Saturday, November 28, 2009

Thanksgiving Weekend Mortgage Litigation Roundup

by Calculated Risk on 11/28/2009 11:55:00 AM

CR Note: This is a guest post from albrt.

Thanksgiving Weekend Mortgage Litigation Roundup

CR forwarded me a couple of links recently, so I told him I’d write up a summary for your holiday weekend entertainment. I’m also including a little ubernerd bonus at the end.

Mortgage Cancelled Due to Unconscionable, Vexatious and Opprobrious Conduct

One case has been mentioned in the comments a few times, but for hat tip purposes I believe it was first sent in by Art Vandalay. The link is to a summary at Law.Com, which has a link to the decision. Note that this is a local trial court decision – the county trial courts in New York are called the Supreme Court, while the highest court is called the Court of Appeals.

The bottom line in this case is that the trial judge spent several months trying to encourage IndyMac to modify a mortgage that was in foreclosure. The borrowers made a number of different offers, including offering to have other family members cosign on the modified loan. IndyMac refused, and also submitted some questionable information to the court. The judge finally had enough and decided that the note and the mortgage should be “vacated, cancelled, released and discharged of record.”

This is a very unusual result in a foreclosure case. Not only did the judge refuse to enforce the mortgage by foreclosure, he actually wiped out the debt completely. The decision is entertaining, but it doesn’t highlight any legal principles that are likely to affect other mortgages other than the most fundamental of all legal maxims: “try not to piss off the judge.” It’s very hard to guess whether a decision like this will be upheld on appeal.

More Trouble with Paperwork in Massachusetts

The other case is from Massachusetts, which as you may recall has strict standards for recording mortgage documents. This link is also a Law.Com summary with a link to the recent decision in the case of MERS v. Agin. Hat tip Dogbert.

The first thing to notice about this case is that Mr. Agin is a bankruptcy trustee, not a borrower. The borrower declared Chapter 7 bankruptcy, which essentially means there is no workout plan, and everything will be liquidated except certain property that is exempt by law. A house (or a certain amount of equity in a house) can be exempt, but this is unlikely if there is a significant mortgage.

A Chapter 7 trustee has two major responsibilities: to make sure the debtor is not withholding assets, and to serve as a referee among the different creditors. Mr. Agin, perhaps with prompting from some of the other creditors, filed a motion asking the bankruptcy court to determine whether the mortgage was valid. The bankruptcy court decided the mortgage was not valid because the borrower’s name was not filled in on the notary acknowledgement. The federal district court upheld the decision.

As a result, the mortgage was eliminated but the debt was not. The mortgage lender became an unsecured creditor, just like a credit card lender. The house will be sold, but the proceeds will be split between all the creditors on a pro-rata basis instead of going to the mortgage lender first. I don’t see any obvious reason to expect this decision to be overturned on appeal.

For Ubernerds: A Note on Bona Fide Purchasers

Footnote 2 of the Agin case contains a mysterious reference to a legal doctrine that may be of interest to the ubernerds amongst us:

Section 544 allows the trustee to avoid a transfer of an interest in real property of the debtor to the extent a bona fide purchaser of the property may avoid the transfer “without regard to the knowledge of the trustee or of any creditor.”
The footnote doesn’t make much sense unless you understand the significance of being a bona fide purchaser without knowledge. This site has a pretty good definition:
bona fide purchaser n. commonly called BFP in legal and banking circles; one who has purchased an asset (including a promissory note, bond or other negotiable instrument) for stated value, innocent of any fact which would cast doubt on the right of the seller to have sold it in good faith. This is vital if the true owner shows up to claim title, since the BFP will be able to keep the asset, and the real owner will have to look to the fraudulent seller for recompense.
A “purchaser” includes anyone who has given value, which means it generally includes a secured lender as well as a buyer. A “holder in due course” is similar to a BFP, except that the term is generally limited to a purchaser of a negotiable financial instrument. Purchasers of debt instruments are not just worried about whether the person who sold the instrument was the “real owner” – they are also worried about whether the borrower will try to avoid repaying the loan by accusing the original lender of fraud or something similar. BFP status protects against both of these things.

Like most everything in the law, the BFP concept is hedged with all sorts of qualifications, mostly having to do with reasonableness – a bona fide purchaser should not be able to ignore things that a reasonable person should have known. The most obvious example is that a BFP cannot ordinarily ignore a document that was properly recorded in the local land records.

In Agin, the issue was whether the missing name on the acknowledgement was enough to make the mortgage void. An ordinary person who purchased the debtor’s house might not have been able to avoid the mortgage if the purchaser should reasonably have known from the records that the mortgage existed. But the bankruptcy statute allowed the trustee to be treated as a BFP of the debtor’s house regardless of what he knew or should have known, so all he had to do is show that the mortgage document had a material defect.

So an ordinary BFP doesn’t get quite as much protection as the bankruptcy trustee in Agin, but lenders and investors do consider BFP status important. There are many things to be said for and against giving special treatment to BFPs, but the point I’d like to make today is that the bona fide purchaser concept creates decidedly mixed incentives for due diligence. A buyer or lender wants to discover everything that a reasonable person should discover, but does not particularly want to discover any problems that could be avoided by a BFP without knowledge.

The BFP concept played a significant role in the Wall Street securitization process. As Judge Long noted in footnote 29 of the Ibanez ruling:
The Ibanez Private Placement Memorandum is quite explicit regarding the separateness of “Originators” and “Servicers” and the reasons for that separateness. See Private Placement Memorandum at 84 (explaining the “information barrier policies” intended to protect the trust’s status as a holder in due course of the notes and insulate it from claims of fraud, misrepresentation, etc. in the making of the loans).
In other words, as many of you suspected all along, “hoocoodanode?” was officially part of the plan for creating mortgage backed securities. Systematic and willful ignorance was incentivized. If Wall Street created a system where each bogus mortgage passed through the hands of a couple of intermediaries who had no ability to do any due diligence on the quality of the loan, then the end buyer of the loan would, legally speaking, be in a better position to collect than the original lender by virtue of BFP status. Did the mortgage broker tell the borrower the loan was fixed rate when it really wasn’t? Oh well, no way the mortgage pool trustee could have known about that after the loan passed through the hands of an originating lender, an unrelated depositor and a legally separate issuer.

Whether for better or for worse, this system is pretty clearly not playing out as intended. BFP status does nothing to protect lenders from broke borrowers and half price houses, both of which were foreseen by knowledgeable people who were not willfully ignorant of details about loan origination. And even the limited protection of BFP status may not be available in cases that are actively litigated, since it won’t be hard to prove that everyone in the industry knew brokers were filling in the blanks on stated income loans with whatever numbers were needed to make the applications go through.

So I guess this is just one more reason why all the Fed’s ponies and all the Treasury’s men are not going to be able to put Humpty Dumpty back together again.


CR Note: This is a guest post from albrt.