How Paperwork for Two Massachusetts Mortgages Tripped Up Banks

January, 2011
Morningstar Andrew Raines

NEW YORK -(Dow Jones)- Fears about the costs for banks from foreclosure document problems reemerged Friday, when a high court in Massachusetts ruled in favor of two defaulted home borrowers whose mortgages had been securitized.

The court affirmed a lower court's ruling that the trail of paperwork for two Springfield, Mass., mortgages wasn't complete. That judgment spooked investors in banks that own piles of mortgage-backed securities, on fears they could be left without recourse to recover soured loans.

The question of who holds the legal right to the mortgage, and therefore the home, has become yet another hole the banks need to plug to convince investors they have the flood of legal issues from foreclosures under control.

This hole specifically arises from the complicated process a mortgage goes through when being securitized, a process that ultimately has provided the grease for mortgage creation in the U.S.

For instance, the loan taken out by Antonio Ibanez, one of the defendants in the Massachusetts case, was sold at least four times from the time he took the loan to the time it was foreclosed on, according to the court documents.

Ibanez had first gotten his adjustable-rate subprime loan from a mortgage originator called Rose Mortgage. Ibanez signed what is known as the note, a promissory note that details the conditions of the loan and gives the holder the right to the collateral. Rose Mortgage then, according to the court papers, properly transferred the mortgage and the note to Option One, then an arm of H&R Block Inc. (HRB) which gathered mortgages and sold them to Wall Street.

Option One endorsed the note without an officially designated new owner, instead using "payable to bearer," and also assigned the mortgage without a specific designee, according to the documents.

This was the key point where the Massachusetts court determined the rules had been broken: because no specific asignee was named, the mortgage was never transferred legally.

Option One, however, proceeded to sell the note to Lehman Brothers, which then bundled the mortgage along with hundreds of others and sold it to its own subsidiary, Structured Asset Securities Corp.

That entity then sold the loan pile to the mortgage-backed security investment trust, with U.S. Bancorp (USB) acting as a trustee. The trust took the loans and created ten tranches of investments out of the pool of mortgages and Lehman Brothers turn sold those tranches to investors at various rates.

Option One remained in the picture for Ibanez's mortgage, playing the role of servicer, meaning the entity with authority to foreclose. Eventually the servicer of the loan became American Home Mortgage Servicing Inc., which initiated the foreclosure case.

The so-called "show me the note" defense is not new. But Friday's ruling caught some in the legal world by surprise because it hadn't been considered a particularly viable defense, said Andrew Raines, partner at California law firm Raines Feldman.

The ruling "gives lawyers all over the country new ammunition and a new precedent," Raines said.

While the Massachusetts ruling won't be carried out across the country, it created more uncertainty that other judges could rule similarly.

American Home Mortgage said Friday the ruling as a whole actually affirmed the securitization process, but was lost on a specific Massachusetts law that wouldn't carry to other states.

On Sunday morning, New York City Comptroller John C. Liu led seven public pension systems, which hold $430 billion combined in investments, blasting big banks for their mortgage pratfalls.

"There is a fundamental problem in their procedures," Lieu said in a release, "that endangers not just homeowners, but shareholders, and local economies."

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