Megan McArdle on Foreclosure Fraud Crisis

Megan McArdle has a series of posts on the foreclosure crisis. What’s a ‘Libertarian Solution’ to the Foreclosure Mess?, Reader response, Foreclosure Options. It comes off the question highlighted at Balloon Juice:  Why aren’t libertarian outlets discussing the foreclosure crisis?

Given that McArdle and I are likely to disagree on many points, I found it a solid read and hope more libertarians get engaged in this important conversation.  I may have more later, but a few high-level points right now.

1) Contra Balloon Juice, some libertarians have responded, usually finding that homeowners are in the wrong to be challenging this and the sooner we liquidate the homeowners the better off the economy will be. Arnold Kling, for instance: “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.”

And Mark Calabria of Cato “The current efforts by states to use technical mistakes by lenders to allow borrowers to remain in homes without paying could ultimately undermine the very concept of a mortgage.”

Those were from some months ago, I’m not sure if that’s where they still stands.  I discuss these approaches in those posts. If libertarians were quick to argue that we need to strictly respect contract and thus not support mortgage cramdown, or fixing defects in our bankruptcy laws when it comes to homeowners, they now have to consider that respecting contracts might mean trustees have no standing to foreclose, something they don’t seem all that keen on.

2) Mcardle:  Already I have a number of readers who seem to think that there is some sort of option specified in the mortgage contract.  There isn’t….The advocates of jingle mail are essentially arguing that there’s an embedded option, and nothing wrong with exercising it; not that there is an actual option.

Let’s be clear on what the claims are.  If you live in a state where you have the right for judicial bankruptcy you pay extra for that.  This has been well-proven by Karen M. Pence of the Board of Governors of the Federal Reserve System, in her paper, Foreclosing on Opportunity: State Laws and Mortgage Credit (“[D]efaulter-friendly foreclosure laws are correlated with a four percent to six percent decrease in loan size. This result suggests that defaulter-friendly foreclosure laws impose costs on borrowers at the time of loan origination.”)

That’s why I find approaches by libertarians to essentially skip judicial foreclosure for a bank-friendly “rocket docket” quick approach (what the two suggestions above imply) to be improper. They were charged a fair rate in a competitive market for a judicial review, and they should take advantage of it if they find it appropriate.

Also, if you look at any of the economic literature around consumer lending all of it refers to a default option (example: “The results in the column illustrate the effect of the prepay and default options, trigger events, and loan- level characteristics on default when we do not control for recourse”). People are certainly charged for this and a lot of thought goes into thinking it through state-by-state;  modeling this option is a big industry.   It’s not an explicit option, but embedded options are the most important to think through.

3) McArdle:  “Let’s turn it around,” I asked. “What if the bank decided that it wanted to exercise the same sort of option?…What if the bank foreclosed on your house, even though you made the payments, because it figured it could make more money taking the house and selling it?” (Not a likely scenario, I know, but a useful thought experiment.)

Banks exercise the same sort of option all the time when they resell mortgages (and hopefully notes!) from one entity to another entity. That’s the problem we have right now, that this reselling option banks use was so sloppy it’s tearing up the economy.

This is why if you are the type of person who thinks markets self-regulate through consumer demand and reputation there’s a major problem, as consumers have no choice over their mortgage servicer. If you don’t like your servicer, and refinance your mortgage with another bank, that bank can still sell off your mortgage and you can still end up serviced by the same institution.  Given that the servicers haven’t been functionally regulated  (Andy Kroll, Mother Jones: “An OTS spokesman could name only one formal action the agency has taken against a servicer—Ocwen, in 2004. An OCC spokesman said his agency has never taken action against servicers.”) this was a disaster coming down the pipeline for a while.

There are many other problems with the foreclosure crisis other than the note problem, but the note problem clearly brings together the whole shoddy mess of the issuance and management of mass mortgage debt, a network that spun out of control over the past 20 years. McArdle’s post bring up a good point;  there should be clarifications on what a proper Democratic response should be to this crisis.  The short answer is that the servicing model has broken down, so there needs to be mechanisms that allow for circumventing that process in the negotiation of bad mortgage debt.

