Sunday, November 21, 2010

Understanding “Mortgage-gate” Beyond the Headlines

“The ability to simplify means to eliminate the unnecessary so that the necessary may speak.” - Hans Hofmann
The mortgage back security (MBS) market is somewhat of a mystery to many, yet it serves an important role in financing the growth of housing within the US.   In its most basic form, the MBS market is where a loan originator (a bank) can sell an existing loan to a private investor thus freeing up money to finance another home purchase.  So the MBS market is in many ways a broker between those buying a home and those looking to invest money.  Unfortunately as investors seek yield, this once simple product is now more complex.

Today it’s easy to read about mortgage-gate, the stories are plentiful.  On the surface it sounds like a simple paperwork issue or delinquent homeowners trying to live for free.  There is no denying that a vast majority of cases involve a homeowner who has failed to pay their mortgage.  The investor has every right to foreclose and minimize their loss.  Let’s dig a little deeper into the MBS market though and understand what is really going on.
When a home is purchased there are two important documents, a note and a mortgage.  The note is the IOU, while the mortgage is the right to the house, the security interest.  Each time the house is sold, the mortgage is assigned at the county so there is a public record of who owns what.  As housing surged and in an effort to eliminate the cost associated with these mortgage assignments the larger banks joined forces and created MERS (Mortgage Electronic Registration Systems).  The
initial mortgage assignment was made in the name of MERS and in all future assignments; MERS would continue to “own” the mortgage thus requiring no further action in the county.
Where are we currently?
All of the fifty attorneys general are investigating the home foreclosure process.  MERS in many cases owns the mortgage but not the note.  You cannot split the note and the mortgage.  In splitting these two instruments an unsecured creditor has been created.  The holder of the note cannot foreclose, as they have no security interest (they don’t own the mortgage).  The holder of the mortgage has the security interest but since they don’t own the note the homeowner is never in default.
What is currently being investigated is who has the legal authority to initiate foreclosure?  Was fraud perpetuated upon the legal system through false documentation and state notaries?  Why have multiple foreclosures been brought on the same home?   Is there a need for a national moratorium on foreclosures on a state-by-state level?
Where do we go from here?
Foreclosures have all but stopped as many banks have issued self-imposed moratoriums pending internal investigations.  Investors of MBS (pension funds, GSE, PIMCO, Federal Reserve) have also begun to inquire if they have recourse to put back (return) defaulted securities. The case being made by these investors is the trust which manages the MBS on behalf of the investor was never assigned the note and therefore the transaction was not completed within the allotted 90-day period.
The implications are massive and estimated in the hundreds of billions of dollars.   Unfortunately though, the way these securities were constructed 25% of the holders of an MBS are needed to initiate a put back.  Without 25% the investor cannot proceed.  In a recent BAC conference call, CEO Brian Moynihan was quoted, “our perspective on this, we're going to be quite diligent defending the interests of our shareholders. This really gets down to a loan-by-loan determination, and we have, we believe, the resources to deploy against that kind of a review.”  The banks are ready to fight any put back by aggressive legal review, at least that is their current strategy.
Other current investigations
Reports of the same note being sold to multiple investors have surfaced.  Did originators sell the same note multiple times, knowing they would default and each time take out insurance (credit default swap) on the transaction?
The chief underwriter for Citibank under deposition has stated that up to 80% of the MBS they bought for resale were defective.  Did Citibank knowingly purchase these defective securities below par value and not disclose this information when selling to investors at par value?
Banks refusal to show loan documentation after repeated subpoenas have raised questions as to whether the original note was ever assigned to the trust, if not this would be the basis for a put back.   Others have questioned if these notes were destroyed.
The implications upon the housing market, securitization and the banking sector could be massive.   Banks are not capitalized to absorb put backs in the hundreds of billions.  So in a worst-case scenario we would see either massive capital raises or restructuring.  At a minimum the foreclosure process will remain stalled causing added expense to the banks and a continued reduction in state tax receipts from delinquent property taxes.  Right now it’s hard to determine the exact outcome, many have said it’s no longer a matter of protecting bank capital structure but rather the integrity of our legal system.  One thing for sure is the recent sign of a double dip in housing prices will put even more pressure on the financials.


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