Arnold Kling  

A Few More Thoughts on the Foreclosure Scandal

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I am not a lawyer, so treat the following as an amateur's view.

When you obtain a mortgage on a home, two documents get recorded. One is a mortgage, which as I understand it is just a piece of paper that says (if I am the homeowner), "Arnold Kling cannot sell this house until he pays off his loan!" Another document, which we will call the mortgage note, gives the terms and conditions of the loan. The lender, who we will call the noteholder, has the right to foreclose if I do not meet the terms and conditions of the loan.

The "foreclosure scandal," as I understand it, is that with securitization, the actual noteholder has changed in ways that may not have been recorded properly at the county records office. However, the identity of the noteholder is well defined in the trading systems used by mortgage securities traders.

Morally (as opposed to legally), the borrower is not really a party to this controversy. That is, the borrower did not abide by the terms of the note. The borrower has no moral claim to anything at this point.

The potential dispute is over whether the party demanding foreclosure is the rightful noteholder or not. That dispute should morally (again, not necessarily legally) be resolved among the parties that might claim ownership of the note. In theory, those parties could be getting all worked up over the documents, signatures, and so on being used in the foreclosure process. In practice, those parties are not disputing one another. The process that the industry uses for identifying ownership interests in the mortgages seems to be working, as far as the relevant parties are concerned.

However, the %&*#^ lawyers for the borrower come in and claim standing to challenge the foreclosure on the grounds that the foreclosure notice was sent by someone who has not properly documented that he is the noteholder. Legally, they may have standing to do this. Morally, they do not.

The sensible policy would be for the government to step in and legislate that borrowers have no standing to sue unless they are claiming to have complied with the terms of the note. If necessary, a Federal law could give precedence to the systems that the financial industry has in place for resolving potential conflicts among noteholders, rather than allow local rules to interfere with interstate commerce in lending.

What I think of as obviously sensible public policy looks like it's friendly to "the banks," and so the #@#%$^ lawyers naturally made a point of bringing the issue to the media's attention three weeks before the election. That way, instead of responding with sensible policy, the politicians have to show themselves hating on the banks. But if there were any justice, this "scandal" would be regarded as nothing but baloney sandwich.

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COMMENTS (26 to date)
ThomasL writes:

I think you are right that the borrower is unimportant in this.

However, I think you are wrong that this not a real scandal.

The owners of the securities were promised by the sponsors that the associated mortgage notes would be held in trust. Since that was not always done, the assets that were supposed to be secured by the note are effectively unsecured.

If that proves true, then it is fraud or malfeasance on a massive scale by the sponsors of the MBSs against the purchasers of the MBSs.

Pandaemoni writes:

I think a more sensible policy would be to enact a law indicating that the holder of a note need only prove he or she has a legal/economic interest in the note to have standing to force a foreclosure, regardless of whether that interest is recorded in the local land records. Alternatively, you would still have to let your homeowners have the right to challenge whether or not the foreclosing party has any interest in the note. (I prefer my solution.)

Imagine, hypothetically, that your proposed sensible policy were in place, and that (i) Hal the homeowner was in default on his Note and (ii) that Hal's evil next door neighbor, Cal, hates his guts.

First, a "default" does not necessarily mean "failure to pay." It could mean that there was, for example, a failure to buy exactly the right insurance coverage because Hal's deductible is $100 higher than what is permitted under the mortgage. "Default" is a blanket term that catches any failure under the mortgage, and any failure could lead to an exercise of remedies.

Second, imagining that this is a payment default, suppose Cal learns of it and so he files a foreclosure proceeding. Under your proposal, Hal has no standing to challenge Cal's presence. Hal has to hope that the actual mortgagee steps in, and the identity of the actual mortgagee may be tough to find, given the securitization in which Hal's mortgage note was included.

Now, even imagining that the actual mortgagee has an incentive to foreclose, in the more traditional world it may be to the mortgagee's benefit to negotiate a settlement instead. So there is some value in making sure the party that has turned up in court is the proper party, or an agent for the proper party. Cal clearly should have no right to make the call here, and Hal should have some ability to challenge Hal's standing.

