How to Understand Debt and Money in Foreclosures Today

Everything is summed up in the words of Reynaldo Reyes from Deutsche Bank: It’s all very counterintuitive, which means that the truth runs against basic assumptions that once worked. The assumptions are not true and the truth seems to be untrue.

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THIS ARTICLE IS NOT A LEGAL OPINION UPON WHICH YOU CAN RELY IN ANY INDIVIDUAL CASE. HIRE A LAWYER.
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For 13 years I have been trying to distill into words a description of securitization as practiced by the investment banks. In theory securitization is neither a dirty word nor an immoral practice. And to be fair, the illegality of today’s foreclosures is partially the responsibility of legislators and regulators who failed to keep up with financial innovation.

I’ve hit upon an analogy that might prove helpful to many people.

After centuries of scientific theory and investigation, physicists came up with a hypothetical particle called an atom. Later I use the atom as an analogy to an actual cash debt owned by a borrower to some legal person who has suffered a risk of loss relating to nonpayment of the debt.

Eventually the atom was proven to be an actual particle. Then scientists fairly quickly discovered that atoms were in turn composed of even smaller attributes or particles — electrons, protons and neutrons.

With debts, financial analysts and innovators discovered that a debt can be broken up into different attributes — interest, principal, monthly payments, fees etc. And they found that each of these attributes could be separately sold. But this created a monetary split which the law did not recognize. Nevertheless it occurred. The law requires the presence of a specific legal person who possesses a claim based upon actual loss from nonpayment. With the split the potential claimants immediately broadened to everyone who had purchased any attribute of the debt.

This makes it  difficult if not impossible to present or even identify one legal person who actually has the legal standing to bring a claim for nonpayment. Hence no creditor is alleged or identified and no ownership of the debt is alleged or proven.

After parsing out the main attributes of atoms, scientists discovered many hypothetical particles that were not completely or directly observable but whose existence could be determined by reference to certain behavior of the some of the known attributes. Some particles were not only difficult to observe, their presence at any location was based upon calculations of probability rather than any actual observation of real world events. Other particles came into existence and then disappeared in microseconds. Some eventually have been proven. Others are still subject to scientific investigation. That is particle physics. And of course we all know that this knowledge developed into a theory for producing a bomb of heretofore unimaginable power to destroy — or power the planet depending upon how it was used.

Careful analysis shows that atomic theory closely correlates with securitization of debt.

Securitization, to be clear, is the process of distributing the risk of any investment to many people. There is nothing wrong with it. It has been done for centuries and it is the basis for capitalism which is our system and seems, by general agreement, to be the best economic system humans have yet to devise, despite its obvious shortcomings.

“Securitization” since 1983 has taken on a more particular meaning, i.e., the distribution of risk on consumer debt, and in particular residential loans because those are the biggest debts. All paper instruments that declare ownership of a particular asset derive their value from that asset. So all such paper instruments are by definition derivatives whether the paper is certificate of common stock, a bond, car title or anything else. “Derivatives” has taken on a more particular meaning, i.e., instruments that derive their value from debt.

In theory securitization of debt can be accomplished on one of two ways: either many people invest in one debt or many people invest in many debts. The obvious answer is that diversification of investment diminishes the risk of a total loss. So securitization became the investment by many people into many debts.

So far, so good.

In the ordinary way of doing business on Wall Street, brokerage houses are fee-based intermediaries who facilitate the purchase of investments in various types of paper instruments including regulated securities. So for example an initial public offering of securities by a company, the brokerage house underwrites the offering by taking on some risk and receiving a fee for its role in creating and selling the securities offered to the public.

And that is how it worked in all legal transactions. People who were or said they were licensed brokers and sold nonexistent shares of nonexistent companies or who took a position in the ownership of equity (stock) of a bankrupt company and then sold them to the public making outlandish claims were routinely closed down, jailed, fined and subject to asset seizure.

Three things happened that changed Wall Street.

First accounting rules starting  changing in the 1960’s that allowed for something called “off balance sheet” transactions. This enabled management of a company or a brokerage company to manipulate the economic and financial reports relating to securities trading on Wall Street. Despite outcries from conservative members of the American Institute of Certified Public Accountants, the practice  was institutionalized and continually widened in its application ever since. This prompted the publication of Unaccountable Accounting by Abraham Briloff in the 1960’s.

Second, brokerage houses were allowed to convert from partnerships in which the managers had personal risk in everything that was performed in the name of the brokerage house to corporations that could actually issue their own stock. This produced capital for the brokerage house, but it also eliminated management’s personal responsibility for the losses or illegality of actions undertaken by the brokerage house which had been mounting campaigns to call themselves “investment banks.”

So Wall Street continued to be largely governed by its members when they were no longer actually accountable for anything that happened. After that they pursued strategies that would never have been undertaken when they were personally liable. Junk bonds emerged out of the undervalued bond market. And then “mortgage bonds” (derivative certificates) emerged in which the junk was massaged into triple AAA rated investments.

Knowing that the investments were junk, the brokerage houses used their extensive influence and leverage in Washington DC and managed to convince Congress and President Clinton that it was good idea to repeal the Glass-Steagal act and deregulate the “mortgage bonds” and all other instruments deriving their value from mortgage bonds. This eliminated government oversight except for the Federal Reserve at which Alan Greenspan admits now that he had 100 PhD’s working for him a Chairman of the Fed, none of whom understood the complex derivative agreements. Greenspan admits that he erroneously decided that market forces would make any needed correction in whatever  Wall Street was doing. What he now understands is that market forces could not operate in the environment that Wall Street created and controlled.

