In August, the Kansas Supreme Court issued a ruling against a mortgage tracking service which may prove very costly to banks in foreclosure, leading to massive writedowns. It could be a life saver for many trapped in the foreclosure process. The case goes to the core of the functioning of massive markets in securitization and derivatives and has wide-ranging importance.

The service, MERS (Mortgage Electronic Registration System), is a privately-owned registry set up in 1997 by Fannie Mae, Freddie Mac and several large banks including JPMorgan Chase, Citigroup and Bank of America. In foreclosure, MERS is often the party which files on behalf of the lenders behind the mortgage against homeowners. The Kansas ruling effectively blocks MERS from bringing legal action on the lenders' behalf in certain foreclosure situations, potentially putting the kibosh on  MERS' legal authority on the more than 60 million mortgages it holds and subjecting the lenders to huge losses.

This is a complicated but important case I want to break down for you below.

Securitization at fault

The crux of the case has to do with mortgage-backed securities and the process of securitization. In a bygone era, almost all mortgages were held as loans on the books of the originating banks.  In this case, if a mortgage went past due, it was a matter to be worked out between an individual homeowner and an individual mortgage holder.

However, when the mortgage-backed securities (MBS) market took off, mortgages were sliced and diced into tranches and packaged into securities and sold on to investors.  These same securities were then sliced and diced and packaged with other securities into collateralized debt obligations (CDOs). CDOs were often then sliced and diced further still into CDOs-squared – that is CDOs of CDOs.

Often times, the underlying mortgages in these instruments were high-risk, sub-prime mortgages. But the ratings agencies could still give them AAA ratings, making them eligible for investment by teachers' pension funds and municipalities restricted from holding risky assets. So these securities were then sold on to investors around the world to remote investors like small towns in Norway and banks in Germany. When the housing market fell, the value of these securities plummeted much more than the house prices as securities are derivatives, leveraged against the value of the underlying asset. The result was a financial crisis of epic proportions.

Making matters more complicated for the homeowner, the originating lender is often not the servicing agent of a mortgage. Payment from the homeowner and to investors who are the ultimate owners of the security is handled by a mortgage servicer who collects a fee for its work.

What this has meant is that there is considerable distance between a homeowner and a mortgage holder, such that in the event of foreclosure, it is not a matter of picking up the telephone and calling Mr. Smith at the local Bank. Often times, there is a byzantine web of originating bank, mortgage holder (if loan is sold), mortgage servicer, MBS pooling/securitizing agent, and investors. Needless to say, the average person doesn't have a clue as to who to call in order to get relief to avoid foreclosure. The obvious port of call is the mortgage servicer, who is the one party with whom a homeowner has ongoing contact.

Mortgage Servicer

Below is a research report written by the National Consumer Law Center just this past month on why consumers in jeopardy of suffering foreclosure cannot get loans modified.

It starts:

The country is in the midst of a foreclosure crisis of unprecedented proportions. Millions of families have lost their homes and millions more are expected to lose their homes in the next few years. With home values plummeting and layoffs common, homeowners are crumbling under the weight of mortgages that were often only marginally affordable when made.

One commonsense solution to the foreclosure crisis is to modify the loan terms.