That said, I do agree that the fact that the new mortgagee's name was not properly recorded should not matter,/* which is to say that the new mortgagee should be the one in court, but he or she should have the same rights regardless of whether the legal formalities were satisfied.

/* One aside, is that in many states, an assignment of a mortgage and note prompts a recording tax. In certain places, my understanding is that tax can be substantial—in the extreme 2% of the amount secured by the mortgage. In some places, like New York State, that leads to a great deal of twisting and turning by assignees in an effort to avoid paying that tax. It may be that, in some cases, the failure to record the transfer also effectively evades the tax. In those cases, and since those taxes are not going away, my proposed rule would be that if the noteholder proves his or her legal/economic interest in the note and retroactively pays the tax, then he or she will be deemed to have standing to foreclose.

Mike V writes:

I have a great reluctance to apply morality to a court proceeding prior to a legal ruling. Once you start applying morality then you need to discuss the morality of an unconscionable mortgage, with both parties sharing the blame.

Also, the flawed affidavits are, in my mind, a fraud on the Court. After all, the Court uses it to recognize the parties with standing. While the homeowner has an ulterior motive for raising a flawed filing, it needs to be raised for a correct legal ruling, and the homeowner is the only party willing to raise it.

drobviousso writes:

I generally agree and can't think of a moral reason that a homeowner should have moral justification in challenging a foreclosure like this. But I have hust a few thoughts/questions:

If there is no official record of a change in note holder, how does a home owner know that the person claiming to be a note holder really has the legal authority to foreclose? I've recently seen some businesses processing foreclosures using tactics that would make a collection agent blush, and I'm not sure I would believe they are the kind of businesses that wouldn't use fraud to get you out of your home even if they don't have a right to it. Just tonight we had someone ringing doorbells in the neighborhood (at 10:00 PM!) telling people that one of our neighbors is in foreclosure in an effort to shame her into paying up.

If you were a title insurer, ten years down the road, would you be comfortable writing insurance on property with an off the books transfer or four? My wife, a former employee of a title insurance agency said "ha ha ha, no."

Hyena writes:

The most obvious use of the law would be to foreclose upon people when you're not the noteholder. You would do this for direct fraud or as a scare tactic in some other type of collection. Without standing to sue in the matter, the homeowner would be without recourse when it happened; the actual noteholder would have to step in and defend their claim in court.

The title system simply needs to be modernized and made more accurate. This isn't a new problem: in 2008 the New York Daily News stole the Empire State Building using fraudulent title claims, exposing just how broken New York's title code was (is?). The solution is to make chains of title easier to track and harder to fake, not enact new legal norms with obvious negative effects.

Arnold Kling writes:

I agree. See my earlier post.

Æternitatis writes:

Prof. Kling is almost entirely right in this.

The one exception I would take is to the notion that a delinquent borrower has no interest in the matter at all. If the claim of the note-holder is fraudulent (or otherwise incorrect), the true note-holder could subsequently sue the borrower again and the borrower could find himself on the hook for the house twice. Hence, even a delinquent borrower might have a legitimate interest in ensuring that the alleged note-holder is in fact the only legal claimant.

The best solution would be to require the alleged note-holder to indemnify the borrower against any future claims by other parties claiming to be note-holders. If a court finds that the alleged note-holder has a prima facie case that it is the legal note-holder (for which the trading system information would be sufficient) and that the alleged note-holder has credibly indemnified the borrower against any other claims, a delinquent borrower should lose all right to object.

mlb writes:

Arnold, I think the outrage makes sense. So far throughout this crisis the banks have gotten away with countless acts that were morally reprehensible yet legal (or at least not illegal). The population is frustrated. So if you can't challenge the banks on moral grounds you have no choice but to challenge them on legal grounds. This is a rational response to the threat of a society dominated by banking & large corporate interests. What would be your solution to clawing power back - I dont think you have one.

