Why mortgages aren’t modified and what a ruling stopping foreclosures means

In August, the Kansas Supreme Court issued a ruling against a mortgage tracking service which may prove very costly to banks in foreclosure, leading to massive writedowns. It could be a life saver for many trapped in the foreclosure process. The case goes to the core of the functioning of massive markets in securitization and derivatives and has wide-ranging importance.

The service, MERS (Mortgage Electronic Registration System), is a privately-owned registry set up in 1997 by Fannie Mae, Freddie Mac and several large banks including JPMorgan Chase, Citigroup and Bank of America. In foreclosure, MERS is often the party which files on behalf of the lenders behind the mortgage against homeowners. The Kansas ruling effectively blocks MERS from bringing legal action on the lenders’ behalf in certain foreclosure situations, potentially putting the kibosh on  MERS’ legal authority on the more than 60 million mortgages it holds and subjecting the lenders to huge losses.

This is a complicated but important case I want to break down for you below.

Securitization at fault

The crux of the case has to do with mortgage-backed securities and the process of securitization. In a bygone era, almost all mortgages were held as loans on the books of the originating banks.  In this case, if a mortgage went past due, it was a matter to be worked out between an individual homeowner and an individual mortgage holder.

However, when the mortgage-backed securities (MBS) market took off, mortgages were sliced and diced into tranches and packaged into securities and sold on to investors.  These same securities were then sliced and diced and packaged with other securities into collateralized debt obligations (CDOs). CDOs were often then sliced and diced further still into CDOs-squared – that is CDOs of CDOs.

Often times, the underlying mortgages in these instruments were high-risk, sub-prime mortgages. But the ratings agencies could still give them AAA ratings, which made them eligible for investment by risk-averse investors like teachers’ pension funds or municipalities. So, these securities were then sold on to investors around the world into remote places like small towns in Norway and banks in Germany. However, when the housing market fell, the value of these securities plummeted; and they fell much more than the house prices as the securities are derivatives and leveraged against the value of the underlying asset. The result was a financial crisis of epic proportions.

Making matters more complicated for the homeowner, the originating lender is often not the servicing agent of a mortgage. Payment from the homeowner and to investors who are the ultimate owners of the security is handled by a mortgage servicer who collects a fee for its work.

What this has meant is that there is considerable distance between a homeowner and a mortgage holder, such that in the event of foreclosure, it is not a matter of picking up the telephone and calling Mr. Smith at the local Bank. Often times, there is a byzantine web of originating bank, mortgage holder (if loan is sold), mortgage servicer, MBS pooling/securitizing agent, and investors. Needless to say, the average person doesn’t have a clue as to who to call in order to get relief to avoid foreclosure. The obvious port of call is the mortgage servicer, who is the one party with whom a homeowner has ongoing contact.

Mortgage Servicer

Below is a research report written by the National Consumer Law Center just this past month on why consumers in jeopardy of suffering foreclosure cannot get loans modified.

It starts:

The country is in the midst of a foreclosure crisis of unprecedented proportions. Millions of families have lost their homes and millions more are expected to lose their homes in the next few years. With home values plummeting and layoffs common, homeowners are crumbling under the weight of mortgages that were often only marginally affordable when made.

One commonsense solution to the foreclosure crisis is to modify the loan terms. Lenders routinely lament their losses in foreclosure. Foreclosures cost everyone—the homeowner, the lender, the community—money. Yet foreclosures continue to outstrip loan modifications. Why?

Once a mortgage loan is made, in most cases the original lender does not have further ongoing contact with the homeowner. Instead, the original lender, or the investment trust to which the loan is sold, hires a servicer to collect monthly payments. It is the servicer that either answers the borrower’s plea for a modification or launches a foreclosure. Servicers spend millions of dollars advertising their concern for the plight of homeowners and their willingness to make deals. Yet the experience of many homeowners and their advocates is that servicers—not the mortgage owners—are often the barrier to making a loan modification.

See the problem?  This is exactly why loan modifications are not happening in large enough numbers.  This goes to incentives – mortgage servicers are not incentivized to make modifications. In fact the incentives go the other way – foreclosure.