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15 Responses to Megan McArdle on Foreclosure Fraud Crisis

  1. joseph says:

    “Given that McArdle and I are likely to discuss on many points,”

    Did you mean disagree?

  2. Mike says:

    Yikes! My fewer typos 2011 resolution isn’t working out so well. Thanks for catching.

  3. Altoid says:

    I’m obviously not up on my libertarian tenets, but why aren’t these people talking about the sanctity of property? That’s supposed to be the bedrock of our economic and legal order, or am I missing something? Contract is supposed to be important because it upholds property. Right?

    We say colloquially that “the bank owns the house” while we’re paying off a mortgage, but if I understand the process and the law in the least little bit, that isn’t what happens at all.

    What happens (in most states, at least) is that I buy a piece of real property– I’m the owner of record, so it’s mine, mine, all mine. All the rigamarole around a closing is to establish my clear title to it and my ownership of it. It is true that in order to buy it most people need to pledge it as collateral for the loan. However, that only underlines that it’s mine, *not* the lender’s.

    If I violate the loan terms, the lender does have the right to take possession from me. For the libertarians out there, this is where the state acts by compulsion on behalf of the lender. But real property has special standing, underpinned by historical experience, because of its value and because it’s where people live and in cases like farms it’s how they’ve historically supported themselves and their families. Thus the law has hedged my ownership with what should be powerful protections against erroneous seizure, guided by the state, on behalf of the lender. They have to prove beyond doubt that they’re entitled to enlist state power against me.

    That, it seems to me, is the bedrock rational position. A bank or agency that can foreclose on me because it says so is one that can foreclose on Megan McArdle, Arnold Kling, and Mark Calabria because it says so. Haven’t we seen that?

    The fact that investment banking standards (ie, none) have been imported into real estate record-keeping is no concern of the property owner and it really should alarm the bejeesus out of these people. Where is the sanctity of contract if the PSA hasn’t been followed? If the lender, servicer, and whoever can’t keep track of the pledges of collateral and payment, which is the substance of the contracts? What does that say about the place of contract in the investment banking world, which happens to rule our world?

    Or am I missing something?

    • Andrew says:

      Altoid,

      I’m not a lawyer (and I don’t play one on TV). I am an avid reader of Mike’s site and others which have discussed foreclosure fraud in the last six months or so. Next minute I’ll say I stayed in a Holiday in, I know…..

      A bit of Googling points us to a distinction between Title Theory and Lien Theory states. See, for example http://www.helium.com/items/2007532-real-estate-law-difference-between-a-lien-theory-and-a-title-theory

      So in a title theory state (like Massachusetts) title rests with the mortgagor, the entity which issued the mortgage, or its valid assignee. In colloquial terms, and up until a few months ago, we might have said with “the bank,” but we’ve learned (those of us who aren’t fluent in real estate law) that securitization is designed, if it works, to pass the legal title (residing in the mortgage) through a chain of entities into a trust, which then issues securities whose cash flows are collateralized by the Notes (agreements of the debtor to pay the mortgage) and by the Mortgages (which permit the holder of the Mortgage to foreclose in defined circumstances). See some of Mike’s earlier excellent posts, and sites like naked capitalism, for more detail.

      In lien theory states, the buyer (debtor) does retain title to the property, but a lien is recorded on the property which confers rights to obtain the title if the conditions of the loan aren’t met.

      This overlaps with, in some way that I’m not clear on, the procedures of the states in permitting foreclosures – whether a state is a judicial or non-judicial foreclosure state. I don’t think there’s a correlation of 1 – ie, if you’re title theory, then you’re non-judicial foreclosure. But I don’t know this.

      Anyhow, in Ibanez my understanding is that the courts found that title had not been validly assigned to the entity seeking to foreclose. Only if the chain of assignments was cured could that entity act in foreclosure. This aligns with your later point that a bank (or any other person or entity) can’t just foreclose because it says so. A larger point is that those who argue that we should just ignore (or legislate to remove) these legal requirements because they’re just sloppy paperwork may well run into a brick wall.

