Foreclosuregate and Systemic Risk

Oh $#!^ is an understatement...

I continue to try and think through the various issues of foreclosuregate. There are a lot of them. And some of them are petrifying. In my last post, I wondered about title issues. In this one, I wanted to sketch out my understanding of the possible problems to the entire global financial system: systemic risk.

As I see it, there are two related but distinct issues in foreclosuregate. The first is one of fraud in foreclosures, leading to the possibility of defective title. This one will hurt the real estate industry in ways we can’t quite foresee, but we’ll work through these things in due time. The second issue is a problem with the chain of title. This is the big scary one. This is the one that could cause real nightmare scenarios of financial collapse.

Let’s just sketch it out for now.

Chain of Title

Wikipedia defines chain of title as:

chain of title is the sequence of historical transfers of title to a property. The “chain” runs from the present owner back to the original owner of the property. In situations where documentation of ownership is important, it is often necessary to reconstruct the chain of title. To facilitate this, a record of title documents may be maintained by a registry office or civil law notary.

Basically, chain of title ensures that whoever owns a piece of property does in fact own it. Any encumbrance on the property — mortgages, liens, etc. — would be noted in the chain of title to inform possible purchasers and lenders that the property in question has existing claims on it.

The most frightening possibility out of foreclosuregate is that quite apart from the problem of fraud (which has to do with false affidavits), the participants in the mortgage securitization market may have made serious mistakes in maintaining the chain of title. One law professor, Adam Levitin of Georgetown Law, has been all over the issue. Here’s an excellent post about the general issue, as well as one court case that bears on it:

Now here’s the real kicker: there’s no reason to think that the Kemp note was a unique, one-off problem. All evidence from actual foreclosure cases points to the lack of a chain of endorsements on the Kemp note being not the exception, but the rule, and not just for Countrywide, but industry-wide. Certainly on the non-delivery point (separate from the non-endorsement problem), Countrywide admitted that non-delivery was “customary.” If either of these issues, non-delivery or non-endorsement is widespread, then I think we’ve got a massive problem in our financial system.

The consequences of this “non-delivery” or “non-endorsement” are dire.

RMBS Trusts

I’m going to skip over the details of how mortgages are securitized for this blogpost, although they’ll be in the longer work, but suffice to say that the critical legal issue here, as Prof. Levitin and others point out, is that virtually every mortgage-backed security is issued by a trust organized under New York law. New York trust law requires far more than what has been the customary practice of the mortgage securitization industry to effectively transfer assets into the trust. Furthermore, the Pooling and Services Agreements (PSA) under which the trusts were organized and solicited investors can, and often did, require more than what the industry custom was.

None of this mattered while the housing market was going up, and defaults were rare. When the housing market tanked, and foreclosures became widespread, the problem came to the surface.

What Prof. Levitin and others point out is that IF the industry custom turns out to be the norm rather than the exception, virtually every single RMBS trust will turn out to own nothing. All of those bonds that these trusts issued become unsecured debt, rather than secured debt backed by actual houses sitting on actual land.

That in and of itself creates massive problems, since unsecured debt can be discharged in bankruptcy. The value of those mortgage-backed securities would plummet.

Far worse for the banks that organized these trusts (the “sponsors”), if the transfer of mortgages failed, it means that all of those mortgages are on the bank’s own books as assets of the sponsoring bank. Furthermore, all of those RMBS investors that thought they were investing in mortgage-backed securities would have a putback claim: they would force the sponsors to give them their money back in exchange for the now-not-mortgage-backed securities.

We get news today that BofA settled a putback claim with Fannie Mae and Freddie Mac for $2.8 billion, with another $3 billion set aside for future claims. We also know that non-GSE’s (so-called private label) are claiming upwards of $67 billion from BofA alone. And we get wind that international creditors might be looking into pursuing claims.

The bottom-line is that if all or most of the RMBS investors seek putback or other damages, the amount of liability to the largest American commercial banks dwarfs the total reserves and market capitalization of all of these banks put together. Again, Prof. Levitin:

The banks are in serious trouble if there are widespread securitization fails. If the loans weren’t transferred to the securitization trusts, then they are on bank balance sheets, which means that (1) the losses on the loans are the banks (to be sorted out with the investors), and (2) the banks need to be holding capital against the loans that haven’t gone into foreclosure. Depending on the scale of the problem, the banks might not have enough capital to cover the securitization fails, which means we’re in Dodd-Frank resolution territory. (Emphasis mine)

That, ladies and gentlemen, is systemic risk. We’re essentially talking about the insolvency of almost all of the largest banks in the United States.

Consequences of such a collapse of the global financial system are impossible to predict, but suffice to say that we’re now in the “forget about the real estate market, and start worrying about stocking up on canned goods, anti-biotics, and ammunition” territory.


