Friday
Mar042011

MERS and the Evolution of Foreclosure

Simply, foreclosure is a legal process a bank uses to recover the money it lent by taking ownership of property purchased with the bank’s money after a default.  When borrowing money, a borrower will generally execute a promissory note (“Note”) (contract to pay back the money) and a deed of trust (security for a loan containing a right to foreclose).  The deed of trust is filed in the public land records in the county where the property is located as notice to the world that there is lien on the property.  A mortgage is another name for a deed of trust.  The deed of trust, not the Note, gives the bank the right to foreclose on its security.

Traditionally, a bank would hold onto the original Note and deed of trust until the loan is paid off, either by the terms of the note or at a foreclosure, at which time the Note would be canceled and a release of the deed of trust filed in the public land records.

Today, banks transfer or assign Notes to third parties. Selling the loans provides more money to the banks in order that they may finance more loans.  The bank transfers possession of the Note and endorses the name of the new owner on the back of the Note.  Upon receipt of the Note and the proper endorsement the new owners step into the shoes of the original bank which includes the right to foreclose.

The transfer of Notes to third parties unrelated to the original transaction has spawned a sprawling secondary market that is at the center of our current global financial crisis.  Crucial to the transfer of real estate loans in this secondary market is an electronic registration system, referred to as MERS, created to privately track Notes.  MERS stands for Mortgage Electronic Registration System.

Created by large banks with the stated purpose of saving the cost of recording documents relating to real estate transfers and facilitating the transfer of these real estate documents in a secondary market [1], MERS in reality helped turn home ownership into a security.[2]

MERS has come under increased scrutiny in foreclosure actions because of the 2,871,891 U.S. foreclosures in 2010, the chances are high that MERS, claiming involvement in approximately 50% of US residential loans, is tracking the Notes and is named in the deed of trust as the “nominee” of the person or entity in possession of the Note.

The questions concerning MERS focus on how does MERS legitimately circumvent a centuries old recording system with its private electronic tracking system and how can MERS be a legitimate “nominee” of the ultimate “holder” of a deed of trust and a “mortgagee” at the sam time.   Condensed even further how does MERS’ involvement in the transfer of Notes and its self-proclaimed status as “nominee” of the accompanying deed of trusts affect foreclosures.

Specifically, this article reviews the effect of separating a Note from its deed of trust when a Note is assigned to a third party and the recorded deed of trust remains with MERS designated as “nominee” for the holder of the Note.

WHAT MERS DOES

MERS facilitates the transfer of real estate loans into the secondary market by tracking the transfer of the Notes.  A typical journey for a residential loan in the secondary market ultimately ends in a security with a pool of other residential loans known as a REMIC[3]or mortgage backed security.

  • A bank sells, assigns and transfers the mortgage loans to a “sponsor,” which is typically a financial services company or a mortgage loan conduit or aggregator;
  • The sponsor sells, assigns and transfers the mortgage loans to a “depositor”;
  • The  Depositor sells, assigns and transfers the mortgage loans to the trustee of a REMIC;
  • The Trustee will hold the mortgage loans in trust for the benefit of the buyers of the securities or certificate holders.

The transfer of possession of the Note ideally follows this journey but sometimes does not.   Rather than recording each assignment of the Note in the local land records, MERS tracks the Notes on its electronic registry.

There is no actual transfer of possession of the deed of trust where MERS is identified in the deed of trust.  MERS, as “nominee” for the original lender and any successor and assigns, retains its beneficiary interest in the deed of trust on the only recorded document of the loan transaction in the local public records for property transactions. In short MERS privatized part of the mortgage recording system without legislative or judicial authority.   MERS’s authority comes solely from its contract with its members who are the banks making the loans.

The MERS’ system of tracking Notes while maintaining control of the deed of trust conflict with traditional principles of real property law.  MERS has essentially separated the promissory note and the security instrument, the deed of trust, allowing the debt to be transferred without an assignment of the security instrument.   

DEED OF TRUST FOLLOWS NOTE

The concept that a deed of trust follows the Note is long standing law.  The United States Supreme Court first articulated this principle in 1872 in Carpenter v. Longan, 83 U.S. 271,274 (1872):  “The note and mortgage are inseparable; the former as essential, the latter as an incident.  An assignment of the note carries the mortgage with it, while an assignment of the latter alone is a nullity.”

