Chain of Title Page 5
Nonbank lenders Option One, New Century, and First Alliance started in the mid-1990s, joining Countrywide and Long Beach Mortgage, which would eventually become Ameriquest. Federal Reserve statistics show that subprime lending increased fourfold from 1994 to 2000, to 13.4 percent of all mortgages. Brokers were under significant strain to pump out subprime loans with high interest rates or else lose their warehouse lines of credit. So lending standards flew out the window. Practically no applicants were rejected.
That these loans were harmful concerned nobody. The Clinton administration wanted to increase homeownership rates, which had fallen amid the S&L collapse. It wasn’t likely to crack down on irresponsible lending practices if they served that goal. Anyway, the Federal Reserve held responsibility over consumer protection for mortgages, and Alan Greenspan viewed regulations the way an exterminator viewed termites.
Investment banks also got more sophisticated about the securities. Mathematicians fresh out of college—quantitative analysts, or “quants”—spent their working hours converting risky subprime loans into something that could secure a coveted AAA rating, guaranteeing sale into the capital markets. For example, banks had no problem selling high-rated tranches of their mortgage-backed securities, but the lower-rated mezzanine and equity tranches were more of a puzzle. To solve this problem, they built something called a collateralized debt obligation (CDO), using the same tranching mechanism, squeezing AAA ratings out of low-rated junk. Then they would make CDOs out of the unsold portions of CDOs, creating what was known as a “CDO-squared,” and so on. Investors knew they were buying securities backed by mortgages; they didn’t know they were getting repackaged leftovers of the worst bits, julienned through financial alchemy into something “safe.”
CDO sales increased exponentially after market deregulation through the Commodity Futures Modernization Act in December 2000, in one of President Clinton’s last official acts. You didn’t even have to own the mortgages to wager on whether they would go up or down. “Synthetic” CDOs just tracked the price of certain mortgage securities, with investors taking up either side of the bet. This multiplied the amount of money on the line well beyond the value of the mortgages and turned the whole thing into gambling.
The securitization machine resembled the children’s game of hot potato. Everyone stopped caring whether the borrower could pay back the loan, because everyone passed the default risk up the chain. The lenders didn’t care because they sold the loans to Wall Street banks; the banks didn’t care because they passed them on to investors; and the investors didn’t care because Wall Street’s financial wizards lied to them. Investors were assured that the loans were of high quality; furthermore, they were told that even if a few failed, slicing and dicing thousands of loans from all over the country into bonds would make up for the delinquencies and eliminate the risk. The geographic diversity of the bonds would insulate investors from a regional market collapse, and everyone knew that mortgage markets were regional; you never saw a broad-based price decline. The credit rating agencies, paid by banks to rate the securitizations, blessed the whole scheme, either out of ignorance or to make sure they grew their businesses.
In the late 1990s, amid the Asian financial crisis, Wall Street pulled back on warehouse funding for nonbank lenders. Subprime lending momentarily stopped, and some lenders went out of business. But this was only a blip. Though consumer lawsuits exploded during this period, complaining of predatory practices, the Federal Reserve and other regulators showed no interest. When the smoke cleared, the remaining subprime lenders and their Wall Street funders started up the machines again. The second wave of subprime mortgages dwarfed the first wave.
The entire industry was assembled on a mountain of fraud, starting from the first contact with a prospective home buyer. Many brokers over-inflated home appraisals to increase the loan balance. Some pushed borrowers into “no income, no asset, no job” (NINJA) loans by telling them they would get better deals if they falsely inflated their income. These were also called “liar’s loans.” If loan officers demanded income verification, brokers would sometimes even use Wite-Out and replace the numbers on W-2 forms, or construct fake tax returns with a photocopier, to get them through underwriting. In his book The Monster, Michael W. Hudson describes one loan sent to underwriting that claimed a man coordinating dances at a Mexican restaurant made well over $100,000 a year. The dance coordinator got the loan.
