Monday’s Adjudication Roundup

Strip-Downs Are Good

The Philadelphia Fed has posted a Working Paper, Using Bankruptcy to Reduce Foreclosures: Does Strip-Down Of Mortgages Affect The Supply of Mortgage Credit? The paper’s abstract reads,

We assess the credit market impact of mortgage “strip-down” — reducing the principal of underwater residential mortgages to the current market value of the property for homeowners in Chapter 7 or Chapter 13 bankruptcy. Strip-down of mortgages in bankruptcy was proposed as a means of reducing foreclosures during the recent mortgage crisis but was blocked by lenders. Our goal is to determine whether allowing bankruptcy judges to modify mortgages would have a large adverse impact on new mortgage applicants. Our identification is provided by a series of U.S. Court of Appeals decisions during the late 1980s and early 1990s that introduced mortgage strip-down under both bankruptcy chapters in parts of the U.S., followed by two Supreme Court rulings that abolished it throughout the U.S. We find that the Supreme Court decision to abolish mortgage strip-down under Chapter 13 led to a reduction of 3% in mortgage interest rates and an increase of 1% in mortgage approval rates, while the Supreme Court decision to abolish strip-down under Chapter 7 led to a reduction of 2% in approval rates and no change in interest rates. We also find that markets react less to circuit court decisions than to Supreme Court decisions. Overall, our results suggest that lenders respond to forced renegotiation of contracts in bankruptcy, but their responses are small and not always in the predicted direction. The lack of systematic patterns evident in our results suggests that introducing mortgage strip-down under either bankruptcy chapter would not have strong adverse effects on mortgage loan terms and could be a useful new policy tool to reduce foreclosures when future housing bubbles burst.
This paper seems to cut through some of the hyperbole that surrounds this topic. Its concluding paragraphs indicate how a modest introduction of strip-downs would have only a modest impact on the availability of mortgage credit. It contrasts such a modest step with more far-reaching proposals, such as using eminent domain to take underwater mortgages throughout an entire jurisdiction. The paper seems to argue that the more modest proposal could be acceptable to the lending industry. I am not so sure that that is true, particularly in the current political environment. But it is certainly true that strip-downs could be a useful tool to have when “future housing bubbles burst,” as they most certainly will.

Carney, Epstein, Macey & Reiss on GSE Litigation

I was on an interesting panel today on the state of the Fannie/Freddie shareholder litigation. Judge Lamberth’s ruling in Perry Capital LLC v. Lew et al. was bad news for the plaintiffs in all of the shareholder suits. The panel was hosted by Michael Kim, CRT Capital Managing Director & Senior Research Analyst, and featured

  • John Carney – Wall Street Journal
  • Richard Epstein – NYU Law School
  • Jonathan Macey – Yale Law School
  • David Reiss – Brooklyn Law School

The agenda for the panel included

  • an overview of the litigation timeline for the cases in Iowa District Court, the Court of Federal Claims and the U.S. Court of Appeals for the District of Columbia
  • a detailed analysis of Judge Lamberth’s Ruling and
  • a review of legal strategies and the outlook going forward

The more of these panels I am on, the more I am struck by the passionate intensity of those representing the shareholders. They are convinced that they are not only right, but also that the judiciary will see it their way. I lack this conviction.

It is not that I am so sure that the shareholders will ultimately lose (although that is a good possibility). Rather, it is that the facts and the law are extraordinarily complex in these cases. Because of this complexity, I find it hard to predict how the judges assigned to hear these cases will choose to frame them.

Judge Lamberth and other judges deciding cases arising from government action during the financial crisis often frame their decisions with a narrative of extraordinary government intervention during a period of great uncertainty. As a result, those judges have granted the government as much deference as they can.

Many of the shareholder advocates analogize from precedents drawn from more pedestrian situations and believe that courts will hew closely to them. I am quite skeptical of that approach. Judges lived through the crisis too and are all too aware of the precipice we were on. I think they will think twice before second guessing those who had to call the shots with such severely limited information, and did so while under unrelenting pressure to get it right when the stakes were so high.

Is Freddie the “Government” When It’s In Conservatorship?