Servicers have four main sources of income, listed in descending order of importance:

  • The monthly servicing fee, a fixed percentage of the unpaid principal balance of the loans in the pool;
  • Fees charged borrowers in default, including late fees and “process management fees”;
  • Float income, or interest income from the time between when the servicer collects the payment from the borrower and when it turns the payment over to the mortgage owner; and
  • Income from investment interests in the pool of mortgage loans that the servicer is servicing.

Overall, these sources of income give servicers little incentive to offer sustainable loan modifications, and some incentive to push loans into foreclosure. The monthly fee that the servicer receives based on a percentage of the outstanding principal of the loans in the pool provides some incentive to servicers to keep loans in the pool rather than foreclosing on them, but also provides a significant disincentive to offer principal reductions or other loan modifications that are sustainable on the long term. In fact, this fee gives servicers an incentive to increase the loan principal by adding delinquent amounts and junk fees. Then the servicer receives a higher monthly fee for a while, until the loan finally fails. Fees that servicers charge borrowers in default reward servicers for getting and keeping a borrower in default. As they grow, these fees make a modification less and less feasible. The servicer may have to waive them to make a loan modification feasible but is almost always assured of collecting them if a foreclosure goes through. The other two sources of servicer income are less significant.

If servicers’ income gives no incentive to modify and some incentive to foreclose, through increased fees, what about servicers’ expenditures? Servicers’ largest expenses are the costs of financing the advances they are required to make to investors of the principal and interest payments on nonperforming loans. Once a loan is modified or the home foreclosed on and sold, the requirement to make advances stops. Servicers will only want to modify if doing so stops the clock on advances sooner than a foreclosure would.

Worse, under the rules promulgated by the credit rating agencies and bond insurers, servicers are delayed in recovering the advances when they do a modification, but not when they foreclose. Servicers lose no money from foreclosures because they recover all of their expenses when a loan is foreclosed, before any of the investors get paid. The rules for recovery of expenses in a  modification are much less clear and somewhat less generous.

In addition, performing large numbers of loan modifications would cost servicers upfront money in fixed overhead costs, including staffing and physical infrastructure, plus out-of-pocket expenses such as property valuation and credit reports as well as financing costs. On the other hand, servicers lose no money from foreclosures.

This is a very important document for anyone looking to do a loan modification. I strongly suggest you read it, download it and act upon it.

By the way, the largest servicers are:

  • Bank of America: $2.1 trillion, up from $530 billion a year earlier (via its acquisition of Countrywide – this is WHY bank of America bought Countrywide)
  • Wells Fargo: $1.8 trillion, up from $1.5 trillion a year earlier
  • JPMorgan Chase: $1.5 trillion, up from $795 billion a year ago (thanks in large part to its acquisition of Washington Mutual)
  • CitiMortgage (a division of Citigroup): $792 billion, down from $799 billion a year earlier. Citi is hurting i everywhere)
  • ResCap: $391 billion, down from $449 billion in the first quarter of 2008.

As you can see, consolidation has meant the big are getting bigger. Despite a recession, servicing fees are increasing, not decreasing.

You should DEFINITELY read my post “How refinancing helps the likes of Bank of America and Wells Fargo” because this demonstrates why these banks are going to rack up monster fees in mortgage servicing.

Landmark National Bank v. Boyd A. Kessler, Kan 2009, No. 98,489

That brings us to the Kansas case. According to the Kansas City Business Journal, the case can be summarized as follows:

A Ford County man went into bankruptcy in 2006. He had taken out two mortgages on the same property, one to Landmark National Bank and one to Millennia Mortgage Corp. Landmark foreclosed on its mortgage. Millennia had sold its mortgage, which eventually landed at Sovereign Bank, though that transaction never was recorded in Ford County.

Neither MERS nor Sovereign received notice when Landmark filed its foreclosure. That’s because the notice went to Millennia, still registered in Ford County, which is like telling someone that a stranger’s car is about to be towed.

Landmark won a default judgment, essentially wiping out Sovereign’s mortgage. MERS and Sovereign sued to set aside the judgment, arguing that MERS should have received notice. They lost at trial and on appeal.

Supreme Court justices had a difficult time accepting what MERS was and why it would be entitled to receive notice of a foreclosure when it was not a lender and had no stake in the property behind the mortgage. In addition, the court found, the original mortgage required notice only to the lender, not MERS.

