The Free House Myth

As challenges to whether a "bank" (usually actually a securitized trust) has the right to foreclose because it owns the note and mortgage become more common, rumors swirl about the ability to use such tactics to get a "free house." There are a few instances of consumer getting a free house, see here and here, for examples, but these are extreme situations not premised on ownership, but on a more fundamental flaw with the mortgage. In general, the idea that even a successful ownership challenge will create a free house to the borrower is an urban myth. I'll explain why below, but there is a policy point here. The myth of the free house drives policymakers to complain about the moral hazard risks of holding mortgage companies to the law and tries to set up homeowners who are paying their mortgages against those who are not. It serves the banks' political agenda to be able to point to the "free house" as an obviously unacceptable alternative of consumers winning legal challenges. It's key then to understand that the "free house" is largely a creature of consumers' and banks' over-active imaginations.

In sorting out why even a successful ownership challenge does not give homeowners a free house, it is helpful to parse some key concepts. The first one is standing, which is the right of a party to ask a court for the relief it seeks. This comes in different flavors, including constitutional standing, but in the foreclosure context, usually boils down to whether the moving party is the "real party in interest." In re Veal, the recent decision from the 9th Circuit BAP authored by Judge Bruce Markell, mentioned previously on Credit Slips , contains a discussion of standing in the foreclosure context. At least in part, the concern of the real party in interest doctrine is to make sure that the plaintiff is the right person to get legal relief in order to protect the defendant from a later action by the person truly entitled to relief. Note that standing is a concept that only applies in court; here that means in judicial foreclosures. In states that allow non-judicial foreclosure, the issue is slightly different. Does the party initiating the non-judicial foreclosure have the authority to do so under the state statute authorizing the sale? For example, cases such as In re Salazar discuss whether a recorded assignment of the mortgage is needed, as opposed to an unrecorded assignment, to initiate a foreclosure. Under either standing or statutory authority, a "win" by the homeowner leads to the same result. The foreclosure cannot proceed.

But this win is not the same as a free house. Just because a party lacked standing or statutory authority does not mean that there is not some party out there that does have the authority to foreclosure. Nor does a win on standing mean that there cannot be action taken to give the initial foreclosing party the authority that they need, which might occur by transferring possession of the note or by executing a series of assignments, to foreclose at a later date. Unless other problems exist, there is still a valid note that obligates the homeowner to pay money due and there is still a mortgage encumbering the house. The homeowner does not get a free house. Rather, the homeowner just doesn't lose her house today to foreclosure. These are pretty different outcomes!

This doesn't mean that I think the standing/ownership issue is inconsequential. For homeowners, a successful challenge that results in the dismissal of a foreclosure can lead to a loan modification or the delay itself can give the homeowner the time to find another solution. For investors in mortgage-backed securities, the problems with paperwork likely increase their loss severities in foreclosure, both because of increased litigation costs and because of delay in correcting problems. (And there may be even more serious problems for investors relating to whether the transfers even succeeded in putting the homes in the trust.) But we shouldn't confuse these issues with the idea that what is at stake in sorting out this mess is giving a "free house" to some Americans, despite the lamentations of this LaSalle Bank lawyer after a judge ruled that LaSalle as trustee lacked standing to foreclose. A fruitful discussion of these issues needs to begin with a clear understanding of the consequences of the problem, as well as empirical evidence on how widespread these problems are. The free house is political handwringing, not legal reality.

Comments

[Adam Levitin]

It's certainly not a "free" house. I think it'll be a nightmare for homeowners who prevail in one of these actions to try and sell their homes. Just because party X can't foreclose doesn't mean that there isn't a valid mortgage still on the property. No buyer is going to want to buy (and no title insurer will want to insure) unless that mortgage is paid off. And that means determining who is the mortgagee. Adverse possession and/or quiet title actions might help solve some of this, but they are not self-executing solutions. Homeowners will have to go to court and litigate. That's expensive and it takes time. So, at best, these homeowners are getting not "free" houses but houses with a severely depressed value.