Professor Dale Whitman posted a commentary on Federal Home Loan Mortgage Corp. v. Kelley, 2014 WL 4232687, Michigan Court of Appeals (No. 315082, rev. op., Aug. 26, 2014)  on the Dirt listserv:

This is a residential mortgage foreclosure case. The original foreclosure by CMI (CitiMortgage, apparently Freddie Mac’s servicer) was by “advertisement” – i.e., pursuant to the Michigan nonjudicial foreclosure statute. Freddie was the successful bidder at the foreclosure sale. In a subsequent action to evict the borrowers, they raised two defenses.

Their first defense was based on the argument that, even though Freddie Mac was concededly a nongovernmental entity prior to it’s being placed into conservatorship in 2008 (see American Bankers Mortgage Corp v. Fed Home Loan Mortgage Corp, 75 F3d 1401, 1406–1409 (9th Cir. 1996)), it had become a federal agency by virtue of the conservatorship with FHFA as conservator. As such, it was required to comply with Due Process in foreclosing, and the borrowers argued that the Michigan nonjudicial foreclosure procedure did not afford due process.

The court rejected this argument, as has every court that has considered it. The test for federal agency status is found in Lebron v. Nat’l Railroad Passenger Corp, 513 U.S. 374, 377; 115 S Ct 961; 130 L.Ed.2d 902 (1995), which involved Amtrak. Amtrak was found to be a governmental body, in part because the control of the government was permanent. The court noted, however, that FHFA’s control of Freddie, while open-ended and continuing, was not intended to be permanent. Hence, Freddie was not a governmental entity and was not required to conform to Due Process standards in foreclosing mortgages. This may seem overly simplistic, but that’s the way the court analyzed it.

There’s no surprise here. For other cases reaching the same result, see U.S. ex rel. Adams v. Wells Fargo Bank Nat. Ass’n, 2013 WL 6506732 (D. Nev. 2013) (in light of the GSEs’ lack of federal instrumentality status while in conservatorship, homeowners who failed to pay association dues to the GSEs could not be charged with violating the federal False Claims Act); Herron v. Fannie Mae, 857 F. Supp. 2d 87 (D.D.C. 2012) (Fannie Mae, while in conservatorship, is not a federal agency for purposes of a wrongful discharge claim); In re Kapla, 485 B.R. 136 (Bankr. E.D. Mich. 2012), aff’d, 2014 WL 346019 (E.D. Mich. 2014) (Fannie Mae, while in conservatorship, is not a “governmental actor” subject to Due Process Clause for purposes of foreclosure); May v. Wells Fargo Bank, N.A., 2013 WL 3207511 (S.D. Tex. 2013) (same); In re Hermiz, 2013 WL 3353928 (E.D. Mich. 2013) (same, Freddie Mac).

There’s a potential issue that the court didn’t ever reach. Assume that a purely federal agency holds a mortgage, and transfers it to its servicer (a private entity) to foreclose. Does Due Process apply? The agency is still calling the shots, but the private servicer is the party whose name is on the foreclosure. Don’t you think that’s an interesting question?

The borrowers’ second defense was that Michigan statutes require a recorded chain of mortgage assignments in order to foreclose nonjudicially. See Mich. Comp. L. 600.3204(3). In this case the mortgage had been held by ABN-AMRO, which had been merged with CMI (CitiMortgage), the foreclosing entity. No assignment of the mortgage had been recorded in connection with the merger. However, the court was not impressed with this argument either. It noted that the Michigan Supreme Court in Kim v JP Morgan Chase Bank, NA, 493 Mich 98, 115-116; 825 NW2d 329 (2012), had stated

to set aside the foreclosure sale, plaintiffs must show that they were prejudiced by defendant’s failure to comply with MCL 600.3204. To demonstrate such prejudice, they must show they would have been in a better position to preserve their interest in the property absent defendant’s noncompliance with the statute.

The court found that the borrowers were not prejudiced by the failure to record an assignment in connection with the corporate merger, and hence could not set the sale aside.