The typical borrower too easily fell prey to this routinized deceit. Some lenders took borrowers eligible for prime-rate loans—people with perfect credit, like Lisa Epstein—and gave them subprime ones. Others forged borrowers’ signatures on disclosure forms that would have actually explained how much in interest and fees they were paying. Some brokers used light-boards or even a bright Coke vending machine to trace signatures and enable the forgery. Others presented borrowers with a loan at closing whose first few pages looked like a fixed-rate loan, masking the toxic mortgage underneath. When the borrower signed all the papers, the broker ripped those first pages off.
The fraud continued up the chain as well. The Financial Crisis Inquiry Commission found that a third-party firm called Clayton Holdings, brought in to reunderwrite samples of loans backing subprime mortgage securities for twenty major banks, consistently found defects in half the loans in the samples. Clayton relayed its findings to the banks, who promptly used them to negotiate after-the-fact discounts on the full loan pools from originators. Those discounts never got passed on to bond investors, who remained ignorant about the defects. In such cases, the securitizers knowingly sold defective products to investors without disclosure, and took extra profits based on how defective they were. It was clear securities fraud.
Many investment banks knew about, and indeed drove, the poor quality of the loans. Internal documents later uncovered in a lawsuit against Morgan Stanley, the largest buyer of mortgages from subprime lender New Century, showed the bank demanding that 85 percent of the loans they purchase consist of adjustable-rate mortgages. When a low-ranking due diligence official told his supervisor about the litany of problems associated with New Century loans, she responded, “Good find on the fraud :). Unfortunately, I don’t think we will be able to utilize you or any other third party individual in the valuation department any longer.” In other words, finding the fraud got people fired.
In September 2004 the FBI’s Criminal Division formally warned of a mortgage fraud “epidemic,” with more than twelve thousand cases of suspicious activity. “If fraudulent practices become systemic within the mortgage industry,” said Chris Swecker, assistant director of the FBI unit, “it will ultimately place financial institutions at risk and have adverse effects on the stock market.” Despite this awareness, almost no effort was put into stamping out the fraud. In fact, when Georgia tried to protect borrowers with a strong anti-predatory lending law in 2002, every participant in the mortgage industry, public and private, bore down on them. Ameriquest pulled all business from the state. Two rating agencies, Moody’s and Standard and Poor’s, said they would not rate securities backed by loans from Georgia, cutting off the state from the primary mode of funding mortgages. And the Office of the Comptroller of the Currency, which regulated national banks, told the institutions that they were exempt from Georgia law. Georgia eventually backed down and replaced the regulations, rendered moot by an unholy alliance of the industry and the people who regulated them.
Banks issued $1 trillion in nonprime mortgage bonds every year during the bubble’s peak. Subprime mortgages made up nearly half of all loan originations in America in 2006. Total mortgage debt in America doubled from 1999 to 2007. There was so much money in mortgages that loan brokers right out of college made $400,000 a year. Traders on Wall Street made even more.
Home prices appreciated rather slowly for fifty years, but between 2002 and 2007 they shot up in a straight line. In several states, annual price increases hit 25 percent. Since this boosted property values, boosted the economy, and made the indus
try more profitable, few politicians or regulators raised alarms. Even Fannie Mae and Freddie Mac, locked into buying “conforming loans” for their securities, lowered their standards and bought subprime loans once they started to lose market share to the private sector. Everyone mimicked industry claims that the market transformation was good for homeowners, and for a little while it was: even amid rising prices, homeownership rates rose over this period to an all-time high of 69.2 percent. Nobody wanted to stop the merry-go-round while the song was still playing.
