In Search of the Lost Notes

In Search of the Lost Notes

A recent story on www.bloomberg.com addresses a dilemma that mortgage note buyers and mortgage servicers may face when they attempt to foreclose on home loans: some courts are requiring foreclosure plaintiffs to present the original note evidencing the foreclosed debt. Some of the cases are state court cases involving foreclosure directly, and some are bankruptcy cases usually involving lift-stay motions. The fact pattern follows a now-familiar path:
 
·       loan originators lend money for the purchase of houses
 
·       those debt obligations then are packaged into tranches of residential mortgage backed securities (RMBS), either directly or after being sold intact multiple times
 
·      a mortgage service company is retained at some step to collect mortgage payments, interface with the mortgagor, and generally service the mortgage (sometimes, an originator-owned affiliate also services the mortgages, e.g., Countrywide)
 
·      the tranches are sold to buyers around the world
 
·      some entity in the debt ownership chain may or may not have gone out of business, gone bankrupt, or been purchased by or merged into another entity
 
·       the loan document paper trail is at risk for fragmentation every time ownership of the debt changes  
 
·       the mortgagor defaults
 
·      either the loan servicer or the putative current noteholder attempts to foreclose on the debt based on whatever documentation is at hand
 
The rub begins when judges hearing the foreclosure cases require the foreclosing party to present the original note as proof of ownership. (It would be interesting to hear from Louisiana lawyers about how the property record system in the southern Louisiana coped with the disruption associated with hurricanes Katrina and Rita.)
 
The Bloomberg article leads the critical reader to think about several aspects of the post-subprime bust story. First, the proof issue isn’t between only the defaulting mortgagor and the putative noteholder, as one might infer from this quote: “Judges are human beings,'' said Kenneth M. Lapine, a partner at the Cleveland law firm Roetzel & Andress LPA. “They no doubt feel the little guy needs all the help he can get against the impersonal, out of town, mega-investment banking company.'' There also is the matter of assuring that the true creditor receives relief. Imagine the scenario where Creditor A secures relief in foreclosure of a note that Creditor A thinks it owns, but in fact non-party Creditor B owns all or part of that note. To complicate the hypothetical further, imagine that non-party Creditor B actually owns the entire note, and is quite amenable to a non-foreclosure resolution. At best, non-party Creditor B discovers the caper in time to intervene and protect its interest; at worst the homeowner loses her house and credit rating unnecessarily. That hypothetical might make students facing a Creditor Rights Law final wake up in a cold sweat, but it also implicates broader issues of standing, joinder, and due process jurisprudence in general. Add a few successive sales of the formerly encumbered/now REO property with a few quitclaim deeds or bankrupt title insurers in the process and the hypothetical makes a tasty morsel for a Real Property Law final exam.  
 
Another aspect of mild interest is that the proof of note ownership issue in non-bankruptcy cases applies mostly to only mortgage-theory instruments. In pure deed of trust states, and with deed of trust instruments in the states that allow both forms, title likely would pass from debtor to putative noteholder non-judicially. (This Credit Slips post and its links present some timely comment about non-judicial foreclosure.) Usually, there would not be a judge to assure that the foreclosing party is the true noteholder; one would hope that the deed of trust paper trail is up to the task. In bankruptcy cases, the proof of note ownership issue probably arises mostly where the moving party seeks to lift the automatic stay in order to take the encumbered property from the mortgagor (it also is possible that the fight could be between the bankruptcy trustee and a creditor of a bankrupt noteholder). It might be that quarrels over debt ownership in trust deed transactions that were fed into the RMBS machine simply aren’t (as) visible to outsiders as are incidents involving ordinary mortgages. That raises the issue of whether the popular term “foreclosure rate” accurately tracks defaulted loan turnovers, especially for deed of trust transactions involving hard-money lenders.        
 
One wonders whether lenders will begin hard lobbying to change states’ laws in an effort to make it easier to foreclose without producing the original note. In some ways, the current document-trail mess was foretold in the 1980s savings and loan crisis, but some might ask whether we learned much. The document tracking problem was difficult enough then, and that often was simply finding documents buried in the RTC’s file stores. Computerize the documentation more, shred the transactions into confetti strips of ownership rights, multiply the number of players (some of whom are international) by thousands of times, crank up the fraud machine, open the liquidity floodgates, maybe outsource the recordkeeping to the lowest cost provider, then slam on the brakes, and the result becomes a lot more complex. It will be interesting to see what the legal system and the entire RMBS process learn from this bubble ride.           
 
More about the proof of note ownership issue can be found in Kenneth M. Lapine on In re Foreclosure Cases 2007 U.S. Dist. LEXIS 84011 (N.D. Ohio 2007)