MERS In the Spotlight Again

The Washington Post published a long article on the Mortgage Electronic Registration Systems ("MERS") this Sunday – "First the electronic mortgage superhighway. Then, the pileup." (Previous online version here.) The spotlight on MERS must be increasingly uncomfortable for the parent firm's (MERSCORP) 45 employees (MERS itself has no employees) who work in Reston, Virginia (a suburb of Washington, DC). The article states that "MERS is facing lawsuits from across the country seeking unpaid county recording fees. Several state courts have rejected attempts by MERS to act on behalf of banks seeking to foreclose on delinquent mortgages. And Congress is weighing legislation that would bar home loan giant Fannie Mae from buying any mortgage listed in MERS, potentially a death knell for the registry."

I have written on this subject in two previous posts (here and here). The new Washington Post article will no doubt increase the attention played to the MERS controversy. Court decisions currently are mixed on MERS, but if a major court decision does not go MERS' way, financial institutions and markets could be in for some real trouble.

MERS seems to be modeled after the Depository Trust Company ("DTC"), which serves to "immobilize" securities held in street name and operate a book-entry system to transfer securities among member firms. The firms in turn mark their books and the last tier in this book-entry system indicates the beneficial owners of the securities. However, MERS was constructed on the cheap, and does not have anything similar to the large underground vault that DTC has in Manhattan filled with paper securities.

Also, the legal regime for real property differs from securities. One of the purposes of MERS is to avoid the fees and the work involved in filing with local authorities the transfers of mortgages. There is some question whether listing MERS with local authorities is sufficient. There are also questions concerning whether MERS serves to separate the notes, which set out the terms and conditions of the loans, and the mortgages, which give the right to the lenders to foreclose on property should the borrowers default. Case law dating from the 19^th Century indicates that a mortgage separated from the note is worthless. This also implies that a note without the mortgage is unsecured, which has important implications in a bankruptcy proceeding. Moreover, some claim that MERS serves to disrupt a clear record of the chain of ownership of the mortgage and the note.

Obviously, to the extent that fraud is involved, as it would seem to be in the case of "robo-signers," shredded and/or forged documents, improper notarizations, and so on, there is no argument that this does not pose a serious problem. The more troubling question is whether the MERS system itself works as a legal matter even without such clearly improper action. One can easily find some extremely heated discussion of MERS as itself a fraud. For example, see L. Randall Wray's three part series for The Huffington Post on MERS ("Anatomy of Mortgage Fraud") which begins here. At the end of the series, he writes: "Some might think I have used the 'F' word excessively and cavalierly throughout these three pieces. To be sure, fraud is something that must be proven in court and since it involves intent that is not easy. I am using the term in the common everyday sense of the term and I think it accurately describes the behaviors I have outlined--and I am not alone. Christopher Peterson, Associate Dean and Professor of Law at the University of Utah calls MERS "a deceptive and anti-democratic institution", a "shell company" with a structure that could 'arguably be considered fraudulent'."

Also, Yves Smith has written very critically of MERS on her blog naked capitalism. For example, see "Will MERS Exam Be a Whitewash?" and "Why MERS Needs to be Taken Out and Shot." (Incidentally, "Yves Smith" is a pseudonym. It is a clever pun based on the Book of Genesis and a famous Scottish economist.) A more dispassionate look at the legal challenges MERS faces can be found in this Reuters article. On the other side, for an argument that MERS will likely in the end fend off the legal challenges, see "MERS Prevails In The Show-Me State." The author, a lawyer who works for a "creditors' rights law firm," concludes her article with advice to those on her side of the issue: "In order to stay on the winning side, lenders need to continue to adapt their procedures and policies to timely provide foreclosure counsel with documents and information. Likewise, foreclosure counsel must continue to update their archive of case law with favorable decisions, such as the ones cited in this article. With a united front in defending these challenges, MERS will knock out claims left and right, eventually finding itself in a permanent place of victory."

While some of the rhetoric is over the top, there is a serious problem. Not only are the legality of many foreclosures in question, but so are the validity of the securities backed by mortgages, which face both security and tax law questions. In addition, local governments are realizing that they may have lost significant fee income because of MERS. For example, one lawsuit claims that California local governments are owed at least $60 billion (not a typo) in recording fees. Apparently, the state has not joined in the lawsuit, and it is not clear it will, but $60 billion might seem to be a tempting amount of money for a state with serious budget problems. Other state and local governments are looking into this.

It will take some time for the legal issues to be settled in the states. While The Washington Post article speaks of legislation that would effectively mean the end of MERS by prohibiting the GSEs from purchasing or securitizing mortgages which are in MERS, one can be sure that there are lobbyists who are fighting to preserve MERS and, if necessary, get legislation passed that blesses what has been done in the past. The constitutionality of any such legislation, if enacted, could well end up being decided by the Supreme Court.

The creation of MERS in the 90s in such a way that these legal challenges are gaining traction is a failure of both the government and the private sector. Government regulators did not analyze MERS as much as they should have when it was created. They had plenty of authority under banking, security, and tax laws to demand changes if they thought it necessary. For its part, the private sector (major banks and Fannie and Freddie) did not listen to warnings about the legal risks. These failures now pose risks to all of us.

Acting Comptroller John Walsh indicated that the OCC and other bank regulators are looking into MERS. While his statement to this effect seems more focused on operational issues, the OCC and other government agencies must be worried about the legal issues. I suspect that they do not know what to do. The risks the government must see if court decisions go against MERS are that financial institutions and financial markets could again be in serious trouble and that Fannie Mae and Freddie Mac could face even more losses, which it seems would need to be covered by the federal government (meaning all of us). On the other hand, the Executive Branch will find it difficult to influence what state and federal courts will do, and the legal questions about MERS are not frivolous.

Some may think MERS will eventually be found to be a proper and legal mechanism for handling mortgages. It has to be, they may believe, because otherwise, the financial system would again be put at risk, and, after all, those foreclosed on are in default on their loans.  Perhaps.  But it may not go that way. One hopes that some creative thinking in the government is being done about what might be done to resolve the MERS issues in a fair, workable, and legal manner.