Yet Another Problem with Mortgage-Backed Securities

I heard about this legal case at Ohio where a Cleveland judge has thrown out 14 home foreclosure suits brought by Deutsche Bank on behalf of mortgage investors. The reason is that Deutsche Bank couldn't produce documentation to prove their ownership of these houses. Initially it didn't seem to be a big deal, but the latest issue of Business Week has a very good article on this case which provides some deep analysis on the legal implications.

Basically it is not a rare case that investment banks manufacturing these kind of mortgage pools and products can't show any ownership documents. In the good old days, banks provided mortgages and had the titles of those homes as collateral stored in the banks. But during the recent unprecedented financial alchemy on MBS and CDOs, investment banks "innovatively" create pools composed of thousands of mortgages and then sliced and diced them into hundreds of tranches and products in order to "add value" and earn a higher margin. By selling these products in various tranches, investment banks have realized a higher aggregate value than just by selling the original mortgages alone. In one of my earlier blogs, I called this process as value-destroying modern financial alchemy.

When the structured product group of Deutsche Bank or any other bank put these kind of mortgage pools together, they are supposed to process and obtain the so-called assignment papers for each mortgage to indicate the transfer of ownership. However, out of convenience and cost-saving concern, it turns out that Wall Street firms commonly neglect to do that. From the cost side, for each mortgage, banks have to pay lawyers and paralegals to draft documents, take care of filing, get all necessary signatures, keep records, etc. You can imagine that cost adds up and multiplies quickly if you are doing thousands of them, and they eat into your profit margin.

Can Deutsche Bank fix this problem quickly by just getting the paperwork done for these 14 homes? Unfortunately there is a big legal difference in timing when you do the paperwork before the default of these loans vs. after the fact. There is a legal doctrine called "holder in due course" which protects mortgage investors from problems with underlying loans. This doctrine basically doesn't allow homeowners to file claims to original mortgage investors. However, the biggest issue here is that this protection is gone if the banks conduct assignment paperwork and transfer titles after the loans are already in default. In other words, homeowners in default can now file counter lawsuits and claims in their legal foreclosure defense that they were lied to when they were applying for loans, probably a common scenario in the subprime sector.

This will become a legal nightmare for banks which have created tons of these mortgage pools and structured products the last several years if they don't have the transfer paperwork done. Can you imagine how banks will defend every individual case in courts all over U.S? Not only are the legal fees are unimaginable, but also the cost benefit ratio of win vs. lose is not very attractive. Banks and their mortgage clients might simply bite the bullet and write them off instead of fighting thousands of them one by one.

History has proved that cheap and easy credit is never a good thing in the financial market. The public will always have to pay a much higher price for the financial alchemy later. This happened to the S&L crisis and the junk bond era in 1980s, and it will prove to be true again this time.

Comments

[GH:]

Terrific piece of investigative reporting, Thomas!

2007 Dec 11 09:51 AM

[Ranboz:]

Very good work. The evidence which supports a home price reversion back to the historical mean seems to keep building.

2007 Dec 11 05:28 PM

[348s:]

Actually, although I respect your business arguments, your legal concerns are largely misguided. The Federal Court hit Deutsche hard because Federal judges feel abused when foreclosures are brought to their courts instead of in state courts where such cases belong. And your HDC arguments are flat out wrong!

2007 Dec 11 06:54 PM

[Renter:]

Not enough hard facts and background on the laws to elude that foreclosed losers have another trick available to save their home.

2007 Dec 12 11:33 AM