In Depth Analysis: CalculatedRisk Newsletter on Real Estate (Ad Free) Read it here.

Sunday, October 04, 2009

MERS v. Kansas

by Calculated Risk on 10/04/2009 06:56:00 PM

CR Note: This is a guest post from albrt.

MERS v. Kansas

Although the internet discussion has died down considerably, I thought it might be helpful to offer some background and some explanation of what happened in the recent Kansas MERS case. I am not involved in the case, but I used to read Tanta’s posts about this sort of thing and I did some research, so I guess I am well-qualified to opine.

What is MERS?

MERS is part of an attempt by bankers to homogenize mortgages so they can be traded among banks more easily. In many cases the ultimate goal is to bundle the mortgages into bonds. From the MERS website:

About MERS

MERS was created by the mortgage banking industry to streamline the mortgage process by using electronic commerce to eliminate paper. Our mission is to register every mortgage loan in the United States on the MERS® System.

* * *

MERS acts as nominee in the county land records for the lender and servicer. Any loan registered on the MERS® System is inoculated against future assignments because MERS remains the nominal mortgagee no matter how many times servicing is traded. MERS as original mortgagee (MOM) is approved by Fannie Mae, Freddie Mac, Ginnie Mae, FHA and VA, California and Utah Housing Finance Agencies, as well as all of the major Wall Street rating agencies.
Got it? I didn’t think so. MERS’ claim that its loans are “inoculated against future assignments” is an unmixed, but also unenlightening metaphor. Inoculation most commonly means exposing someone to a pathogenic organism or other immunologically active material in order to promote the development of antibodies. I can’t think of anything in the MERS process that can be profitably compared to either a pathogen or an antibody.

What actually happens is that a MERS mortgage is recorded once, usually with MERS shown as the “nominee” of the lender. MERS then tracks loan assignments, including both repayment rights and servicing rights. The output of the tracking system is approximately as good as the input from the lenders. When something happens, MERS is supposed to notify the interested parties.

In some cases MERS will act for the interested parties in lawsuits. If a MERS lender wants MERS to file a foreclosure suit, the lender is supposed to find the original note, endorse it in blank, and give it to a certifying MERS officer before the foreclosure is filed. That makes MERS a “holder” of the note, even if MERS is not actually the owner of the note. Being a holder is generally sufficient to allow MERS to foreclose.

Tanta explained how endorsement works here. MERS apparently has more computers involved, but when it comes time to produce the note in litigation it still amounts to pretty much the same thing. Pathogens and antibodies aside, MERS can’t really provide protection from all the potential errors and problems that came up when loans were being traded and securitized at warp speed all over the country. Many of the cases where MERS has gotten in trouble involved a misplaced note, but it is generally not clear that the problem was MERS’ fault, and it is not all that much different from what happens when a non-MERS lender files a foreclosure suit without having the original note handy.

This should be enough background to understand what happened (and did not happen) in the recent Kansas Supreme Court case.

The Kansas Supreme Court case

In Landmark National Bank v. Kesler , Landmark held a first mortgage and foreclosed on Mr. Kesler’s property. Landmark obtained a default judgment and was able to sell the property for more than the balance due on the first mortgage.

There was also a second mortgage on the property. The document for the second mortgage showed an outfit called “Millennia” as the lender, and showed MERS as the lender’s nominee. The document said notice should be sent to the lender, and did not say much about the nominee. Landmark sent notice of the foreclosure suit to Millennia, but not to MERS.

As it turned out, the second mortgage had been sold to an outfit called “Sovereign,” so Millennia no longer had an interest in the case. After the foreclosure judgment and sale, but before the distribution of the proceeds from the sale, Sovereign entered the case and tried to set aside the foreclosure judgment. Sovereign’s problem was that it never recorded anything to show that it held an interest in the property, so it really didn’t have much of an argument that it was entitled to notice of the foreclosure.

In order to address this problem, MERS joined in the case a couple of months later. MERS was essentially on Sovereign’s side, arguing that even if Sovereign wasn’t entitled to notice, MERS was on the original mortgage and was entitled to notice, and MERS would have notified Sovereign if MERS had received notice.

Not surprisingly, the judge held Sovereign was not entitled to notice because it didn’t register the assignment of the loan in the public records. The judge also held MERS was an agent of the lender at most, and did not have a sufficient interest to be able to show up late and overturn the judgment.

The Kansas Supreme Court upheld the judge’s decision, based in part on the conclusion that MERS didn’t own an interest in the note or the mortgage. This is what got a lot of attention on the internets, but most commentators seem to have missed the point. The court did not say the mortgage was invalidated because MERS separated the mortgage from the note. The court said MERS did not appear to own either the mortgage or the note. Part of the reason for the court’s conclusion was that you can’t separate a mortgage from the note it secures.

The key to the Kansas decision, like most judicial decisions, is in the details. The actual mortgage document required notice to the lender, not to MERS. The mortgage document listed MERS as a “nominee,” but never really defined what a nominee was or provided any basis for arguing that a nominee is entitled to notice above and beyond the notice given to the lender.

