Philosophers might not agree, but in the world of economics and business, at least, it is possible for something to be true and still not be right. One of those things is illustrated by the words: “We’ve always done it that way. That’s the way the system works.”
Public awareness of the subprime credit crunch really began with one investment fund’s discovery that it had a mess on its hands. The fund owned securities based on collateral so poorly documented and in such disarray that it was impossible to put a market value on them — so the fund notified investors that it was suspending payouts on these securities.
Now it seems that similar poor documentation is going to make it more difficult, maybe even impossible, to foreclose on properties with delinquent mortgages.
A recent Federal District Court ruling in Cleveland has introduced a novel concept to the foreclosure process: evidence. Judge Christopher Boyko Jr. issued an order dismissing 13 foreclosures that had been filed by Deutsche Bank, saying that the bank had not presented satisfactory evidence that it owned the mortgages.
Some people might call it a legal technicality, but it is an important one. To get legal standing in a federal court foreclosure proceeding it is not enough simply to swear that you own something, even if nobody challenges that claim. You have to show how you came to own it.
Deutsche Bank was unable to do this. It is the trustee for what are called securitization pools, which were the bundled-up mortgages that served as collateral for the securities sold in financial markets. Investors had purchased these securities, often called collateralized debt obligations, with the idea that their risk was tempered by the underlying mortgages and the ability to foreclose on them if payments were not made.
In the rush to get these securities to market, though, it seems that the documentation got pretty sloppy. The transfers of ownership — sales or assignments — were not documented in a way that allowed someone to connect the dots from the original mortgage to the holder who wanted to foreclose. This is very similar to the chain of custody documentation issues that fans of television programs such as “CSI” and “Law &Order” might be familiar with.
The result was that Deutsche Bank was left trying to convince the court that it owned these mortgages when the documents didn’t say anything of the sort. As it turned out, the court wasn’t buying it. And it didn’t buy the argument, described in the decision as, “Judge, you just don’t understand how the system works.”
When Deutsche Bank could not come up with the proper documentation, Boyko dismissed the case. Two weeks later, a similar case, involving 32 foreclosures, was dismissed by Judge Kathleen O’Malley, also of the U.S. District Court in Cleveland.
With respect to the overall U.S. economy, there are two reasons to applaud these two rulings. The first is that it is not in the best interest of the economy to move quickly on foreclosures unless there is good reason to believe that the house can be sold promptly, which is unlikely in most real estate markets today. This ruling might slow things down and encourage lenders to work out payment plans with homeowners, which would be much better for the housing market and, consequently, for our economy.
The second benefit of the ruling to our economy will be to discourage the “free-wheeling, don’t worry about it” element in our financial securities markets. Debt markets are supposed to appeal to investors with a calculated, restrained appetite for risk. But it is easy to lose faith in a system that is careless with details about who owes what to whom.
As individuals, we will benefit from having foreclosure proceedings done the correct way, which protects and preserves our rights. Few homeowners in foreclosure have the cash resources to be represented by an attorney, with the result that is, as the court decision described, a “quasi-monopolistic system where financial institutions have controlled, and still control, the foreclosure process.” Individuals coming out of a foreclosure process often end up owing a lot more money than when they went in.
The overall impact of these two federal District Court decisions is still hard to assess. There is every reason to believe that the documentation problem is chronic in the subprime bundled mortgage market, so the case is likely to have many parallels. Still, the decisions are not binding on other courts.
But at the very least, the decisions are forcing the financial industry to stop for a moment and try to clean up its act. And that, for the economy, is a very good thing.
James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101” monthly for the Snohomish County Business Journal.
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