How The Mortgage System Works!

AND how its been rattled...

How The Mortgage System Works — And How It's Been Rattled
By Peter G. Miller

Foreclosures are setting off fresh tremors across the country but not because of any surge in unpaid loans. An elaborate system designed to assure good title to your home and solid assets on lender books has been shaken by revelations of botched foreclosure affidavits.

This is a problem because courts rely on sworn affidavits as evidence, and it appears that large numbers affidavits were signed but not read. If an affidavit has not been read then it's possible lender claims are wrong. Since we don't know which affidavits are accurate and which are not, massive numbers of audits will now be required to find out if any owners unfairly lost their homes. Already court systems and title insurance companies are tightening standards to protect homeowners, many areas have set up foreclosure freezes and state prosecutors have begun to investigate past foreclosures for evidence of fraud.

Because owners missed payments few foreclosures are likely to be reversed as a result of affidavit worries but other questions have emerged, questions which bring uncertainty into the financial system.

“It's important to get the process right to assure that both homeowners and lenders are protected,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com. “At a time when a quarter of all residential sales involve foreclosures it's in everyone's interest to be certain that titles are clean and that all court actions have been by the book.”

Step 1: A Note Is Created
It used to be simple: Local lenders made local loans and kept them. Such “portfolio” lenders still exist but now the odds are overwhelming that the cash you receive at settlement comes from far, far away — and that the party who originated your mortgage no longer owns the loan.

To figure out how the lending system really works today let's start with you. You want to finance or refinance a home. In exchange forcash from a lender you agree to repay the debt over time and with interest. Your promise is in writing in the form of a mortgage note. You pledge the property as security for the loan — if you don't make payments the lender has the right to take the house through foreclosure.

The “lender” could be a bank, credit union, savings and loan association or insurance company but most likely your loan was originated by a mortgage broker or a mortgage banker. In general terms, a mortgage broker sells loans from lenders who have cash while a mortgage banker has the capital to finance the loan.

The reason for such sales is that if a loan originator has $5 million and makes 20 mortgages for $250,000 apiece he has no more money to lend. If he sells the loans he has fresh capital and the ability to make more mortgages and generate more income. Originators without cash simply retail loans from sources with capital such as big banks or insurance companies.

You got cash and the lender got a mortgage note and the promise of repayment when you financed your property. Now your loan originator gets cash by selling the loan and passes the mortgage note to buyers on Wall Street, a process which is now entirely common: In 2009 mortgage-related securities worth nearly $2 trillion were issued.

Step 2: Notes Move To Wall Street
Once on Wall Street your mortgage and other mortgages can be bundled together to create a mortgage-backed security (MBS) or a collateralized debt obligation (CDO) — a combo security stuffed with mortgages, car loans, credit card debt, student loans and other forms of debt. Generally such investments are described as mortgage- related securities.

None of this happens easily or automatically — or without lots of fees and charges.

First, we need an “issuer” to create securities that can be sold to investors. This is a bankruptcy-remote special purpose entity, meaning that the loans cannot be taken by creditors if the issuer goes bankrupt.

Next, an underwriter organizes and sells the mortgage-related securities to investors. The investors want the cash flow from the mortgage interest paid each month by borrowers. The underwriter also creates a market so investors can buy and sell interests in the mortgage-related securities.

For their part the investors want to know that their mortgage-related securities are good, marketable and insurable. To get this information they rely on “raters” who evaluate each security to determine the level of risk it represents — less risk means a lower interest rate, more risk requires a higher interest rate for investors, if they will invest at all.

Investors also want their securities to be protected so that if a large percentage of loans fail there's a financially strong third party to step in and limit losses. This third party — what most of us would call an insurer — provides a “credit enhancement” in the form of guarantees to investors.