[Kelly A. Greene]

The author skims the surface of the latte and finds after skimming the surface there is no more cream. Duh.
The Banks are often appearing as trustees on behalf of NY Trusts most of which died on or about 2008. If the trusts are dead than who has the right to appear in court? Nemo est hires viventis. No one is the heir of a living person and I would suggest, no one is the a trustee able to act on behalf of a dead trust. If the paper was successfully transferred to the trust, then perhaps the thousands of suckers who bought a RMBS are the owners. But if the paper was never successfully transferred, then the trusts and the trustees are certainly not the owners with standing. The original lenders might be but after phony documents have been created assigning the note and the mortgage to dead trusts, how could they possibly have the right of ownership?
The "myth" of the free houses was created not by consumers "oy!!" but by the very Banks who are picking up "free" houses every day by pretending to be trustees acting on behalf of dead trusts or trusts that never properly held the mortgages and notes. It is very much like Ronald Reagan calling a nuclear submarine the Corpus Christie or calling armed combatants "peacekeepers." The "free house" was the Orwellian double speak created by Bankers for Bankers and their judicial minions and hand maidens have adopted their language very well.

[Fred]

The goal of the foreclosure defense bar should be to aggressively pursue "free homes" for as many people as possible, notwithstanding that only a few "free homes" will ever be obtained. The bar should network nationally to share information and to co-ordinate strategy akin to the plaintiffs-asbestos network.

Why? Washington can't or won't fix the problem, and the lenders are vulnerable and in some respects defenseless.

In a manner of speaking, this would facilitate the market solving the problem.

[Polly C. Maker]

It appears that with all the transfers, assignments, and failures to attach timely endorsements and allonges to promissory notes, many if not most of the modern mortgagees will have difficulty showing they are the holder in due course.

If it is impossible for the mortgagees to produce the proper documents, how will this not result in a free house? How can a lawmaker ensure that there is some balance- so that the homeowner is protected from a wrongful foreclosure; but also that they won't be encouraged to default because they think they'll win in court because of the mortgagee's failure to keep good records?

[Ken Doran]

I represent homeowners in foreclosure by raising defenses including assignment and robo-signing issues where it seems to make sense. A severe practical limitation is that in real life the free house is rare indeed. If the goal is stable long-term home ownership, fighting those battles is at best a very chancy way of achieving it. Chapter 13 to cure arrearages and/or void unsecured junior mortgages is better option, where it fits the situation.

[Virginia]

I'm beginning to think investors were well aware and complicit in the scheme... At least their agents were. How does a borrower sign mortgage documents on the 17th of the month and the Trust close on the 28th of the same month and all the revenue streams get calculated, Prospectus docs get printed and the sold to the investors in less than a week? Not really plausible. Which means investors bought something Wall Street did not own. Nemo dat. The investors had to know or should have known the mortgages were not yet signed when they funded or agreed to fund. Buyer beware... No wonder investors don't want to partner with the borrowers. They were both duped - just one had more warning.

[Martin Andelman]

I certainly agree that the idea of the "free house" does drive policymakers to fret about moral hazard and the horrors all but certain to result when mortgage companies are held to the law. Also, as you've stated, it does serve the bank's political agenda to be able to point to the "free house," as a seemingly inequitable resolution.

And yes... it does facilitate the creation of an imaginary divide between the (fictional classifications) of irresponsible and responsible homeowner.

Having spoken at length with literally thousands of homeowners caught up in today's foreclosure crisis, I have to tell you that I've never spoken with one whose goal was to get "a free house." And I think it's important to recognize that this whole endorsed note - REMIC trust - issue would likely never have come up had servicers simply modified loans as they contracted to do, and dare I suggest, treated their borrowers like... oh, I don't know... shall we say... human beings?

However, now that the note being properly negotiated into the trust is fast becoming dinner table conversation around the country, it seems clear that the banks must know that they've got real trouble right here in River City. Because even though you may be correct in saying that if the trust is shown to not own a given note, then the sponsor or originator does own it... as a practical matter, I'm not sure either will claim their rights as the owner of the loan. In fact, as things stand today, I'm fairly certain they won't... and they certainly haven't yet that I can see at least.

So, what happens then? What happens if the trust doesn't own a loan and no one else wants to show up and claim it?

What I'm saying is that the key components that made the whole securitization scheme work were the REMIC trusts with their pass-through tax status, and the off-balance-sheet SPV, which allowed the banks to get the loans off of their books where they'd have to reserve for losses, et al. When you take the REMIC trust out of the picture, I'm not at all sure that either party... the trust or the bank-as-sponsor or originator... wants the loan... or the house that goes with it. In fact, I'm pretty sure neither does.