But this holding raises an interesting issue: When is failure to record a mortgage assignment ever prejudicial to the borrower? One can conceive of such a case, but it’s pretty improbable. Suppose the borrowers want to seek a loan modification, and to do so, check the public records in Michigan to find out to whom their loan has been assigned. However, no assignment is recorded, and when they check with the originating lender, they are stonewalled. Are they prejudiced?

Well, not if it’s a MERS loan, since they can quickly find out who holds the loan by querying the MERS web site. (True, the MERS records might possibly be wrong, but they’re correct in the vast majority of cases.) And then there’s the fact that federal law requires written, mailed notification to the borrowers of both any change in servicing and any sale of the loan itself. If they received these notices (which are mandatory), there’s no prejudice to them in not being able to find the same information in the county real estate records.

So one can postulate a case in which failure to record an assignment is prejudicial to the borrowers, but it’s extremely improbable. The truth is that checking the public records is a terrible way to find out who holds your loan. Moreover, Michigan requires recording of assignments only for a nonjudicial foreclosure; a person with the right to enforce the promissory note can foreclose the mortgage judicially whether there’s a chain of assignments or not.

All in all, the statutory requirement to record a chain of assignments is pretty meaningless to everybody involved – a fact that the Michigan courts recognize implicitly by their requirement that the borrower show prejudice in order to set a foreclosure sale aside on this ground.

Reiss in Bloomberg on CS Lawsuit

Bloomberg quoted me in Credit Suisse Waits for $11 Billion Answer in N.Y. Fraud Suit.  It reads in part,

As Credit Suisse Group AG (CSGN) sees it, time has run out on New York Attorney General Eric Schneiderman’s pursuit of Wall Street banks for mortgage fraud that helped trigger the financial crisis.

Schneiderman sued Credit Suisse in 2012 as part of a wide-ranging probe into mortgage bonds. He claimed Switzerland’s second-largest bank misrepresented the risks associated with $93.8 billion in mortgage-backed securities issued in 2006 and 2007.

Credit Suisse asked a Manhattan judge in December to dismiss Schneiderman’s case, as well as his demand for as much as $11.2 billion in damages. The bank argued that New York, by waiting so long to file the lawsuit, missed a three-year legal deadline for suing. The state countered that it had six years to file its complaint.

If the bank wins, Schneiderman will face a new roadblock as he considers similar multibillion-dollar claims against a dozen other Wall Street firms. The judge in New York State Supreme Court could rule at any time.

“It would obviously tilt everything in the favor of Credit Suisse and similarly situated financial institutions,” said David Reiss, a professor at Brooklyn Law School, hindering New York’s remaining efforts to hold banks accountable for mistakes that spurred a recession.

*     *     *

Since the latest bonds cited in Schneiderman’s suit originated in 2006 and 2007, if the judge chooses the bank’s argument, the lawsuit may be dismissed. If the judge takes Schneiderman’s more expansive view, most or all of the suspect bonds may still be covered by the litigation.

“The entire case is time-barred,” Richard Clary, a lawyer for the bank, told Friedman at the December hearing. Lawyers for the state argued that such limits weren’t intended to apply to the attorney general.

“We’ve successfully resolved cases filed within six years,” Deputy Attorney General Virginia Chavez Romano said, citing last year’s JPMorgan accord. “It has been our decades-long practice.”

So far, New York’s courts have broadly interpreted the statute in finding a six-year period, Brooklyn Law School’s Reiss said. That may be changing as legal scholars and financial industry lawyers question its propriety.

“Having these incredibly long and ambiguous statutes of limitations is not particularly fair,” he said.

*     *     *

Friedman’s ruling in the Credit Suisse case may be crucial to Schneiderman’s probe of close to a dozen other banks, and whether he can sue them successfully.

New York agreed with the firms in October 2012 that any legal deadline for bringing fraud claims against them would be suspended while he continues his investigation, a person familiar with the matter said.

Such tolling agreements stopped the clock on any statute of limitations and ensured Schneiderman can bring fraud claims against banks for conduct going as far back as 2006, said the person.

Brooklyn Law School’s Reiss said the banks may have agreed to the delay to avoid forcing Schneiderman to file a “kitchen sink complaint with every possible allegation in it” just to beat the clock. Doing so also builds good will with regulators and may also facilitate a favorable settlement.