What scares me the most about this is that despite all of the reading and research, I haven’t seen a real credible solution. People like Levitin suggest that the Federal government stay “ahead of the systemic risk” but it isn’t real clear what they could do. Clearly, allowing all of the large commercial banks to just go bankrupt is not an option. But given the nature of the problem, it isn’t real clear what can be done about it.

Congress could, in theory, pass a law that retroactively validates all of the problematic transfers into RMBS trusts. There’s a pretty good chance that such a law would run afoul of several Constitutional provisions, including the Due Process and Takings clauses, not to mention that Congress would be running roughshod over state laws over the one area where local control is the strongest: real estate. And that’s not to take politics into account: homeowners who are losing their homes to improper foreclosure are not likely to be real thrilled about legislation that allows the Wall Street banks to avoid bankruptcy by retroactively validating flawed chain of title. If you think demagogues won’t make hay out of such a populist issue, you haven’t been paying attention to American politics.

What is far more likely, I think, is a Federal moratorium on foreclosures. Without foreclosures, a lot of these title problems lose the urgency they have to homeowners and their attorneys. That isn’t a solution per se, but it might buy us enough time to go back and re-establish the chain of title into all these RMBS trusts. Whether such retroactive title work would pass muster under New York law is another matter altogether. Perhaps all of the Trusts would need to be re-established, with the proper chain of title, and all of the banks reach private agreement with their investors.

Courts, particularly the Supreme Court, could simply rule that the transfers were valid. That would be the “simplest” way to head off the problem. The trouble is, the legal problems with these asset transfers appear to be real. And it is not clear that even the Supreme Court has the power to invalidate New York trust law, unless it somehow rules that the New York trust law is invalid under the United States Constitution. I can think of no grounds for such a ruling. Pragmatism might argue for such a ruling, but if the Justices have a shred of integrity, they can’t possibly come up with such a ruling. That ruling could be the worst Supreme Court decision since Griswold v. Connecticut and Plessy v. Ferguson.

Federal regulators could somehow step in and nationalize the banks, essentially having the U.S. Treasury take on the liability from these flawed RMBS trusts onto the balance sheet of the United States of America. At least that would prevent a global financial collapse for a while. But since we’re talking about amounts in the trillions of dollars, I haven’t the faintest idea whether Congress and the American public would stand for such a thing. It also is not at all clear that even the Treasury could take on such a debt burden on top of the $14 trillion that we’ve rung up by the end of 2010, at least not without crashing the dollar, which has all sorts of other consequences.

Are you scared yet? I know I am.

Consequences for the Industry

Since I can’t really even begin to understand the consequences of the worst-case scenario here, I’m not sure how to even gauge what the consequences are for the real estate industry. I think I can safely say, however, that while I sincerely hope that Fannie Mae’s latest projections come true, that I don’t believe it would. Not while this sword of Damocles is hanging over our heads.

At a minimum, while this legal uncertainty persists, I believe that private market funding for mortgages would go south in a big way. That means higher rates, tighter lending standards (since banks may have to think that they have to hold these loans on their books for quite some time), and simply less money available to fund residential mortgages. It may require a major court decision on the chain of title issue; it may be precipitated by the filing of a massive class action lawsuit (coming your way soon, thanks to the plaintiff’s bar). But I think it’s coming.

I also believe that title insurance companies are in for a rocky 2011 and beyond, while we all work through this chain of title mess, and that’s assuming that we don’t have catastrophic financial collapse.

A foreclosure moratorium would have obvious impact on the industry. How many people would simply stop paying their underwater mortgages while a moratorium is in place is unknown, but I’d have to figure quite a few would. What happens to REO and short sales is not yet known – I’d love your thoughts on such a thing if you’re active in REO’s and short sales.

So… I recognize that this qualifies as a “sky is falling” type of (possible) over-reaction. But I’m basing this on my research so far. If you know of any counter-evidence, I’d love to hear about it. If you have a different perspective, I’d love to hear about it. Because I desperately want to be wrong on these as I work on the larger report.



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  1. I certainly can’t argue with your research or the speculation on possible consequences of a systemic failure. One thing is certain, people will always need a place to live. As I see it the outcome of foreclosures is going to significantly increase demand for rentals, making real estate a pretty good investment right now if one has the liquidity to do it.

  2. I certainly can’t argue with your research or the speculation on possible consequences of a systemic failure. One thing is certain, people will always need a place to live. As I see it the outcome of foreclosures is going to significantly increase demand for rentals, making real estate a pretty good investment right now if one has the liquidity to do it.

  3. I see a problem with new mortgages. I’m being contacted by lenders now for new buyer leads. The LO’s mantra, got any buyers? Short sales are becoming more difficult and my prediction is 2011 will be a worse year for short sales. Unpopular as this is to agents, cash buyers will be king this year.

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