Date published: November 8, 2010
Let us be blunt: The mortgage foreclosure crisis, which first burst into full public view in October when Bank of America suspended all foreclosures, has the potential to completely destroy the American real estate sector in an epic legal and economic meltdown that would make the crisis of 2007-2008 look like the proverbial Chinese tea party.
To grasp the enormity of the crisis now unfolding, it is important to understand the nature of mortgages. Until as recently as two decades ago, most mortgages were undertaken entirely by a single creditor, usually a local bank. The mortgage remained at the bank where it was issued, and was either repaid or defaulted on. In the case of the latter, the bank - holder of both the note (the IOU) and the mortgage lien - foreclosed and repossessed the property.
Beginning in the 1990s, it became fashionable to sell mortgages to other parties, and the mortgage securitization industry was born. Mortgages were sold, repackaged, and sold again, and a bewildering array of mortgage-backed securities was created to underwrite this new market. The United States mortgage business not only went national but international as investors worldwide rushed to get a piece of the lucrative American real estate sector.
To help streamline the process, Fannie Mae and Freddie Mac created a national mortgage electronic registry called MERS (Mortgage Electronic Registration System, Inc.), whose purpose was to streamline the transfer of mortgages by helping mortgage securitizers to avoid the costs and inconveniences of recording mortgages at local courthouses.
Unfortunately for the mortgage sector, there were two big problems with that approach. In the first place, mortgages and mortgage transfers are governed by state, not federal laws. By providing a means to circumvent the hassles of state laws and local jurisdictions, MERS effectively ran roughshod over state authority. The other, potentially greater, problem is that the critical document in a mortgage transaction - the one that empowers the creditor to enforce the terms of the mortgage on a delinquent homeowner - is the note, in 45 out of 50 states. A note, like any claim on assets, must be properly signed to have the force of a title. If it is sold to a new owneri it must be signed again, and so forth. Only thusly can what is called the "chain of title" be legally established.
But many, perhaps most mortgages that have been sold and repackaged again and again over the last few years were done so electronically, thanks to MERS, and typically lack the requisite signatures. Their chains of title, in other words, have been broken.
This time around, the problem is less economic than legal, but the ramifications are truly appalling. It is entirely possible that no title can be established on any mortgaged property unless the mortgage is older than eight or ten years. Millions of mortgage holders - even those not in foreclosure - may be able to abandon their mortgages and leave lenders on the hook, if banks are unable to produce proof of ownership. And the entire banking system could well implode under the weight of untold billions of dollars more in losses that cannot be recouped. The federal government might attempt another TARP-esque bailout - but without any prospect for repayment.