At the end of 2006 the song stopped, and homeowners used to refinancing out of trouble were stuck. Even before this point, you could see warning signs in skyrocketing early payment defaults—people missing their very first mortgage payment. Foreclosures started to occur in large enough numbers—they nearly doubled in 2007, and again in 2008—that mortgage-backed securities, even the senior tranches that were supposed to be infallible, took losses. Investors tried to dump the securities, and banks stopped issuing new ones. Brokers suddenly had no money to make new loans; by 2008, all of them were either out of business or, in the case of Countrywide, sold to Bank of America. The entire system, which soared along with home prices, crashed when those prices dropped. And because the system had been replicated multiple times, in CDOs and other credit derivatives, failures cascaded through Wall Street investments and led to a catastrophic financial crisis.
Lisa read about all this and internalized it; after a couple of weeks of intense study, she could cite chapter and verse on previously unknown financial industry machinations. She started to daydream while working, her mind filled with theories about mortgage-backed securities and what caused the crash. At work or at home, it became hard for Lisa to concentrate on anything else.
Of all the websites she sought out, none deconstructed securitization and Wall Street malfeasance like Living Lies. Neil Garfield went much deeper than the surface layer of fraud in the subprime scam. He viewed the originators as straw lenders, because they immediately sold the loan and did not care about its quality. To Garfield, this violated modest federal mortgage laws such as the Truth in Lending Act. Garfield called such originators “pretender lenders” and thought the fact that they relinquished their interest in the loan by having investors pay it off in full could form the basis of a legal challenge.
More interesting to Lisa were Garfield’s contentions about promissory notes, mortgage assignments, and pooling and servicing agreements. “The reality is that nearly all securitized mortgage loans are worthless and unenforceable,” Garfield wrote in one post. “The ONLY parties seeking foreclosures . . . do not possess ANY financial interest in the loan nor any authority to foreclose, collect, modify or do anything else,” he wrote in another. He quoted a bankruptcy attorney in Missouri, who added, “Democracy is not supposed to be efficient—because in the tangle of inefficient rules lies the safety and security of popular rights. The judge is not there to clear the sand from the gears of the machine—the judge is the sand.” Lisa didn’t understand Garfield’s line of argument at first, but a lot of Living Lies commenters were agitated about it, talking about document fraud and broken chain of title. And the discussion refreshed Lisa’s memory about something in her court summons.
Count II in the complaint was entitled “Re-establishment of Lost Note.” Lisa needed more information about what that actually meant—what was the difference between the note and the mortgage?—but it surprised her that the plaintiff admitted that it lost a key document and was trying to reestablish it in some manner. Others at Living Lies had note problems; for example, Andrew “Ace” Delany’s lender could never supply the note, although he asked for it every week. What was with this epidemic of lost notes? Where did they go? And how did that impact foreclosure cases?
As the twenty-day deadline for responding to the summons loomed, Lisa wanted to find out.
3
SECURITIZATION FAIL; OR, CIRILO CODRINGTON AND THE PANAMA DOC SHOP
None of Lisa Epstein’s options for dealing with her foreclosure seemed very attractive. She could try the Home Affordable Modification Program, or HAMP, which President Obama announced from Mesa, Arizona, on February 18, 2009, the day after Lisa was served. She pulled the speech up at the White House website. The idea was that the Treasury Department would give mortgage servicers incentive payments to modify delinquent loans. In the speech, Obama kept stressing borrower responsibilities more than the responsibilities of fraudulent lenders or securitizing banks. Did he not understand how this crisis happened? Plus HAMP involved applying through Chase Home Finance, Lisa’s servicer, which spent nine months losing her paperwork, ignoring her requests for help, and driving her into foreclosure by advising her to miss payments. Common sense dictated they wouldn’t be much better at administering a new program, no matter how many inducements the government gave them.