This case was decided on 28 August 2009 in favor of the homeowner Boyd Kessler (Document and link below). The issue was predatory lending.  But there was more wrong here. MERS does facilitate liquidity in the MBS market, but it does a lot of other things that could harm consumers

  • MERS also acts as a “corporate shield,” protecting lenders from legal action in cases of predatory lending.
  • MERS can foreclose even though it is not the financial party with interest
  • Because MERS is a distant intermediary, foreclosure can proceed without even producing an original mortgage note
  • With MERS in control, consumers cannot access publicly available information to adequately determine who the holders of their note are.

If MERS is blocked from filing suit in many cases, there will be large losses accumulating at the holders of these notes. Expect to hear more about this very important case.


Landmark Bank v. Kessler, Kansas Appeals Court (MERS), 2008



Landmark National Bank v. Boyd A. Kessler, Kan 2009, No. 98,489 – Kansas Courts Documents

Why Servicers Foreclose When They Should Modify and Other Puzzles of Servicer Behavior (pdf) – National Consumer Law Center

The Mortgage Machine Backfires – Gretchen Morgenson, NY Times

The Next Financial Crisis Hits Wall Street, as Judges Start Nixing Foreclosures – Counterpunch

60 Million Fatally Flawed Mortgages – The Classic Liberal

Landmark Decision Promises Massive Relief for Homeowners and Trouble for Banks – Peace Options

  1. Lance Newton says

    Thank you for your well written article. You did not mention much about HAMP modifications, which pay fees to the servicer too and appear to disincent lenders/servicers from doing internal (non-HAMP) modifications. Since lenders/investors have not been mandated to take/make principal reductions part of their modifications, the are not doing so, to the the detriment of all.

    What is your take on why banks can continue to get so many foreclosures and keep them off the market? Where is the tipping point?

    If you have a source that is knowledgeable about accounting practices for lenders that allow them to use off balance sheet tools or other tricks to keep from putting up reserves on REO I would love to hear about it. Take a look at my blog and see if you think there is anything there with merit. unsustainabubble.com

  2. Kevin W. Hardin says

    Mr. Harrison, it is refreshing to see those reporting on the current mortgage crisis work hard to distill the issues and try to understand them. It is very complicated and the average consumer is typically left scratching their head after reading most articles on the subject. I do disagree with your conclusion that Landmark v. Kelser is indicative of a secondary market issue or securitization issue. Having spent 18 years in this industry, I can tell you it is indicative of extreme incompetence and negligence by the second lien holder and the following failed attempt to hide it amongst the MERS issues. MERS is a tremendous tool that has saved homeowners Billions of dollars in closing costs over the years by saving the costs of multiple assignments at closing and future sale of the loan. The issue is the blind octopus treatment of the mortgage by the Note Holder moving forward and their failure to perform their responsibilities at default. Great job on the article. Look forward to reading more.

    1. Edward Harrison says

      Thanks for the reply, Kevin. My desire was not to characterize how many broader implications this case has, but to highlight the fact that it can be used as a tool to restrict MERS from foreclosing in other cases. As such, we will need to see how the specifics of the case are interpreted.

      The key line to why I see this having greater importance comes in the Supreme Court opinion:

      “MERS contends that the Fourteenth Amendment and §18 of the Kansas Constitution Bill of Rights guarantees of due process were violated when the foreclosure action was consummated without MERS receiving notice of the proceeding and without MERS having the opportunity to intervene in the action.”

      MERS is making a constitutional argument, and that means it should be considered by the high court.

  3. Anonymous says

    Do not confuse a mortgage “security” with a “mortgage-backed security” – they are not the same thing. A mortgage-backed security is simply an investment “interest” in a “Pool” of current receivable cash payments. Ownership rights are not the same. An investor in a mortgage-backed security is only has has “pro-rata” share interest in pooled receivables backed by the numerous actual mortgage securities. It is not a direct investment in individual mortgage liens/mortgage notes. This is a serious misconception promoted by uninformed media.

    Make sure that readers understand that any loan modification in the name of the “servicer” is not valid without identification of the actual INDIVIDUAL mortgage/loan owner/creditor/mortgagee. Any loan modification without identification of the actual owner of the mortgage/note is highly questionable.

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