Third once upon a time when you bought a stock you received a certificate. In the 1960’s a new practice evolved — encouraging investors to keep their stocks in “street name.” That simply meant that the brokerage house would have its own name put on the certificate and would simply issue statements to the investor confirming they were holding the certificates for the investor. That seemingly simple event opened the door to a level of moral hazard that eventually resulted in the great recession of 2008. That risk manifested in the “paper crash” of the late 1960’s where some brokerage houses went out of business reportedly because they couldn’t properly account for the location or ownership of stock certificates.

The explanation I learned while I was counting certificates in the back office of one brokerage, turned out to be simple and simply horrifying — the brokerage houses — nearly all of them — were using street name securities on which they borrowed money and traded securities, covered short sales, options etc. Today if you want the certificate you might need to pay several hundred dollars — a distinctive bar to accountability for investments supposedly held at brokerage houses/ “investment banks”

Back to the atom. Each debt is like an atom with its own unique properties. The component parts of the debt, unlike the component parts of an atom, were turned into commodities in which brokerage houses were converted from being intermediaries into principals and assets were converted into revenue. The practice of selling unregulated securities issued in the name of nonexistent legal person or companies became institutionalized rather than illegal.

So among the things that Wall Street brokerage houses sold were cash flow derived from a promise by the investment bank to make the payment through intermediaries, interest rates, hedge contracts, credit default swaps, risk of loss, principal, servicer advances, and options in which various investors took various positions as a bet on whether the value of a certificate would go up or down, whether the rates would go up or down, etc.

In plain language it was the investment bank that issued loans, always through conduits. The borrower was never aware that the sale of that loan product purchased by the consumer was part of a much larger scheme in which his loan would be immediately converted into revenue for the investment bank and its affiliates.

Theoretically there would be nothing wrong with this infrastructure except for one thing. The value of the certificates was largely determined by an index derived from the value of the collateral pledged by borrowers when they took the loan. That index was and remains mostly a lie, but not entirely. The holder of certificates has no relationship to any debt, note or mortgage and is therefore not “mortgage backed” as advertised.

But the more basic problem is that under our current laws, the ONLY claim  allowed by law in foreclosure is one in which a actual legal person claims that it suffered an actual financial loss and that the loss occurred as a result of the borrower’s failure to pay. There is no such loss and there is no such person. The investment bank cannot show its face (1) because it no longer has any interest in the debt and can’t make the required claims and (2) because it can’t admit to a pattern of violating disclosure rules under federal and state lending laws.

So instead, the brokerage or investment banks created an elaborate evolving structure in which a central repository stored all known information about the loans. This repository today is mostly Black Knight. The task of the central repository was to collect data and arbitrarily fill in gaps with data that supported claims to enforce the debt.

In turn, the investment banks used companies that were dubbed “Servicers” that were routinely rotated and appointed to assume the role of administrator over the loans, ownership of which had been parsed and disbursed to thousands of investors most of whom were unrelated to any REMIC Trust name used by the investment bank.

These servicers were given IT platforms that accessed the central repository, but their central  role was to help create the illusion that the records were based upon original notations made at or near the time of transactions that had been transferred to each Servicer. In fact, the only thing that changed was the login and password for each “new servicer.” They would use the term “boarding process” when none was needed nor was any performed. But the use of that term enabled the introduction in court of “business records” that were neither original nor accurate nor audited in any way by anyone. Those records were only reviewed and edited for their value to enforce the debt.

The debt meanwhile had been converted from actual to theoretical like the particles that physicists investigate now. It started out as an asset but evolved into revenue to the players who were involved. The illusion of the debt’s continued existence is maintained solely to enforce it to create additional revenue. In truth, the amount of revenue received from each loan average 11.75 times the the amount of the loan.

Thus the issue of repayment is far less significant than an ordinary loan. And that is the center of what is counterintuitive. Everything is relative in physics and finance. From the borrower’s point of view he must have a debt because he still has not paid it back. And yet there is nobody to whom he can make payment that will take the money, deposit it into an account and record the transaction as a deduction from an asset on its balance sheet showing a loan receivable. In plain language no payment from such  borrowers ever goes to pay down then debt on the books of any player. And that includes the proceeds of a foreclosure sale.

The last element required for any valid court claim is that the remedy sought will fix something that has been broken. Our system of laws requires that. But no such party exists in virtually all cases.

And just to editorialize, fixing the law to provide that any disinterested party could be nominated to enforce the debt does not solve the deeper problem.

The removal of risk from underwriting residential loans fundamentally changed the loan transaction in myriad of ways — each contrary to federal and state lending laws. It virtually guaranteed that the brokerage house would support any effort to get people to sign their names to new and ever more complex loan products that could be parsed and sold within 30 days of creation. It virtually guaranteed a complete disregard for whether the loan, if it can still be called that, would ever be repaid. The risk of loss was not diminished. It was eliminated.

Hence the market forces that ordinarily would bring lenders into line because of risk factors that would produce losses are no longer present, thus completely changing the apparent contract with the borrower into something much larger and broader.

A bright lawyer who can handle complex legal theory can easily make a case and most likely prove a case for implied contract — one that does not negate the loan agreement but rather expands it to include the borrower’s entitlement to share in the unexpected bounty of profits that were generated as a result of this elaborate scheme.

If that concept gets traction THEN it might be possible for a court in equity or a legislature to change the statutory and common law schemes to allow for the appointment of a representative who does not own the debt but nevertheless seeks enforcement so that the derivative infrastructure based upon that loan does not collapse. But first there would need to be an accounting for the profits generated from the origination or acquisition of the loan and then an allocation to the borrower thus reducing the amount he owes.

Then and only then will all the cards be on the table.

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