Step 3: Dividing Ownership
If you buy one share of IBM you own the whole share, but with mortgage-related securities investors buy a piece of the action called atranche — a French word which means such things as slice, block or section. In a sense tranches are like mortgages. If a house secures two mortgages and the owner is foreclosed, the claims of the first loan must be completely satisfied before the second lien holder gets a dime. With mortgage-related securities the claims of the first tranche holder must be paid off before other investors can receive any cash. Of course, this also means that the first tranche has a lower interest rate because it represents less risk while second tranches have higher rates because they're riskier.

Step 4: Investor Representatives
Once the mortgage-related security is created we next come to the practical problem of day-to-day loan administration.

A trustee is appointed to represent all the investors who own the mortgage-related security. The trustee hires a servicer to collect the borrower's monthly payments, release mortgages when paid off and foreclose if necessary. The servicer is a “special” agent who must act within the rules established under a pooling and servicing agreement (PSA) with the trustee.

If we go back to the first step we can see that the borrower got cash and the originating lender received a mortgage note. Once on Wall Street, ownership of the loans is recorded within MERS — the mortgage electronic registration system. MERS then appears to be the nominal holder of the note and the note can be used to create a mortgage-related security. In turn, the mortgage security can be bought and sold without changing local property records to show new ownership of the borrower's mortgage note. Of course, if the borrower doesn't make payments the note can be used to force a foreclosure.

But Is The System Failsafe?
The mortgage financing system appears to be bullet-proof, with lots of protections, safeguards and certainty built in for both borrowers and investors. Unfortunately, no financial system is without risk and much of the mortgage meltdown is related to failures within the mortgage financing system — big failures.

• The ratings agencies overvalued mortgage-related securities which included option ARMs, interest-only mortgages and home loans created with no-documentationo loan applications. The result was that investors grossly overpaid by purchasing weak securities at premium prices and now face big losses.
• Third-party “credit enhancements” turned out to be financed with credit default swaps, complex financial instruments which brought a steady flow of premiums to insurers. Unfortunately not enough was set aside in reserves when investor claims arose. AIG, as one example, defaulted on credit default swaps worth $14 billion according to Newsweek — coverage ultimately paid off with loans from Uncle Sam.
• There's growing controversy over the MERS concept and an expanding “show me the note” movement among foreclosed borrowers. Several courts have rejected lender efforts to foreclose because the mortgage notes did not show a change of ownership on local records with each sale or assignment.
• Because of improper affidavits, borrowers qualified for mortgage modifications may have lost the opportunity to save their homes from foreclosure.
• Mortgage insurers — including the FHA and VA — may have paid lender foreclosure claims that were not justified.
• Title insurance companies who promise to protect homeowners against fraud now face huge new costs.
• Pension funds, insurance companies and other investors will have to review mortgage-related securities to assure that past foreclosures and losses were justified.
• The deliberate manufacture of faked affidavits undermines the legal system, and that's a serious matter to judges. Audits, assessments, fines, suspensions, disbarments and even perjury and fraud charges are being considered.
• A bank can sometimes be a lender, underwriter and servicer at the same time, a situation that can set off worries about conflicts of interest. For instance, a bank with lots of second mortgages may not want to foreclose on a homeowner who fails to make mortgage payments because then the bank's second lien would likely become worthless. Meanwhile, the investors who own the first lien are hurt because income from the note is unpaid. In such situation investors can ask the bank/servicer to buy back the loan — and if “asking” is not sufficient they can sue. Investors holding mortgage-related securities worth $600 billion have come together to challenge Wall Street banks, according to William Frey, president of Greenwich Financial Services.
• Outright fraud is an ongoing worry. One enterprising New Jersey mortgage broker gamed the system by originating loans and then selling the same mortgages multiple times. According to federal prosecutors he generated fake paper worth $11 million over a two-year period before being caught. How Wall Street underwriters, raters and insurers missed such fraud is unclear.

In the end it turns out that the financial fortress created to transform home loans into securities has more holes than an old cheese. The result is a new and harsh look at the system from borrowers, lenders, investors and regulators — to say nothing of courts, trial attorneys and state prosecutors.

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