      • Altoid says:

        Thanks for your reply, Andrew. I followed your link, and to me it reads a little bit differently. The question in title-theory states seems to me who has physical possession of the deed, rather than whose name is on it. The key paragraph is ambiguous, however:

        “In a title theory state, the bank or finance company that is issuing the loan will hold the title until the loan is satisfied. At the closing, the seller will assign the deed to the property to the buyer. When the buyer in turn signs the loan papers, he will give the deed to the loan holder to be held as security until the loan has been paid in full.”

        The first sentence seems to say that the bank’s name is on the deed (“hold the title”). But the following explanation seems to me to be saying that the buyer’s name is on the deed but once that part of the closing is accomplished, the deed is physically turned over to the lender, who walks out with my deed in its portfolio, as a further protection for the lender and an inducement to me to pay up. “Hold” in the first sentence is physical, not legal, in other words. So in PA, evidently a lien-theory state, I’ve had the deed all along; if I bought in MA my name would be on the deed but the bank would hold it until I paid.

        My bigger point builds on one that Yves Smith and others have been very clear on, that real estate law and procedures developed over a very long time for the mutual protection of sellers, buyers, lenders, and tax-collecting entities, and are generally well-settled within jurisdictions. I believe that traditional lenders in the field understood them well. But in the more recent period, particularly with securitization, denizens of the finance world who don’t understand them and have no patience with them have tried to import their own normal conduct into real estate transactions. It’s a different mind-set– short-term in orientation and sloppy about at least the non-financial details because after all once the deal is done what can you do? The world moves forward, not back, and we can’t reconstruct every deal. (Unrelated, but this is the same theory Microsoft followed in its early anti-competitive practices– if you drive small competitors out of business there’s no entity left to sue you.) This world and real estate are incommensurable.

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  5. The whole reputation argument is hokus pokus. Story time:

    My father long ago bought a used car that went kaput after a week. You see, the dealer had filled the rear differential with sawdust which was something my father had thought only existed in John Steinbeck novels. Well, my father got his money back by going back and threatening to beat the man to a pulp (we’re talking about the solution of a twenty two year old fresh out of the army here). But the dealer remained in business for many years after that. Who knows how many people didn’t get they’re money back?

    If libertarians ever got their wish they’d soon realize that all those consumer protection laws were put in place for a reason. And those reasons haven’t gone away. It’s kind of like what my father told me about the sixties “We broke all the old rules and the result was we quickly found out why most of those rules were there…”

  6. Russ says:

    This just proves what liars all economic “libertarians” (i.e. propertarians) are, and what a fraud their alleged ideology is.

    The examples above (perfectly typical) demonstrate that they really have nothing but contempt for the “sanctity of contracts” except where those contracts are to the advantage of the rich. The same for so-called “property rights”, which always mean in practice the right of big holders to steal from smaller ones.

    Obviously, any libertarian who actually had integrity, whatever changes he advocated in the law, would want to see all existing contracts fully work themselves out, no matter how destructive that would be to the banks.

    Needless to say, anyone with integrity also wouldn’t spew the lie that these are mere “technical errors” and “mistakes”. We know this is systematic fraud on both borrowers and MBS buyers (and on the courts). Anyone who’s not a criminal or an abettor of criminals would start with this fact, and discuss from there.

  7. Sumoking says:

    “any libertarian who actually had integrity, whatever changes he advocated in the law, would want to see all existing contracts fully work themselves out, no matter how destructive that would be to the banks.”

    I am eternally dismayed that the perfectly sensible libertarian enclined section of the population seems to completely lose it when confronted with big business and in particular companies.

    The enitire idea of a limited liability company is contrary to the central tennant of libertarian ideology that “you must be responsible and accept consequences”. Setting up a legally fictious fall guy makes a mockery of that as there is nobody to take the responsibility. Sadly companies are so uselful to the economy that there is no way you could ever roll them back but it depresses me that so many of my brethern are happy to take the side of a state created monster over the individual.

  8. yorksranter says:

    What if the bank foreclosed on your house, even though you made the payments, because it figured it could make more money taking the house and selling it?

