Tuesday, December 27, 2016

How to steal a house: the wind-up

I just finished David Dayen's Chain of title. If you have any interest in the foreclosure crisis of the previous decade, I recommend it highly.

If you have any interest in learning about double standards in our economy, I recommend it highly.

If you have any interest in pursuing fairness in our economy, I recommend it highly.

The question is, How do you steal a few million houses and get away with it?

The short answer is, You make stuff up.

The slightly longer answer is, You play fast-and-loose with the law, and you prey upon politicians, some combination of their fears of tanking the economy, their willingness to be impressed by people with money, and their sense that the easiest path to re-election is to be nice to people who run the financial sector.

To understand both the shorter answer and the longer one, it's useful to have a condensed, but hopefully comprehensible, orientation in the area of mortgage securitization.

A mortgage is essentially a promise by a borrower (say, you) to make a series of payments to a lender, to pay off the loan you got from the lender - call them Friendly Bank. If it wants to, Friendly Bank can sell your mortgage to another financial institution, perhaps Big Bank. Big Bank pays a lump of money to Friendly Bank, and Friendly Bank transfers the mortgage to Big Bank. Now your monthly payments go to Big Bank, instead of Friendly Bank.

A mortgage has a certain amount of risk inherent in it, because the homeowner could default - they might stop making their mortgage payments. Traditionally, mortgage default rates were pretty low, because homeowners struggled mightily to make their payments, for the obvious reason of not wanting to lose the place where they lived. However, in the 2000's, lenders found ways of financing mortgages to people with worse credit histories, so the risk was somewhat higher.

To spread that risk, you can take a bunch of mortgages and "securitize" them. Big Bank goes out and buys 100 mortgages from Friendly Bank a bunch of other lenders. If each individual mortgage was a promise to pay something like $1,000 per month, then the group of 100 mortgages represents a promised flow of about $100,000.

Big Bank can now turn around and sell off claims to a piece of that $100,000. Say it finds 10 buyers. Each of them pays Big Bank a lump sum of money, and in return gets a "security," a financial instrument that promises payments of $10,000 a month, for some specified period of time.

Of course, Big Bank can't be sure that it'll receive that entire $100,000 every month. A few borrowers may miss a payment (not you, of course, but maybe someone else). A borrower or two might flat-out default and stop paying entirely. But most people will keep paying.

So we can think of the monthly stream of payments into Big Bank as something between $70,000 and $100,000. Perhaps the most likely number is something like $96,000. But it's possible it could be as low as $80,000. Perhaps it could be as low as $70,000 but that's extremely unlikely, and anything less than that is essentially inconceivable.

And so that stream of $100,000 per month can be divided up based on the likelihood of actually getting paid. If you buy part of that $70,000, it's all but certain that you will be paid, and so you should pay a reasonable price for that sort of certainty. If you buy the stream between $70,000 and $80,000, there's a larger chance (though still small) that you won't get paid in full, so you get a small discount. The $80,000-to-$90,000 stream is less certain still, and the last $10,000 is a real risk and so the right to that stream of money should sell for the lowest price.

That's the basic idea of securitization. But to make it work, Big Bank has to actually have the right to collect your payments (and your neighbors'). And it's no small thing to make sure that it does have that right.

U.S. property law traces back to English law, and the English figured out by the mid-1600's that there was real value in carefully and reliably documenting who owned what. Without good records, I could pay off a few people to perjure themselves in court and swear that they heard you agree to sell me that pasture down by the creek. So England started requiring transfers of property to be backed up by signed documents. Later, they stiffened the rules so that the signatures had to be notarized.

In the U.S. adaptation of this system, each country created a record of landownership. For a sale of real estate to be valid, a properly executed document needed to filed with the county clerk, for a modest fee, something like $25 or $50. Transfers of mortgages were subject to the same rules.

That system made sure that we knew who owned what, and who owed what to whom, but it took a little time to register each transfer. And there were those fees. If you were simply buying a home, a pair of $50 fees to record your ownership and the mortgage wasn't a big deal. But if your business model depended on securitizing lots of mortgages, then securitizing the resulting securities, that small amount of time to record every transfer is a big deal. And that $25 or $50 every time a mortgage is "assigned" to a new beneficiary? That really starts to eat into your profits.

So the banks set up a company called the Mortgage Electronic Registration Systems, or MERS.
Instead of filing with county recording offices each time a mortgage transferred - and paying that fee - banks instead listed MERS as the "mortgagee of record" in the initial mortgage assignment. Then, for subsequent transfers, the parties would go to the MERS database and list trades on an electronic spreadsheet. Banks could make unlimited transactions inside MERS; the county recorder only knew about the original assignment. (p. 47)
MERS makes its money "on the front end from mortgage originators, who pay to use the MERS database." (p. 47)

It was a very clever system that made it much more economical to create mortgage-backed securities. With one teensy little problem: setting up MERS saved banks the trouble of going to every county records office every time some mortgage or other changed hands, but only from the perspective of keeping their own records. It in no way eliminated the legal requirement to do things the old-fashioned way, paying county recorders to make sure it was clear who owed what to whom.

As Dayen explains, banks were marketing things called "mortgage-backed securities," but they were arguably "non-mortgage-backed securities," since the banks selling them hadn't actually completed all the legal steps to document their proper ownership of the mortgages.

When the housing market peaked and more borrowers started falling behind, banks started initiating foreclosure proceedings against more and more homeowners. A lot of these cases went through without the homeowners objecting. Dayen repeatedly refers to the shame that most people feel when the bank forecloses on their home. There's a sense of failure, of not having lived up to one's obligations, of being a deadbeat.

But a few borrowers looked at the foreclosure papers and realized they didn't recognize the names of the banks on there. "If I've been sending my mortgage checks to Bank A, why is Bank B trying to kick me out of my house?"

And so some of them asked to see the documentation establishing that Bank B did indeed have the right to foreclose on them. They demanded that Bank B show the chain of title from the origin of the mortgage to the entity now trying to kick them out of their house.

But the MERS spreadsheet didn't actually prove ownership, so it didn't carry any legal weight to point to that. Rather, the banks needed to show proper assignments of mortgages to new beneficiaries.

Oh, and one more thing. The mortgage-backed securities were run by entities called "trusts," and the law governing them was quite clear:
The mortgage and the note had to be physically conveyed into the trust and delivered to the document custodian, with the mortgages assigned and the notes endorsed with a wet-ink signature at every step along the way, culminating in assignments and endorsements to the trustee. And this had to be done within ninety days of the transaction, with no grace period beyond that closing date. Only then would you have a "true sale" of the loans from originator to trustee. (p. 37-38)
What do you do if it's 2008 and you're trying to foreclose on a house, and the homeowner asks to see the documentation conveying their mortgage into a trust back in 2003?

You fabricate the documentation you need. Which is the subject of my next post on this topic.

Just so you don't think I recommend this book without reservation, there's a scene early on where one of Dayen's principle subjects is spending time in the hospital staying with her young daughter, who's just had surgery. Late at night, while her daughter's asleep, the mother goes online to look up documents related to foreclosure fraud. Dayen writes that the mother would sometimes be the only person awake in the entire hospital. My wife - a nurse who works a night shift in a hospital - emphatically confirmed my hunch that Dayen is off-base on that point.

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