The agreements don’t necessarily mean that suits will be filed, the person said. If Schneiderman sues any of the banks, they may then assert the statute of limitations is three years, and not six, just as Credit Suisse has done.

*     *     *

This may be a more potent argument if Friedman rules for the Swiss bank in the pending case.

A three-year statute-of-limitations would mean they can’t be held responsible for transactions before 2009, while a six-year deadline would allow Schneiderman to reach back to 2006.

There’s “great uncertainty” about whether Schneiderman can move forward with the Credit Suisse case in light of the statute of limitations arguments, said James Cox, a corporate law professor at Duke University in Durham, North Carolina.

Reiss said that any ruling would probably be challenged all the way to the Court of Appeals in Albany, the state’s highest court.

Arizona’s “Unholy” Foreclosure Mess

Professor Dale Whitman posted a commentary about Steinberger v. McVey ex rel. County of Maricopa, 2014 WL 333575 (Ariz. Court of Appeals, Jan. 30, 2014) on the Dirt listserv:

A defaulting borrower may defend against foreclosure on ground that the chain of assignments of the deed of trust is defective, and also on a variety of other theories.

The residential mortgage loan in this case was originally made in 2005 to Steinberger’s 87-year-old father, who died two years later, leaving her the property. By 2008, she was having difficulty making the payments, and asked IndyMac FSB to consider a loan modification. She was advised that she must first default, and she did so. There followed a period of more than two years during which she was “jerked around” by IndyMac, with successive promises to consider a loan modification, the setting of (and then vacating of) foreclosure dates, and assertions by IndyMac that she had not properly submitted all of the paperwork required for a modification.

In November 2010 she filed an action seeking a declaratory judgment that IndyMac had no authority to foreclose on the house, and upon filing a $7,000 bond, she obtained a TRO against foreclosure. The following summarizes the theories on which she obtained a favorable result.

1. Lack of a proper chain of title to the deed of trust. The Court of Appeals seems to have assumed that no foreclosure would be permissible without the foreclosing party having a chain of assignments from the originator of the loan. If one accepts this assumption, IndyMac was in trouble. The first assignment, made in 2009, was from MERS, acting as nominee of IndyMac Bank, to IndyMac Federal FSB, but it was made before IndyMac Federal FSB even existed!

A second assignment was made in 2010 by IndyMac Federal FSB to DBNTC, the trustee of a securitized trust. But Steinberger alleged that by this date, IndyMac Federal FSB no longer existed, so this assignment was void as well. She also made the familiar allegation that this assignment was too late to comply with the 90-day transfer period required by the trust’s Pooling and Servicing Agreement, but the court did not pursue this theory.

The court’s opinion is significant for its treatment of Hogan v. Wash. Mut. Sav. Bank, the 2012 case in which the Arizona Supreme Court held that “Arizona’s non-judicial foreclosure statutes do not require the beneficiary [of a deed of trust] to prove its authority.² The Court of Appeals, in Steinberger, read this statement to mean that the beneficiary need not prove its authority unless the borrower alleges a lack of authority in her complaint. There was no such allegation in Hogan, but there was in Steinberger. Hence, the Court of Appeals concluded that Steinberger could contest IndyMac’s right to foreclose. And it felt that Steinberger’s allegations about the defects in the chain of title to the deed of trust, if proven, could constitute a successful attack on IndyMac’s authority to foreclose.

It’s important to realize what the Court of Appeals did not do. It did not disagree with Hogan’s holding that the beneficiary need not show possession of the promissory note in order to foreclose. Several commentators (including me) have criticized Hogan for this holding, but the Steinberger opinion leaves it intact. Indeed, in Steinberger, the borrower raised no issue as to whether IndyMac had the note, and seems to have conceded that it did. The discussion focuses on the legitimacy of the chain of title to the deed of trust, not on possession of the note.