The Colorado Supreme Court upholds this principle.  “The transfer or assignment of a promissory note carries with it, as an incident, the deed of trust or mortgage upon real estate or chattels that secure its payment.” Columbus Investments v. Lewis, 48 P.3d 1222 (Colo. 2002). Stetler v. Winegar, 226 P. 858, 859 (1924).  The concept is codified in C.R.S. § 4-9-203(g).

MERS AND COLORADO FORECLOSURES

Colorado foreclosure statutes require possession of the original Note and original deed of trust.  C.R.S. §38-38-101 provides the “Holder of evidence of debt may elect to foreclose.”  C.R.S. §38-38-100.3(10) defines “holder of evidence of debt” as the person “in actual possession or person entitled to enforce an evidence of debt.”   C.R.S. §38-38-101(1)(b) &(c) requires production of the original Note and deed of trust to start a foreclosure.

MERS cannot enforce the promissory note or deed of trust when MERS is the “nominee” solely for purposes of holding the evidence of debt absent some “authority”.  “Authority” may be granted by the original evidence of debt or deed of trust, to enforce the evidence of debt as agent, nominee, or trustee or in a similar capacity for the obligee of the evidence of debt. C.R.S. §38-38-100.3(10)(d).

Language in a deed of trust which precludes MERS’, as nominee, to initiate a foreclosure is as follows:

“”MERS” is Mortgage Electronic Registration Systems, Inc.  MERS is a separate corporation that is acting solely as nominee for Lender and Lender’s successors and assigns.  MERS is the beneficiary under this Security Instrument.”[4]

Language in a deed of trust ostensibly giving MERS “authority”  to collect the debt through foreclosure would read as follows:

“Borrower understands and agrees MERS holds only legal title to the interests granted by Borrower in this Security Instrument, but, if necessary to comply with law or custom, MERS (as nominee for Lender and Lender’s successors and assigns) has the right: to exercise any or all of those interests, including, but not limited to, the right to foreclose and sell the Property; and to take any action required of Lender including, but not limited to, releasing and canceling this Security Instrument. ”    

Even with this language in a deed of trust, MERS is not entitled to bring a foreclosure action unless it also has possession of the original Note.  Most likely MERS will assign the deed of trust to the person bringing the foreclosure action.

MERS involvement in foreclosures is more common when a trustee of a REMIC forecloses on a property.   These cases are more complicated because the Notes traveling in the secondary market are covered by a different set of rules called “negotiable instruments” under Article 3 of the Uniform Commercial Code.

When MERS is tracking Notes through several layers of “transferees” in the secondary market the Notes are transferred without an endorsement or in “blank”.  The ability to collect or enforce a Note indorsed in “blank” is not that much different from a Note transferred with an indorsement.[5] Transferring possession of the Note to a specific person (“to order”) or in “blank” (“to bearer”) creates a “holder” or “the person in possession of a negotiable instrument that is payable either to bearer or to an identified person that is the person in possession.” C.R.S. §4-1-201 (20).

Under both the Colorado UCC and Colorado foreclosure law, the person entitled to enforce a Note and the person entitled to bring a foreclosure action is the same person.   Colorado UCC § 4-3-301 provides that the “Person entitled to enforce” an instrument means (i) the holder of the instrument, (ii) a nonholder in possession of the instrument who has the rights of a holder…” Colorado foreclosure law § 38-38-101 provides the “person in actual possession or person entitled to enforec an evidence of debt may elect to foreclose.”

In the case of a Note transferred in “blank” and tracked through several layers of holders by MERS, the ultimate “holder of the evidence of the debt” should be a trustee of a REMIC or its agent.   A trustee is usually a large bank or federal lending institution and as such is entitled to special consideration as a “qualified holder”.

A “qualified holder” does not have to produce the original Note if it provides either a bond one and half times the value of the Note or a “copy of the evidence of debt and a certification signed and properly acknowledged by a holder of an evidence of debt” that:  1)they are a “qualified holder” pursuant to C.R.S.§38-38-100.3(20),  2) that “the copy of the evidence of debt is true and correct” and 3) that they promise to “indemnify and defend any person liable for repayment of any portion of the original evidence of debt in the event that the original evidence of debt is presented for payment” C.R.S. §38-38-101(1)&(2)

Similarly, a “qualified holder” does not have to provide the original deed of trust if it complies with the same verification procedure outlined above for Notes.

One possible justification for the above special consideration of big banks acting as trustees for large pools of loans in a security is the “Pooling and Service Agreement” which sets forth how Notes are transferred into a REMIC or mortgage backed security.

