Financial Cryptography

62 Million Contracts are now no longer perfectable. Blame me?

In terms of value at risk, this has to be the winner in the monthly "most outrageous post across my desk" competition:

According to attorney Ellen Brown, author of "Web of Debt", a California bankruptcy court has followed what are now being called "landmark cases in other jurisdictions" in ruling that as many as 62 million mortgages may not be foreclosed on.

The result could force the biggest banks into bankruptcy because having millions of homeowners get title to their homes with no further mortgage payment would decimate the asset portfolio. As pointed out in a San Francisco Chronicle article in 2007:

"The loans at issue dwarf the capital available at the largest U.S. banks combined, and investor lawsuits would raise stunning liability sufficient to cause even the largest U.S. banks to fail...."

This is an issue that I knew about. We tried to solve it. Blame me. Which makes it much harder to write about.

What's going on here? And why the chicken-little panic? How much truth is in this? Unfortunately, some:

The problem is that at the height of the real estate bubble, mortgages were sliced and diced into investment products -- securities -- that changed hands frequently.

Whoa! Stop right there! This was not a problem constrained to the height of the bubble, but a structural innovation that has dominated the last 30-40 years. Permit me to set the record straight:

The problem is that at the height of the real estate bubble since the invention of securitization in the 1970s or so, mortgages were are sliced and diced into investment products -- securities -- that changed hands frequently.

If you wish to understand anything about the financial crisis, understand this:

securitization was a game-changer.

It was invented in the 1970s or so, and it set the scene for the massive boom we saw in the 2000s, and the massive collapse 2007-2009. Most confusing still, it's a good thing. Moving right along...

As a convenience for the mortgage industry, many of these mortgages were recorded electronically by a system called MERS (Mortgage Electronic Registration System).

At issue was when Citibank tried to foreclose on a property in California, the homeowner's defense was that the actual deed was held by MERS and yet since MERS could not offer a homeowner signed documentation to a mortgage agreement, they could not prove ownership and since they couldn't prove ownership, the Deed of Trust could not be transferred and Citibank's note was therefore uncollectible.

Basically, throughout the securitisation process that created the global financial collapse, the issue that was staring us in the face was that the various transactions were not being perfected. That is, the contracts were not being adequately backed up according to the standards of the day. That standard is ultimately measured in court, or not as Citibank has discovered above.

I saw this when I designed my system, and set out to resolve it. The Ricardian Contract form solves the above problem, in part because it is signed, and in other part because it solves a lot of other issues lurking in the mess above. And, when Jim and I filed it into the SEC, they realised that it addressed their concerns, too.

But like this blog post, the problems brought about by securitization's success were put off until tomorrow. And tomorrow's tomorrow. And ... then came 2007. Some singularity somewhere caused systemic ripples throughout the system, which caused all contracts to shake and wobble. But it is important, nay, essential to realise: the fundamental structural feature was securitization. The systemic wobble event was not important. Keep your eye on the securitization ball as it rolls on unchallenged through the USA financial quagmire.

Now they've gone to court, and:

The California bankruptcy court concluded:

"Since the claimant, Citibank, has not established that it is the owner of the promissory note secured by the trust deed, Citibank is unable to assert a claim for payment in this case."

So that's what is meant by a contract not being perfected. You can talk about it. You can sell it, slice & dice it, derive it and steal it. Start a boom, pay outrageous bonuses, watch the bubble burst. But you can't get a court to back all these things up. Which matters not one jot if everyone believes the boom will go forever...

Which leads to somewhat of an observation over modern finance... heck, all finance, and probably all business!

Finance is an inverted pyramid that sits on the apex of dispute resolution. Somewhere in a middle layer are contracts. Somewhere up top on the mesa are mortgages and loans and prosperity and the happiness of owning your own home. Down the bottom is dispute resolution.

If the apex collapses, don't be standing nearby with a camera.

Posted by iang at October 4, 2010 09:54 PM | TrackBack