The only broad effect of this decision is that the court refused to make a special exception for MERS mortgages and require precautionary notice to MERS regardless of what the document said. Most MERS mortgages do say that MERS should get notice. If the mortgage document says that, most courts will enforce it.

There are other cases discussing MERS, some of which provide more general information than the Kansas case. One I would recommend is a decision by bankruptcy judge Linda Riegle on a group of bankruptcy cases in Nevada. The essence of Judge Riegle’s decision is that MERS isn’t entitled to any special status, and needs to have the note in order to take any action on it. The decision is available on Westlaw under the name Hawkins at 2009 WL 901766. Substantially the same decision is publicly available under the case name Mitchell, No. BK-S-07-16226-LBR .

What is the problem?

Mortgages are complicated. Most mortgage primers start with the distinction between states maintaining a “title” theory of mortgages and states maintaining a “lien” theory. This is mostly nonsense, as summed up by an eminent commentator nearly a hundred years ago: “There is no complete adoption of a logical theory in any of the American jurisdictions.” Manley O. Hudson, Law of Mortgages Real & Chattel, in 8 Modern American Law, at 297 (E. A. Gilmore & W. C. Wermuth eds. 1917).

So there are really two basic problems reflected in the MERS cases: (1) mortgages are complicated, and (2) the creation of MERS did not really reduce the complications, it just papered over them.

1. Mortgages are complicated

Mortgages are not homogenous. Not at any level. The borrowers are different, the mortgaged real estate is different, the practices of the banks are different, state laws are different, and federal government involvement is different for different types of lenders and borrowers. An important corollary of principle number one is that whatever a lender does, and whatever MERS does on behalf of lenders, will have different effects in different cases.

As Tanta wisely noted a few years ago, it is very difficult to see how an increasingly centralized industry can deal with all these details, and do it cheaply enough to make a profit when interest rates are at five percent and spreads are thin. In order to do it cheaply enough, the industry got rid of most of its Tanta-caliber people and replaced them with inexperienced temps, or perhaps with MERS. The main reason it worked for a few years was because problem mortgages could be refinanced so easily, and fees could be charged for each refinancing.

2. The creation of MERS did not really reduce the complications.

MERS undoubtedly provides some useful services to banks, but it does not “inoculate” them from dealing with necessary administrative costs. The administrative costs, especially in a lousy market, will probably make high-velocity mortgage loan trading and securitizing an unprofitable venture. As Tanta said, “the true cost of doing business is belatedly showing up.”

The goal of the people who created MERS was to design a system that has traction in local recording systems, and is flexible enough that it could be made to work under the law of every state. The MERS system probably meets this goal when it is done right. In theory, using the term “nominee” gives MERS flexibility in defining the duties and obligations of the relationship. It may also give MERS some flexibility in explaining how the court should treat a nominee after something has gone wrong, as the law of the jurisdiction or the facts of a particular case seem to require. Unfortunately for MERS, experienced judges are wise to this trick and will most likely to continue placing reasonable limits on the ability of MERS to claim it is all things to all lenders.

But setting all the cleverness of the MERS system aside, the system still requires the last lender in the chain to endorse the note over to MERS before the foreclosure can begin. If the lenders have been ignoring their paperwork because they think they are “inoculated against future assignments,” it is possible the lenders are worse off than they would have been without MERS. From what I can see, that is not the case. The way lenders were acting in 2005, if left to their own devices they would probably have lost about 90% of everything. With MERS, they probably did better than that.

So is this a nothingburger?

Sort of. MERS isn’t obscuring land titles in a way that will interfere with future transactions. If a mortgage is paid off, it should be released in the local public records. The odds that somebody screwed something up may go up a little or down a little, but a title company should be able to insure any subsequent sale.

We can also be reasonably certain the MERS cases are not going to invalidate millions of mortgages at one swipe. Because mortgages are complicated, whatever a lender does and whatever MERS does on behalf of lenders will have different effects in different cases. Most of the problems can be attributed to non-standard mortgage documents, poorly drafted foreclosure complaints, or foreclosure complaints filed prematurely without verifying the status of the mortgage and who is holding the note. These problems affect non-MERS lenders in more or less the same way they affect MERS lenders. Having MERS involved might help get things straightened out in some cases, or it might make the problem worse in some cases.

I think the important question is whether, on balance and in the aggregate, the MERS system works well enough to allow lenders to re-start the private label securitization money machine in a few years. I think the answer is probably no.

Of course, since the residential lending industry has effectively been nationalized, it would not be particularly surprising to see fundamental change on a national level that would allow the resumption of securitization. But that would probably bring us back to something like the plain vanilla Fannie and Freddie system that existed before 2000, not the insanely profitable liar loan system that Wall Street had created by 2005.

This post is intended as a tribute to Tanta, who already wrote pretty much everything you need to know to understand these issues, and did it much more cleverly than I can. I have not been able to read all the comments recently, so I apologize if I have inadvertently stolen anyone’s ideas besides Tanta’s.

CR Note: This is a guest post from albrt.