Joe in Morgantown writes:

Æternitatis: Prof. Kling is right about the mess of the title registration system and that it should be reconsidered going forward.

But, his proposal that the law be retroactively changed to accommodate the powerful is very dubious.

The banks' unpopularity does not make their cause just.

mlb writes:

"The banks' unpopularity does not make their cause just."

The banks have pursued a policy of "dont worry about morality as long as actions are legal." The goverment did not change laws to prevent this. To now change laws to prevent citizens from following the exact same policy would be a double-standard (based on power/wealth) and therefore the more questionable moral action. Seems logical to me.

mark writes:

Strongly disagree. Your argument elevates not just form, but fraud, over substance. The borrower has a moral right to deal with the person holding the real economic interest in opposition to the borrower, not by someone who may be acting fraudulently. The entity with the real interest may find it maximizes value to work matters out with the borrower. The entity with the real economic interest may have related investments and relationships that cause it to be more scrupulous and cautions about foreclosing.

Default in a contract does not terminate the contractual relationship. It permits, but does not compel, its termination. The post-default stage is still within the contractual frame and the borrower in default is entitled to all of the rights that exist in that context. When the loan was made, the lender made it against the backdrop of those rights and customs in the post-default environment. The borrower has a moral right to hold on to whatever benefits and protections that environment precribed when the loan was made. Those are risks a sophisticated lender knowingly assumed. If one of them was the borrower's right to be dealt with by the real economic interest, it is morally right to assert that protection.

Æternitatis writes:

@Joe in Morgantown,

exactly whose legal rights is Prof. Kling proposing to alter retroactively?

That would be a very grave problem, but I do not see it. A delinquent borrower never had any right to keep possession of the collateral.

The only question is whether delinquent borrowers should be permitted to delay the process indefinitely by use of frivolous evidentiary objections.

Æternitatis writes:


But everybody who has examined these cases has absolutely no doubt that the foreclosure plaintiff (as documented in the trading systems) is the person with the real economic interest in virtually all cases.

The objections based on paper work problems in county courthouses are fundamentally frivolous—denial of a truth everybody knows for the sole purpose of prolonging the proceedings to the profit of the delinquent borrower who gets to live rent- and mortgage-free.

Jeff writes:

Ah, but see Felix Salmon for the real scandal: The investment banks that packaged mortgages into securities knew (because they had someone examine a representative sample of the loans) that huge numbers of the loans they were packaging did not meet the underwriting standards they claimed to meet. As underwriters, they were legally required to disclose any and all material facts they knew in the prospectus for the MBS, and they didn't. As a result, the buyers of the MBS should be able to force the banks to buy back the securities at the original price, which will put most of them underwater. They may also be prosecuted for criminal fraud.

This could be fun.

Æternitatis writes:


Interesting. I was involved as a lawyer (but not a "%&*#^ lawyer") in structuring MBS for all of the listed investment banks and I had never heard of Clayton Holdings.

More importantly, Salmon manages to completely ignore the elephant in the room. While there were pure private-issue MBS, for the bulk of the market the issuer was one of the government-sponsored (and largely Democrat staffed and legislatively protected) enterprises: Fannie, Freddie, Ginnie, etc. The banks were merely the underwriters (i.e., the dealers and distributors of the bonds) which does carry some legal liability, but they were not the ultimately responsible issuers.

Given that the issuers now are in form, as well as substance, part of the Federal Government, it is the taxpayers which may be on the hook for any fraud.

Ari writes:

Are the borrowers suing, or are they defending themselves against a suit by the wrong party? I think there is a difference between the two, which is related to how you evaluate the morality of what the borrower is doing.

schooner writes:

Shorter Arnold Kling,

The law only applies to little people.

razib writes:

i had the same though as mlb. i kind of lost my faith in this whole thing about the right thing to do in the fall of 2008. from a pure utilitarian perspective i think arnold makes a strong case, but we don't have the social capital and trust anymore to behave in this way. if the elites are crooked and will follow the letter of the law and not its spirit, the little people will assert their own right to be crooked in the same manner.

stuhlmann writes:

Of course delinquent home-owners aren't entitled to a free house or to remain in a house that they stopped paying for, but they are entitled to due process and the rule of law. This would include seeing those who commit fraud and perjury be tried for their crimes.

stephen writes:

This thread reminds me of Robin Hanson's model of "Farmer Society" social norm enforcement. The farmers mostly care about enforcing norms within their own class while the elites get away with murder.

