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"Free House" Free-For-All?

Who really owns all those mortgages which are no longer being paid?

By Petrarch  |  December 4, 2007

Mortgage meltdown, housing crisis, bubbles bursting...  There is one fundamental issue that summarizes it all: people were given loans that they could not afford, for houses too expensive, on the expectation that the property value would continue to increase ad infinitum.

When house values started dropping, folks were caught with their pants down: They could not afford the monthly mortgage payments, which under the terms of the loan often rose enormously after a few years; they could not refinance the loan on better terms, since the uncertainty of the markets has led to banks being reluctant to make loans; they couldn't even sell the houses, since nobody's buying for a number of reasons; and even if they could sell the house, it wouldn't cover what they owed - so they'd be left with no house, and a big debt.

Naturally, in these circumstances, the debtors stayed put in their homes as long as possible - hey, everybody needs a roof over their heads, might as well stay in the one you're in.  This works for a while since the bureaucracy is slow, but after your mortgage payments fall far enough behind, sooner or later the sheriff is going to show up with a notice of foreclosure.  The bank takes your house, sues you for the balance if any, and you're out on the street.

And this is where the story gets interesting.  Back in the day, the banks could pretty much do as they pleased concerning repossessions; this is where we get some of the famous images from the Depression, of people being thrown out in the street on the slightest pretext.  This process has long since been regulated, and there are various ceremonies and formalities involved, designed to protect poor Joe Worker from greedy Mr. Potter at the bank.  One of these elements is involvement of the court system, whereby a hopefully impartial judge rules that the bank is within its rights to repossess the home.

In Ohio, one of the states hardest hit by foreclosures in the current down-market, a routine hearing was in progress between the judge and the bank's lawyers.  Thousands of these things go through every day, but on this particular occasion, the judge made a routine inquiry: he asked the bank to prove that they did, in fact, own the defaulted loan and thus have the rights to the house.

In the old days, this would have been trivial.  Bailey's Building and Loan would go in the file room, fish out the copy of the mortgage that Joe Worker had signed, showing that he was buying the house and Bailey's Building and Loan was providing the mortgage, with the various penalties for nonpayment, etc. and so on.  That, however, is most decidedly not how the mortgage business works today.

Most banks are no longer in the mortgage business at all - they are in the mortgage originating business.  When you buy a house, you go to the bank, get their appraisal, sign the mortgage, and get the money, just as has been done for decades if not centuries.

After that's all done and you're in your house, though, things have changed.  The bank does not just stick your mortgage papers in the safe and wait eagerly for your monthly check, oh no.

The bank takes your mortgage, combines it with thousands of other mortgages they've issued, wraps the whole pile in some legalese and financial mumbo-jumbo, and presto!  It's now a "mortgage-backed security", which is kind of like a corporate bond, except it pays out based on the payments of the individual homeowners, collectively.  If everyone pays as they ought, whoever bought the security receives their payments on schedule; if not, then not.

As with an ordinary stock, the security is divided between many, many different owners.  There are thousands if not millions of individuals, companies, investment groups, even sovereign countries, that own shares of General Motors - no one individual owns the whole thing.  Similarly, these mortgage-backed securities are sliced and diced between whoever happens to want a piece of them.

So who owns GM?  Nobody, and everybody.  Stocks have been around for hundreds of years, and the rights of each investor have long been enshrined in law, mostly but not entirely relating to what percentage you own, with some protections for minority shareholders.  But mortgage-backed securities are very new, and these issues are not nearly so clear-cut.

Here we enter the legal issue of "standing."  You may not like what George Bush is doing, but you cannot sue him unless he does something to you directly and personally.  Similarly, you may know that your neighbor is not paying his mortgage, but you cannot foreclose on him - only the bank that owns his mortgage can do that.  But when the mortgage is part of a mortgage-backed security, who exactly would that be?

Not the bank that he signed papers with - they have long since sold the mortgage on and waived all rights to it.  Ordinarily, they don't have any financial interest remaining; they aren't involved any further.

Not the international investment bank that administers the mortgage-backed security, any more than Citibank owns GM because they handle a lot of their stock.

What about the individual investors who bought shares in the security?  They all own some, but none owns all, or even a majority.  Do they have standing?

The judge scratched his head; he couldn't figure it out - but he was sure it wasn't Deutsche Bank, who had brought the case before him as administrator of the securities.  They did not have standing - they had no right to sue - therefore, they could not foreclose.  Case dismissed!

There was no question that the homeowner had stopped paying his mortgage.  The problem is, you can't just take away the house in the abstract - you have to give it to someone else.  And the judge could not figure out who that someone else should be - nor, to their shock and horror, could Deutsche Bank's lawyers, nor anyone else!

The end result being, although the homeowner doesn't own his house, nobody else does either, and as long as he keeps paying his property taxes, nobody can throw him into the street!  Astounding!

It's hard to know where it'll go from here; in Ohio, there have already been 50 more rulings reaching the same result.  It's difficult to imagine that the billions of dollars involved will go straight down the crapper - but how, exactly, could the clear meaning of the law be negated, to the disadvantage of millions of voters?  In any case, wouldn't that be an ex-post-facto law, specifically forbidden under the Constitution?

Is it even conceivable that this will stick permanently, and all the mortgage-backed securities will turn out to be backed by.... nothing at all?

On the other hand, that's exactly how things are supposed to work when someone's too smart for their own good.  Wouldn't it be amazing to see all those fancy expensive lawyers booted out on their rears, because they did not bother to sit down and answer some fundamental questions about who owns what?  It wouldn't have been that hard to write it into the contracts, after all; and a contract that is validly signed, is binding.  Goodness knows that the lawyers would have no sympathy for you if the shoe was on the other foot.

If only the government can keep their mitts out of the mess for just a little bit longer, a fix for the foreclosure crisis just might be on its way.  If the securities turn out to be worth nothing, all the homeowners end up getting their houses for free.