    This has actually happened, more than once. Anyway, there is no point in responding to McMegan with anything other than mockery. The short answer to your question is that libertarians don’t exist: they are simply members of the Bank party. They speak for the interests of finance and property, nothing else. Libertarians who actually believe that the sanctity of contracts etc counts for banks only exist in political theory.

  9. sherparick says:

    Naked Capitalism does an analysis of the likely Administration’s proposal on resolving the Banks failure to adhere to their contracts with both investors and borrowers. Basically, it is screw the investors and borrowers and relieve the banks from their contractual obligations Ex Post Facto.

    The proposal would actually make it far easier for banks to fraudalently foreclose on mortgages that current or perhaps deficient only due to a single late fee. Right now, with house prices still flat and falling, banks don’t have much incentive to play this kind of game to mess up a current revenue stream. But if house prices start rising again, and inflation diminishes the value of the loan and the profit from servicing it, then the incentives will change.

  10. TC says:

    The fact that these two very prominent libertarians do not know this is not surprising.

    The ‘implied put’ option is widely, widely known in the professional analyst community, and has been for at least a decade.

    The CFA level II program used to reference it in at least one specific learning outcome, plus it is mentioned as a risk for lenders, securitizers, and purchasers of the securities. It is discussed in detail as a viable option for both commercial and residential borrowers, and is called the “implied put” for shorthand within the readings from a few years back.

    I went through the CFA program in the early part of the 2000’s, so this was well known on the analyst side for years before that. Information does not get added to the CFA program a few minutes after someone thinks about it. The CFA Body of Knowledge is what is judged to be must “know information” that has stood some reasonable scrutiny and meets a level of usefulness for a financial analyst.

    I think I just threw out my Stalla Level II books last year, but ask any CFA Charterholder, the implied put has been common knowledge for at least a decade, and probably more.
    (See, I did go through the program and abide by the Code – all you ‘Charterholders’ are chuckling right now)

    Then, that these ‘libertarians’ want to throw out contract law procedures for establishing ownership shows they could care less about the contracts. Mortgage notes are not bearer bonds.

    What if I showed up with a note saying Arnold Kling borrowed from me and pledged me his house as collateral? How is this different than the bank doing this? The legal process evolved over a long time to make the ownership chain nearly idiot proof.

  11. framed says:

    Maybe this is better understood than it appears, but your explanation for the existence of an embedded option relates to recourse, not if the mortgage is issued in a title or lien state.

    The embedded put option in a residential mortgage is due to the existence of an exculpatory clause in the promissory note. If there is an exculpatory clause, the lender has no recourse beyond the property serving as collateral. In other words, in a non-recourse loan, the borrower has the right to sell the property back to the lender at a price equal to the amount owed. This option is in the money when the property value falls below the loan amount. Note that if there is no exculpatory clause, the full amount of the loan is due regardless of the property value (and, in the event of negative equity and foreclosure, the difference can be obtained by a deficiency judgment against the borrower).

    Also, on point #3, the lender has the right to take the property only if (at a minimum) the terms of the promissory note are violated, not whenever they feel like it. The fact that McMegan doesn’t understand this simple point yet is generally considered to be a voice to be listened to on topics of economics makes me very, very sad.

  12. Brian says:

    Wow, how many people commenting here read the McArdle piece?

    The jingle mail option in her piece was explained clearly, short of a few non-recourse states like California and Arizona, most people do not have a simple ‘mail the keys in’ option. Most states have recourse loans where the lender can sue you for the difference between what is owed and what was recovered. That was her point.

    Her point about the bank exercising the same options was not as described here. She outlying the equivalent mail the keys strategy for a bank as follows, a bank loans 200K on a house and the house increases to 300k, the bank takes the house from the owner and sells it for a 100k profit. This is different then the bank selling off the 200k loan to a different lender, and it is much different then the wrongful foreclosures going on now. She was not arguing banks should do this, outlining what that the non-recourse option for borrowers would look like if banks also had it.

    Lastly, go read the piece. She is arguing for solutions that I think many ‘liberals’ would also like. Banks fixing the documentation problems on their own dimes. Not abridging contract law because it’s convenient. Take off your ideological blinders and stop the ad hominem attacks for a second, this coming from a conservative that reads Rortybomb.

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