The language in a “Pooling and Servicing Agreement” provides for the transfer of possession of the original Note and deed of trust including loans registered with MERS that follows common law and Articles 3 and 9 of the UCC.

“In  connection  with the above  transfer and  assignment,  the Sponsor  hereby  deposits with the Trustee or the related Custodian, on behalf of the Trustee, with respect to each Mortgage Loan:
(i)   the original  Mortgage Note,  endorsed  without recourse (A) in blank or to the order of the  Trustee  or (B) in the case of a Mortgage  Loan  registered  on the MERS  system,  in blank,  and in each case showing an unbroken chain of endorsements
(ii)  the  original  Mortgage  and, if the  related  Mortgage  Loan is a MOM Loan,  noting the presence of the MIN and language  indicating that such Mortgage Loan is a MOM Loan,  which shall have been recorded (or if the original is not  available,  a copy),  with evidence of such recording  indicated  thereon (or if clause(w) in the proviso below applies, shall be in recordable form),
(iii) unless the Mortgage  Loan is assigned in the name of MERS,  the original  assignment  to blank, or the assignment  (either an original or a certified copy which may be in the form of a blanket  assignment if permitted in the  jurisdiction  in which the Mortgaged  Property is located) in blank or to “Citibank,  N.A., as Trustee”,  with evidence of recording with respect to each Mortgage Loan in the name of the Trustee  thereon (or if clause  (w) in the  proviso  below  applies or for  Mortgage  Loans with  respect  to which the  related  Mortgaged Property is located in a state other than Maryland, Tennessee,  South  Carolina,  Mississippi  and Florida,  or an Opinion of Counsel has been provided as set forth in this Section 2.01(b), shall be in recordable form),”[6]

CONCLUSION

 Securitization of loansThe securitization of residential loans has been going on for several years and it is only since the recent financial meltdown caused by these securities being populated with sub-prime loans or loans given with no documentation of ability to pay back the loan that MERS’ role in the securitization of residential loans has come to light.     Courts are only recently coming to understand and question MERS’ role in foreclosures.  There is no consensus among the states on the efficacy of MERS.   Some questions to ask if MERS is involved are listed below.

If the person bringing a foreclosure action is a trustee of a REMIC, MERS most likely tracked the Note on its journey into the security.  If MERS is involved, a request to see the actual Note is appropriate because there is a chance the Note has been lost or there has been a break in the chain of endorsements, which is a violation of the Pooling and Service Agreement.    Pay particular attention to the timing of the transfers because each REMIC has a deadline when residential loans can be inserted into the REMIC.

Chances are if MERS has been tracking the Notes, they are also listed as a “nominee” in the deed of trust and should execute an assignment of the deed to the “holder” bringing the foreclosure action.  I doubt that MERS would bring a foreclosure action on behalf of the “holder” but if they do, MERS would have to have a valid assignment of the Note.

As for MERS being both a “nominee” and a “mortgagee”, the idea that a principal can be its own agent does not square with agency law, which is a subject for another blog.

James Knowlton is a lawyer in Basalt, Colorado.


[1] “MERS is an innovative process that simplifies the way mortgage ownership and servicing rights are originated, sold and tracked. Created by the real estate finance industry, MERS eliminates the need to prepare and record assignments when trading residential and commercial mortgage loans.”  www.mersinc.org.

[2] See Peter M. Carrozzo, Marketing the American Mortgage: The Emergency Home Finance Act of 1970, Standardization and the Secondary Market Revolution, 39 Real Prop. Prob. & Tr. J. 765, 799-800 (2004-2005) (“standardization of mortgage documents created marketable commodities. Once mechanisms were in place for the secondary market to operate, events rapidly moved toward the ultimate goal: the creation of a security which has as its base land [and] yet which will be as freely transferable as stocks and bonds” (internal quotation omitted)).

[3] Real Estate Mortgage Investment Conduits (REMICs) are a type of special purpose vehicle used for the pooling of mortgage loans and issuance of mortgage-backed securities. They were introduced in 1987 and defined in the United States Internal Revenue Code (Tax Reform Act of 1986)(IRC 860).

[4] Colorado Single Family—FannieMae/Freddie Mac Uniform Instrument – MERS Form 3006 01/01.

[5] The UCC replaces the more common spelling of “endorsement” with the less common spelling “indorsement.”

[6] Pooling and Service Agreement, Article II, Section 2.01, STRUCTURED ASSET MORTGAGE INVESTMENTS II INC., Stearns ALT-A Trust II, Mortgage Pass-Through Certificates.