and depends on authorities such as state law, bar associations, ethics committees and constitutional law formulated by the U.S. Supreme Court.  Many states define the practice of law to include the giving of advice and opinions regarding another person’s legal rights, the preparation of legal documents or the preparation of court documents for another person.  In addition, all states and the American Bar Association prohibit attorneys from sharing fees for legal services with non-attorneys.

The common remedy for illegal fee sharing is disgorgement.  Remember the magnitude of this business: it accounts for nearly half of LPS’s revenues. LPS is a pretty levered operation, with a debt to equity ratio of over 3:1.  It isn’t hard to see that success in either of these cases would be a fatal blow to LPS.  Similarly, if the allegations are proven true it could have ramifications for all servicers who do business with Fannie and Freddie since they are not supposed to be involved in referring work to a vendor who pays a kickback for a referral.

Taxpayer Blowback From the RMBS Problem

Now the rather sick irony is that this monster screw-up probably affects Fannie and Freddie paper only indirectly; presumably, it will be a given that this will be treated as if the government guarantee covers this little mess.  The Obama Administration is the last bunch of folks that will look into the fine print to see if Fannie and Freddie ought to eat this liability.  I’ll admit I have not looked into the Fannie/Freddie procedures on this one, but I’d have trouble believing their rules would include having the government guarantee extend to operational screw ups that prevent losses on guaranteed mortgages being relieved by foreclosures.  I’d have to believe they have putback procedures which will not be applied because the consequences would be too devastating to Team Obama’s best friend, the banking industry.  So Frannie and Freddie not pushing the losses related to foreclosures back to the banks would be yet another back door bailout.

If this does end up being another backdoor bailout, just how much liability will be assumed by the taxpayer for the $11 trillion mortgage debt outstanding?  Even if the loses covered would be only 10% of the mortgage debt,  That would be more than double what ended up being used by TARP.  And TARP is being largely repaid, but there is no avenue for the mortgage bailout to ever be repaid.

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