Lisa could fight it out in court, but the handful of lawyers taking foreclosure cases in Palm Beach County wanted retainers of up to $5,000, and $340 an hour in consultation fees. If Lisa had that kind of money, she probably wouldn’t be in foreclosure to begin with. Legal aid societies and pro bono lawyers working for free were overloaded and unavailable for someone with a decent job, like Lisa. Banks knew troubled homeowners didn’t have the resources to fight foreclosures; that’s why everyone told her most cases never got challenged. Besides, anytime Lisa would meet with a lawyer—and she talked to several, even drove an hour down to Broward County once—she’d explain her operatic theories about the housing crash, and the attorneys would stare at her like she sprouted horns. They all told her there wasn’t much she could do if she didn’t pay. But Lisa pleaded, “You don’t understand. The bank suing me says they have no relationship with me. How could I just give up?”
Without hope of a last-minute intervention, and without funds for legal representation, Lisa had a third option: fight the foreclosure herself, as a pro se litigant. This sounded crazy to her. She had no legal training, picking up bits and pieces in late-night cram sessions. The saying went that anyone who represents herself as a lawyer has a fool for a client. But Lisa’s motivations went far beyond whether or not she would keep that misbegotten house on Gazetta Way.
Something had gone horribly awry at the highest levels of the economy, causing the largest destruction of wealth in eighty years. Wall Street recklessness played the signature role, and Lisa wanted to challenge that in her small way. Maybe she could unearth some novel strategy, share her knowledge, and help spare other unsuspecting Americans from her pain. It would be difficult, no doubt, maybe impossible, maybe preposterous to even try. But Lisa didn’t think it worth her personal comfort to stay silent. Something about the magnitude of the crisis and the constancy of voices tagging foreclosure victims like her as irresolute deadbeats made her more determined to prove everyone wrong, to keep searching until she found something she could call justice.
While running through all this, Lisa kept coming back to Count II, the “Re-establishment of Lost Note.”
A mortgage has two parts. There’s the promissory note, the IOU from borrower to lender, and the mortgage, which creates the lien on the home in case of default. Foreclosure laws vary from state to state and evolve with every court decision, but in the simplest terms, to be able to foreclose, a financial institution must hold the mortgage, the note, or both. This gives you standing, as it would in most judicial contexts: if you accuse someone of stealing your car, you’d need to establish that you actually owned it in the first place.
During securitization, mortgages were transferred from the originator through a series of intermediaries and then to the trustee, who administers the mortgage-backed trust. Lisa’s case featured three parties in all—DHI Mortgage (originator), JPMorgan Chase (depositor), and U.S. Bank (trustee)—but sometimes these deals had as many as seven or eight transfers. The securitizations included intermediaries mostly to reassure investors that they would still get payments if the originator went out of business, which actually happened quite a
bit. This desire for “bankruptcy remoteness” drove securitization transfers, and it didn’t hurt that every transfer generated another fee.
At each stage there would have to be documented evidence of transfer, like links in a chain—a chain of title, which lays out the different transactions. You can’t skip a link: the chain must show evidence of transfers from originator to depositor to trustee, and everyone in between, in precise order. Mortgages are assigned with a signed piece of paper affirming the transaction. Notes are endorsed the same way you would endorse the back of a check. Theoretically, the originator could endorse the note “in blank,” so that anyone in possession of the note could enforce it. But that theory ran up against the reality of the securitization agreements.
When Lisa finally found copies of the rules governing securitizations, known as the pooling and servicing agreements (PSAs), they all had roughly the same language about transfers. This comes from the prospectus of Soundview Home Loan Trust 2006-OPT2:
On the Closing Date, the Depositor will transfer to the Trust all of its right, title and interest in and to each Mortgage Loan, the related mortgage note, Mortgage, assignment of mortgage in recordable form in blank or to the Trustee and other related documents received from the Originator pursuant to the Master Agreement (collectively, the “Related Documents”). . . .
The Pooling Agreement will require that, within the time period specified therein, the Depositor will deliver or cause to be delivered to the Trustee (or a custodian on behalf of the Trustee) the mortgage notes endorsed to the Trustee on behalf of the Certificateholders and the Related Documents.