Is the court correct that a valid chain of title to the deed of trust is necessary to foreclose under Arizona law? As a general proposition, one would think not. Arizona not only has adopted the common law rule that the mortgage follows the note, but even has a statute saying so: Ariz. Rev. Stat.§ 33 817:  “The transfer of any contract or contracts secured by a trust deed shall operate as a transfer of the security for such contract or contracts.” So if the note is transferred, no separate assignment of the deed of trust would be needed at all. And a recent unreported Court of Appeals case, Varbel v. Bank of America Nat. Ass’n, 2013 WL 817290 (Ariz. App. 2013), quotes the Bankruptcy Court as reaching the same conclusion: In re Weisband, 427 B.R. 13, 22 (Bankr. D. Ariz. 2010) (“Arizona’s deed of trust statute does not require a beneficiary of a deed of trust to produce the underlying note (or its chain of assignment) in order to conduct a Trustee’s Sale.”).

By the way, that’s the rule with respect to mortgages in virtually every state. A chain of assignments, recorded or not, is completely unnecessary to proof of the right to foreclose. The power to foreclose comes from having the right to enforce the note, not from having a chain of assignments of the mortgage or deed of trust.

However, since Hogan has told us that no showing of holding the note is necessary in order to foreclose, what is necessary? It defies common sense to suppose that a party can foreclose a deed of trust in Arizona without at least alleging some connection to the original loan documents. If that allegation is not that one holds the note, perhaps it must be the allegation that one has a chain of assignments of the deed of trust. If this is true, then the opinion in Steinberger, written on the assumption that the assignments must be valid ones, makes sense.

The ultimate problem here is the weakness of the foreclosure statute itself. Ariz. Stat. 33-807 provides, “The beneficiary or trustee shall constitute the proper and complete party plaintiff in any action to foreclose a deed of trust.” Fine, but when the loan has been sold on the secondary market, who is the “beneficiary?” The statute simply doesn’t say. The normal answer would be the party to whom the right to enforce the note has been transferred, but Hogan seems to have deprived us of that answer. An alternative answer (though one that forces us to disregard the theory that the mortgage follows the note) is to say that the “beneficiary” is now the party to whom the deed of trust has been assigned. But the Arizona courts don’t seem to be willing to come out and say that forthrightly, either. Instead, as in the Steinberger opinion, it’s an unstated assumption.

As Wilson Freyermuth put it, after graciously reading an earlier version of this comment, “The Steinberger court couldn’t accept the fact that a lender could literally foreclose with no connection to the loan documents — so if Hogan says the note is irrelevant, well then it has to be the deed of trust (which would presumably then require proof of a chain of assignments).  It’s totally backwards — right through the looking glass.  And totally inconsistent with Ariz. Stat. 33-817.”

To say that this is an unsatisfactory situation is an understatement; it’s an unholy mess. The statute was written with no recognition that any such thing as the secondary mortgage market exists, and the Arizona courts have utterly failed to reinterpret the statute in a way that makes sense. It’s sad, indeed.

There are a number of other theories in the Steinberger opinion on which the borrower prevailed. Some of these are quite striking, and should give a good deal of comfort to foreclosure defense counsel. In quick summary form, they are:

2. The tort of negligent performance of an undertaking (the “Good Samaritan” tort). This applies, apparently, to IndyMac’s incompetent and vacillating administration of its loan modification program.

3. Negligence per se, in IndyMac’s recording of defective assignments of the deed of trust in violation of the Arizona statute criminalizing the recording of a false or forged legal instrument.

4. Breach of contract, in IndyMac’s failure to follow the procedures set out in the deed of trust in pursuing its foreclosure.

5. Procedural unconscionability, in IndyMac’s making the original loan to her elderly father without explaining its unusual and onerous terms, particularly in light of his failing mental health.

6. Substantive unconscionability, based on the terms of the loan itself. It was an ARM with an initial interest rate of 1%, but which could be (and apparently was) adjusted upward in each succeeding month. This resulted in an initial period of negative amortization, and once the amortization cap was reached, a large and rapid increase in monthly payments. At the same time, some of Steinberger’s other theories were rejected, including an argument that, because IndyMac had intentionally destroyed the note, it had cancelled the debt. The court concluded that, in the absence of proof of intent to cancel the debt, it remained collectible.