You see, it occurs to me that the bank coming forward to claim such an orphaned loan... assuming the sponsor or originator is still in business and not long gone into bankruptcy... would trigger several changes that would make it not worth claiming.

For one, the sponsor or originator claiming the loan would now have a loan on the books and therefore the bank would have to reserve for the potential loss.

For another, it would now be a taxable asset, as opposed to the tax liability being passed through to the certificate holders.

And for a third... well, the loan was securitized, right? So the bank's already been paid for the loan, why would someone want to open this sort of can of worms to claim a loan for which they've already been paid?

And last but not least, wouldn't the sponsor or originator coming forward to claim the loan be acknowledging that they didn't properly negotiate the note into the trust? I would think that would be akin to pleading guilty to such a charge in court. In other words, wouldn't it be not a good thing in terms of potential litigation brought by the investors?

And all of that is to say nothing about the actual house that would be reclaimed in conjunction with the loan. Many of these homes are likely to not be in great shape and may very well cost more than they're worth to take back and re-sell, making the claiming of such a loan even less attractive.

And obviously, in many cases, the sponsor and originator will be long gone into bankruptcy.

So again, perhaps not as a matter of law but rather as a practical matter, once a loan is found to not have been properly negotiated into a REMIC trust by the Closing Date as specified in the PSA, although there may be a sponsor or originator who could theoretically claim to be its rightful owner... my guess is no one will.

It appears to me that there's simply no percentage in doing so, and in fact it's much more likely that one would only do so at their peril and financial loss. And all that to reclaim a loan for which the party has already been paid? It seems unlikely, at best.

So, what happens then? Does the homeowner then have a "free house," since that's the term du jour? Can the homeowner seek adverse possession of the property? Or are they forced to live under the uncertainty of not knowing what tomorrow will bring indefinitely?

It's a bizarre situation, to be sure... but when does a homeowner get a "free house?" When the entity the borrower owes doesn't want the borrower's money anymore for other reasons.

There are certainly instances around the country where the trust was found not to hold a loan, and all that I've been able to see up close and personal report no sponsor or originator asserting any claims to the property.

Or, am I wrong?

[Knute Rife]

To add to what Ken Doran wrote, there are definite, tactical advantages to taking these cases to bankruptcy court. Whereas state courts and federal district courts have tended to give the note ownership arguments little if any weight, especially in nonjudicial foreclosure jurisdictions, bankruptcy courts are a different game. First, they are obligated to look out for all interested parties. Consequently, BK courts are cautious about entering orders in favor of one creditor that can prejudice others and will listen to objections to that effect. Second, creditors actually have to prove their claims, including providing proper documentation. If they can't, they are dead in the water. Trustees are growing increasingly savvy about this and are using it to reject claims and block motions for relief from stay.

[Allan]

Free house or no, I have little sympathy for the banks.

For years, these banks have held payees liable to the exact wording of the contract. Pay your mortgage one day late: penalty. Let your insurance lapse, no problem, we will buy really expensive insurance for you. Our lawyers are expensive? Who cares, you are paying for them.

The bottom line is that what is good for the goose is good for the gander in this situation. If I have to follow the rules to perfection, so must the bank.

[Gregory Germain, Syracuse University Col of Law]

Why would it be impossible for a bank to show that their possession of the note & mortgage was the result of an Article 3 transfer? There must be deal documents under which they bought the pool of mortgages (if they own them). If they are acting as an agent, the lawyers need to bring the proceeding in the name of the owner. I think this is mostly about sloppy foreclosure lawyers and the sloppy banks that hire them. For some reason the banks think they can rely on allegations made by employees who have no real knowledge of the facts, and their own computer records showing ownership. The courts are sending the message that the banks and their lawyers need to clean up their paperwork before they bring foreclosure proceedings. This story is much less about fraud than about sloppiness and cost cutting by the banks and their foreclosure lawyers.

The free house theory arises because of res judicata. If the bank is the owner of the note and mortgage, but fails to prove it at trial, res judicata may prevent a subsequent foreclosure action. Same with a dismissal with prejudice. The banks and their lawyers need to take this risk seriously.

I wonder if we will see quiet title actions following the failed foreclosure proceedings, in which the homeowner would be arguing that the bank that failed to prove title to the note/mortgage in the foreclosure proceeding actually had valid legal title?