Some commenters, of which I have a good deal of sympathy, are trying to reject this hypocrisy: if the elite bankers are getting away with it so should the lowly mortgage borrowers.

Here is the thing, though, the bankers are going to get away with it no matter what. By cracking down on this "fraud" the elite lawyers get their piece as well. Sweet! Meanwhile, the rest of us farmers are stuck with a housing market on crack for a longer duration.

Also, kinda related, Eric Falkenstein:

Dan Weber writes:

Morally, I don't think you should be asking the other side in a loan to prove that they have the interest in the loan, without some reason for thinking so.

I know I don't like businesses that operate under the theory of hoping the consumer makes a mistake. (I got into a debate on this blog about a year ago with someone who claimed it was A-OK for health insurance companies to accept applications, hoping that the customer had made a mistake, so that they could rescind them in case of a large payout. I still suspect that person of being a stalking horse for government-run care, because while claiming to support insurance companies, they were only making me hate them all the more.)

Legally, though, there can be serious problems with fraud. These can probably be fixed with something like earnest money and indemnification, but I'd still be careful.

Hyena writes:

Prof. Kling,

Apologies, I've been spotty with the blogs lately.

lxm writes:

Here's some good arguments about the borrowers right to see the note:

I find it truly bizarre that you argue that the borrower has no moral standing to argue with a flawed process. No other entity seems to need any moral standing to defend themselves as best they can. In fact, there is a moral imperative to defend yourself as best you can. I also find it reprehensible that you curse the lawyers the borrower has hired.

I suppose you are concerned with the integrity of the foreclosure proceedings and the effect all these questions may have on the broader market. But your taking your concerns out on the wrong parties.

To blame the borrowers for the flaws of the bankers is to be truly blind, blind to the reality that the banks are expert in the laws and will, as a standard business practice, screw the mortgagee wherever and whenever it can, and blind to the imbalance of power between the parties.

I think you need to rethink all of this and discover why you are so unbalanced here.

Æternitatis writes:


No other entity seems to need any moral standing to defend themselves as best they can. In fact, there is a moral imperative to defend yourself as best you can.
... [T]he banks are expert in the laws and will, as a standard business practice, screw the mortgagee wherever and whenever it can[.]
For borrowers, it is a "moral imperative" to use every baseless legal chicanery to defend their interests.

For bankers, it is nasty "standard business practice [to] screw the mortgagee wherever and whenever it can."

Cognitive dissonance much? Or just one of the legions who feel that equal treatment under the law is an outrage whenever it aids one of your hate groups?

lxm writes:

If there's cognitive dissonance anywhere, it's in Mr. Kling's arguments.

Banks screw people when they can. It's part of their business model. (I am not opposed to banks, but that is what they do, if you let them.)

Mr. Kling argues that mortgagees can't (or shouldn't) use the same tools against the banks that banks use against the mortgagees. That's the cognitive dissonance.

My question is why does Mr. Kling feel more sympathy for the bank screw-ups than he does for the mortgagee screw-ups? Why is he willing to cast a blind eye and forgive the banks and seek to crucify the mortgagees?

It's not as if the banks can't defend themselves, unlike some mortgagees.

Of course, you can always argue that the mortgagees forced the banks to sign those liar loans.

lxm writes:

Well, it now looks like some of the loans were pledged to multiple buyers at the same time:

Those bankers, they are so clever.

I've decided that Mr. Kling is not guilty of cognitive dissonance. Instead he is just deeply conservative. He believes that order is more important than justice. If a few peons get screwed its the price we pay for order. This is a time honored principle.

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