The consequences for the economy and property rights are potentially huge. Here’s a pretty good summary.
Let me try and explain.
State law will vary, but generally speaking, any real estate loan will consist of two things: the note, which is proof of the debt, and the mortgage, which is the lien on the property. The note and the mortgage are pretty much worthless alone; if you only hold the note, but you don’t have the mortgage, you basically only have an unsecured loan. The mortgage gets recorded in the county where the property is located. The note is not recorded, but it can be endorsed over and physically delivered to another party (similar to a personal check). This system has essentially been in place for decades, even centuries (there is property related terminology that has roots in England’s feudal days).
Nowadays, mortgage originators will generally not hold onto the real estate loans they originate. Often the individual loans will get sold and pooled into a trust to create some kind of security, generically known as a mortgage backed security (MBS). The basic process involves signing the note over to the party administering the trust, delivering physical possession of the note to the trustee, and going to the county title records office and paying the fee to have the mortgage reassigned. This has to be done every time an individual loan is sold. It may seem archaic in a computerized world, but the system in place provides clear notice of who owns what, whether property is encumbered, and maintains the chain of title.
There are a couple of explanations why things have become so screwed up. One is that many of the mortgage originators during the real estate frenzy were fly-by-night operations, most of whom are out of business today. Since they weren’t keeping the loans, and since their processes weren’t being scrutinized by those buying their loans, they probably made lots of loans with bad and/or incomplete paperwork. The other reason is that, because there was such a frenzy to buy and sell these loans, and because the traditional process was slow and expensive (having to pay the county title record office a fee to update the record every time a loan was sold), the industry contrived different methods of getting around that process. An example of that is MERS, which was an electronic registry intended to get around the recordation process. The result was notes not getting conveyed when they should have and mortgage records not being updated. When homeowners started challenging foreclosures in court based on lack of standing, courts started ruling in their favor. Perhaps because they knew that they hadn’t dotted all their i’s and crossed all their t’s, the big banks that handle the servicing of most of these loans (and the law firms they’ve retained) have engaged in shenanigans to try to push as many foreclosures through the courts as they could before anyone noticed.
But now everyone has noticed. And a good chunk of real estate loan purchases may turn out to be invalid, meaning the MBS trustees don’t have standing to foreclose (which will screw those who invested in the MBS). Even worse, it calls into question the legitimate ownership of scores of mortgage notes, and it may be nearly impossible to determine if an individual property is truly unencumbered by liens (see this story of a Florida man who purchased a home outright but was still foreclosed on, even though he didn’t have a mortgage).
What will be the result? This is going to make the mortgage mess drag out even longer. As I see it, the banks not only have huge paper profits that they’re desperately trying to realize (even if they have to commit fraud upon the courts to do so), but they also have potential liability to the MBS investors for screwing everything up. Now that they’re being stopped, they may finally realize that they’re going to have write off quite a bit of their paper profit. Unfortunately, because of the paperwork mess, they may not be able to agree to modifications with individual borrowers because they may not be able to find the notes, or they may lack standing because they’re not listed in the title records. Any attempt to get their cronies in Congress to pass legislation to help them (like the bill Obama vetoed that would have required courts to recognize out-of-state notarizations) will run into a huge legal roadblock from the states, as real property law and the evidentiary requirements surrounding it is overwhelmingly a state matter.